Basel III is the global standard for bank regulation, but each country implements it in slightly different ways. Previous posts showed how the SLR and LCR create constraints that impact short-term rates, but different methods of implementing those regulations also affect markets. European banks calculate their leverage ratio in a way that has made their balance sheets significantly more elastic between quarter-end dates. This difference was a key driver of quarter-end dynamics in recent years. But that elasticity is going away in the coming months even as forever QE continues to fill bank balance sheet with reserves. In this post we recap the recent TGA deluge, review how European banks calculate their leverage ratio, and show why the impending end to this loophole will force much higher ON RRP participation.
Free Money Rained Down, and Some Banks Overflowed
Month to date around $400 billion dollars – including stimulus checks and tax refunds – were paid out of the TGA. At the same time money market fund assets continued their upward trajectory and increased $85 billion thus far in March. It’s unlikely that the investors were enticed by 0% (or lower) net yields, but rather their bank had no more space for them. They had to move money out and there aren’t many places to go.
In line with that observation, the drains for excess liquidity in the system are receiving more flow. ON RRP participation has trended higher in March as have volumes in wholesale overnight unsecured markets (as measured by OBFR), which is how excess liquidity is parked on the balance sheets of foreign banks. These are the two overflow drains of the system previously highlighted. Unfortunately, one of the overflow drains is going clog up in the coming months.
U.S. Daily Averaging vs. Eurozone Quarter-End Snapshot
European banks have been able to absorb excess dollar liquidity in recent years primarily because of how their leverage ratio is calculated (no FDIC insurance fees also saves a few bps). A leverage ratio limits the amount of assets a bank can hold for a given level of capital, but it can be calculated in different ways. In the U.S. (and the U.K.) the ratio is calculated based on the daily average of assets, while in the Eurozone it is calculated based on quarter-end snapshots. Some European banks take advantage of this by massively expanding the size of their balance sheet between quarter-end dates, and then quickly shrinking them on quarter-end date to “window dress” their leverage ratio. This activity is concentrated in short-term markets, as those activities could be quickly turned off heading into quarter-end and then turned back on afterwards.
In the prior QE period, European banks held hundreds of billions of excess liquidity that they pushed out every quarter-end date and then took back in afterwards. This affected markets on quarter-end in two ways: rates increased in markets where European banks were net lenders (short-term repo market), and rates decreased in markets where European banks were net borrowers (short-term unsecured). The chart below of tri-party repo market activity clearly shows this dynamic in 2016, where European banks reduced repo borrowing on quarter-ends and forced money market funds to park money in the ON RRP. The sudden withdraw of bank repo lending usually led to sharp spikes in repo rates on quarter-ends.
In the overnight unsecured markets this dynamic was responsible for the saw-tooth like pattern seen where rates would drop several basis points on quarter-end (and month-end, depending on the bank’s internal policies) as some European banks stopped borrowing from the market.
These dynamics were most pronounced when the level of liquidity in the banking system was very high, and a large proportion was held by foreign banks.
The Plumbing Is Different This time
In 2014, QE3 pushed bank reserves to new highs that were not exceeded until recently. Foreign banks opened up their elastic balance sheets and held most of the banking system’s reserves at the time. Their reserve holdings gradually declined as excess liquidity was drawn out of the banking system. Increases in ON RRP participation (hundreds of billions in 2016) and Foreign Repo Pool ($150b, shown below) came from declines in foreign bank reserve levels (that’s where the excess liquidity was, whereas domestic bank reserves were little changed over the period). Quantitative Tightening in 2018 continued to drain liquidity, but this time from both domestic and foreign banks. As excess liquidity in the banking system declined, so quarter-end effects also became less pronounced. (Note: innovations that allowed more efficient use of balance sheets – e.g. FICC Sponsored Repo – also play a role.)
This time around things are completely different. Almost all the excess liquidity is on the balance sheet of domestic banks. This is in part due to how the money entered the system – through massive fiscal spending that went directly into the accounts of the American public, who tend to bank with domestic banks. Temporary SLR relief may have also increased the willingness of large domestic banks to hold excess reserves. But as they reach balance sheet constraints new capacity will have to be found. Foreign banks expanded their balance sheet last time around, but they may not be able to this time.
The Bank of International Settlements saw the quarter-end distortions in markets, and they didn’t like it. They suggested in 2019 that all banks should also report daily average balances for repo beginning in January 1, 2022. The European Banking Authority accepted this recommendation, while also noting that it may expand daily averaging reporting to other markets frequently window dressed (overnight unsecured markets are the obvious candidate). The change in disclosure rules will likely make European banks less opportunistic with their balance sheet as they do not want to appear overly leveraged to investors (of course, it was an absurd loophole to begin with). Balance sheet adjustments are usually gradual, so the effects of this change should begin to show up several months before the 2022 deadline.
This means a big source of extra capacity in the banking system may be going away even as the system tries to accommodate $120b/month of forever QE. This structural change means there will soon only be one drain for excess liquidity – the ON RRP. In time, ON RRP participation could eventually reach hundreds of billions every day. In a sense, every day could be like a quarter-end in 2016.