There is a plumbing explanation for the conundrum of lower nominal yields and higher inflation. Many factors affect yields, but they are in part determined by who has money and the investment constraints they face. QE mechanically increases the investible “cash” of investors who are most inclined to buy bonds, and they have been buying bonds. In our two-tiered monetary system $1 of QE creates $2 of money – $1 of reserves (money for banks) and $1 of bank deposits (money for non-banks). On the reserves side, some banks have significantly changed their behavior and begun deploying their reserves into bonds. On the bank deposit side, the wealthy ended up with the bulk of the newly created bank deposits. The wealthy tend to spend their money on assets, and they appear to be rebalancing some of the deposits into bonds. In this post we show how low rates are pressuring banks into adding bonds to their growing regulatory liquidity portfolio, how the skewed ownership distribution of new bank deposits may be leading to more bond buying, and suggest that low yields may not be a reflection of economic conditions.Continue reading
The new FIMA Repo Facility helps patch up a weakness in the Fed’s global dollar safety net. Since the GFC, the Fed has assumed the role of lender of last resort to the off-shore dollar banking system through it’s FX Swap Facility. Foreign central banks (“CBs”) could borrow from the Facility and use the proceeds to backstop the dollar needs of banks within their country. This helps prevent dollar panics abroad, which would affect the Fed’s ability to control domestic dollar interest rates. The Facility covers virtually all major dollar users, except China. The dollar needs of Chinese banks are backstopped by the Chinese government’s large Treasury holdings. This set-up works, until the Treasury selling is so acute that the market malfunctions and everyone has trouble monetizing their Treasuries. In this post we review the role of the Fed’s FX Swap Facility and show how the new FIMA Repo Facility is largely a China Repo Facility designed to both strengthen rate control and the Treasury market.Continue reading
The Fed’s new domestic Standing Repo Facility (“SRF”) makes Treasuries more fungible with reserves and will thus slightly impact the composition of GSIB liquidity portfolios. Post-Basel III GSIBs are required to hold large High Quality Liquid Asset (“HQLA”) portfolios that in practice largely consist of reserves. Although reserves and Treasuries are equal under the letter of Basel III, regulators prefer banks to hold reserves because they are more liquid. This distinction was further highlighted last March when many investors had trouble liquidating their Treasuries. An SRF addresses this concern by allowing GSIBs to instantly convert HQLA securities to reserves. The primary mechanism through which the SRF impacts markets is thus through GSIB HQLA portfolios. An SRF means GSIBs can hold fewer reserves, and more Treasuries. In this post we review the SRF, show that reserve demand is not currently constraining GSIB HQLA portfolios, and suggest the SRF’s market impact will be slight.Continue reading
Domestic businesses have steadily increased their borrowings even though overall bank business lending appears to be declining. In general, businesses seeking to borrow money (bank deposits) have two main sources: banks or the debt capital markets. A bank loan leads to the creation of new bank deposits and increases the overall money supply, while issuing a corporate bond changes the ownership of existing bank deposits. These two markets for money operate under different constraints and serve different but overlapping borrower segments. In the past year, larger businesses rotated away from from banks to the capital markets while smaller businesses continued to borrow from banks. In this post we describe the two markets for money and show that together they show significant strength in the demand for money from domestic businesses.Continue reading
Bank reserves can never leave the balance sheet of the Fed, but that does not limit how they can be spent. Reserves are a form of money and can be spent on anything. However, banks transact with other banks in a different way than how banks transacts with non-banks. This is due to our two-tiered monetary system, where not everyone is eligible to hold reserves. For the cryptocurrency fans: this is the equivalent of a bitcoin holder able to pay another bitcoin address, but unable to send bitcoin to someone with only a Ethereum address. In this note I sketch out a few illustrations that should be helpful in understanding how this works in a bank-to-bank and bank-to-non-bank scenario.
Note: Although banks can spend reserves on anything, bank are heavily regulated in what they can buy. They cannot go out and load up on equities and high yield or other risky assets without violating risk and regulatory limits. Regulation and profitability, not reserves, is what constrains a bank’s balance sheet.
Bank to Bank Transactions
In this example a bank will purchase an asset – be it a Treasury, office building, car etc. from another bank. The transaction is essentially an asset swap, where Bank A swaps $100 in reserves for an $100 asset that Bank B holds. The aggregate balance sheet of the banking system does not change.
Bank to Non-Bank Transaction
In this example Bank A will purchase an asset from a non-bank, who banks with Bank B. Note that this results in the creation of bank deposits. The Non-Bank essentially converts his asset into bank deposits through the sale. Bank deposits are created when a bank creates a loan asset or buys something from a non-bank. Whereas the aggregate level of reserves in the banking system is unchanged, the aggregate balance sheet size of the banking sector is $100 larger. The spending of reserves by any individual bank does not change the aggregate level of reserves in the banking sector, but it does shift the distribution.
In practice, banks must hold a certain level of reserves to meet regulatory liquidity thresholds. For large banks, this is usually to meet the Liquidity Coverage Ratio. The LCR mandates banks to hold a level of high quality liquid assets like reserves, Treasuries, or reverse repo backed by Treasuries in proportion to their expected 30 day outflows. Banks that spend their reserve levels will thus only buy other HQLA assets like Treasuries or Treasury reverse repo. For example, in late 2018 JPM decided to invest a large chunk of its reserves into reverse repo. This was a time when repo rates (proxied by the Secured Overnight Funding Rate) rose comfortably above the Interest on Reserves paid by the Fed on reserves.
The level of commercial bank reserves is determined by the size of the Fed’s balance sheet, and the proportion of reserves that end up in the Fed accounts of banks. When the Fed purchases securities or makes loans, it creates reserves out of thin air to fund them. A $100 purchase of Treasury securities results in the creation of $100 in reserves. A $100 FX Swap loan also creates $100 in reserves. Reserves can only be created or destroyed by the Fed, but banks are not the only entities eligible to hold reserves.
Reserves can never leave the Fed’s balance sheet, but they can be shifted around the Fed’s balance sheet. Think of it as Bitcoin ledger, where Bitcoins are paid to other wallets but always remain on the ledger. Only entities with an account at the Fed can hold reserves, so the created reserves are shuffled amongst the different Fed account holders as payments are made. For example, when commercial bank A makes a payment to commercial bank B, then reserves are wired from bank A’s Fed account to bank B’s Fed account. The total level of reserves stays the same. Most reserves are held by depository institutions such as commercial banks or credit unions, but there are other notable entities that have Fed accounts. These other entities, such as the Treasury, can at times have large holdings of reserves. The level of reserves held by the banking sector decreases when reserves move into these other Fed accounts.Continue reading
We have a two tiered monetary system, where one type of money is used when transacting with the Fed and between commercial banks (reserves), and another type of money is use when transacting with everyone else (bank deposits). This note explains the two types of money, and how they interact with each other.
Reserves are an unsecured liability of the Fed that can only be held by entities with an account at the Fed. Think of it as a checking account at the Fed, except that deposits in the account can only be used to pay entities who also have a checking account at the Fed. Broadly speaking, only depository institutions like commercial banks or credit unions are eligible to have accounts at the Fed. But there are also other notable entities such as the U.S. Treasury, GSEs like Fannie Mae, and clearing houses like the CME. When these entities make payments to each other, they pay in reserves.
Since reserves can only be sent to entities who also have a Fed account, the total level of reserves in the financial system cannot be changed by account holders. Reserves can never leave the Fed’s balance sheet and are simply shifted from one Fed account to another on the Fed’s balance sheet. It is a closed system. The total level of reserves is determined by Fed actions, which create or destroy reserves. Reserves are created when the Fed expands its balance sheet by buying assets, and extinguished when those assets are repaid. One exception to this is that reserves can be converted to currency at the request of commercial banks. If a commercial bank needs $1 million in currency, it calls the Fed, who then sends an armored truck carrying $1 million in currency to the commercial bank. The Fed then deducts $1 million in reserves from the commercial bank’s Fed account.Continue reading