There is little risk of a crisis in the banking sector, but that does not mean there aren’t badly run banks. QE and Basel III have made the banking sector significantly more liquid and resilient such that a replay of the GFC is very unlikely. However, individual banks under poor management can still be subject to bank runs. At a high level, a bank has short-dated liabilities and longer dated assets. A well managed bank holds enough assets to meet potential outflows, but also manages its liabilities to avoid substantial outflows. This post reviews the basic liquidity problem banks face, shows that SVB was particularly poorly run, and suggests that higher rates and QT will challenge bank liquidity in the coming years.
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A tremendous credit boom took place in 2022 and it may not even be over. The combination of healthy banks, financially strong households, and attractive rates appears to have to led to a surge in bank lending. Banks and credit unions together created $1.5t in cash last year that likely has not yet fully filtered into economic activity. Recall, bank lending creates money out of thin air. Interestingly, higher interest rates have so far only shown very tentative signs of moderating the boom. This post reviews the credit boom of 2022, suggests it was due to the strong financial position of banks and households, and notes that it will be supportive of demand throughout the year.
Continue readingThe banking system is built on trust that the money one places in the care of others will be there when needed. This is as true for the retail investor with deposits at the local commercial bank, as it is for the sovereign with FX deposits at a foreign central bank. Hard earned trust is part of the magic that enables developed market sovereigns to massively deficit spend with limited consequence. The world happily holds their liabilities, be it in the form of deposits or sovereign debt. But that trust is weakened when sovereigns are seizing the assets of their own citizens and other sovereigns without due process of law. The liabilities of the banking sector and sovereign then cease to be risk free assets. Foreign sovereigns must now diversify as a matter of national security, and some citizens must now diversify as a matter of self preservation. This regime change can force a wild scramble into stores of value outside of the banking system including gold, real estate and even crypto.
Continue readingThere are around $2 trillion in pandemic savings held by American households that have yet to be spent. Despite a brief recession, fiscal stimulus supercharged American incomes the past year by maintaining wages through the PPP program, topping off incomes with stimulus checks, and boosting unemployment benefits. At the same time, Americans consumed less than usual as lockdowns limited spending opportunities. As noted by Clarida in two recent speeches (here and here), Americans have accumulated over $2t in pandemic savings that can continue to fuel aggregate demand. In this post we walkthrough how this figure is derived, sketch out the form and distribution of the savings, and suggest that its ‘helicopter’ source implies a further boost to inflation in the coming months.
Continue readingA structural change in the plumbing of the banking system is dampening the impact of monetary policy and may even make rate hikes inflationary. Rates hikes now directly increase the asset returns of banks while leaving their funding costs unchanged – effectively encouraging credit creation. This is because banks have shifted their funding structure away from rate sensitive money market funding to rate insensitive retail deposit funding. The shift is due both to Basel III raising the regulatory costs of money market funding and also the superabundance of retail deposits from pandemic fiscal spending. On the depositor side, the public is also unlikely to see the increases in deposit rates that would arise from a competition for funding. This means the opportunity cost of holding cash will remain low well into the hiking cycle. In this post we review the transition to an asset return implementation regime, show how it changes the incentive structure of banks, and suggest that rate hikes may not be effective in slowing down economic activity.
Continue readingThere 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 readingThe 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 readingThe 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 readingDomestic 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 readingBank 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.
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