Fed should prepare for autumn financial plumbing problem


Federal Reserve updates

Normally, if you are a senior Federal Reserve official, in past years you could look forward to the Kansas City Fed’s late August monetary symposium in Jackson Hole, Wyoming. There you could enjoy unbuttoned chats with peers while basking in the mountain air of the richest town in America.

Instead, this weekend’s Jackson Hole symposium will be a virtual affair partly due to the nasty effects of the Delta coronavirus variant causing a surge in Covid-19 cases.

The bankers might miss those mountainside moments of relaxation. Fed board members have plenty to worry about given that US stock prices are touching historical highs, just as inflationary pressures course through the economy. If any serious market instability does occur this autumn, the traditional season for financial disasters, the Fed will be in the spotlight.

I think the Jackson Hole party planners should have focused this meeting on some immediate monetary stability issues. Frankly, few will remember any worthy Fed comments about battling climate change. But what will the Fed do should the world’s financial plumbing start to rattle?

Already, there are some worrisome gurgles in the system. The Fed has concentrated on making sure US banks have lots of reserves on deposit in their accounts. Yet there are trillions of outstanding transactions around the world that are not, directly, funded by US bank lending. And these have been getting more expensive and uncertain in recent months.

The international monetary system increasingly depends upon the availability of collateral to back trillions of dollars in foreign exchange swaps or interest rate swap agreements. These support trade and investment. Regulators want any participants to guarantee their contract performance by pledging “pristine” assets, cash or equivalents not used elsewhere as collateral. Very often US Treasury bills are required, but also European governments’ short-term debt instruments or, occasionally, gold.

For the Fed, the most important source of liquidity are those reserves it has on deposit, or the nearly $1.4tn it holds in overnight reverse repurchase (reverse repo) agreements with, say, money market funds or banks. Reverse repos allow institutions to borrow using high-quality collateral, like US Treasury bills.

However, those reserves and reverse repos require an account at the Fed. They cannot be re-lent prior to maturity to earn fees and attract other business. That requires collateral such as Treasury bills.

These collateral chains provide a critical source of liquidity in international markets. Manmohan Singh, a financial collateral expert at the IMF, has researched this subject. The international liquidity provided by the relending of these pristine assets shrank dramatically after the 2008 financial crisis.

How much collateral is re-used within the system provides a measure. The world’s largest dealer-banks held $10tn of pledged collateral in 2007, while sourcing just $3.8tn from hedge funds and securities lending, for a re-use ratio of 3.0 times, according to Singh.

By 2016, that pledged figure had fallen to just $6.1tn compared with $3.3tn of collateral sourced, dropping the re-use ratio to 1.8 times. Fewer institutions trusted their counterparts to return this collateral, contributing to financial system deleveraging. Effectively, less credit was available.

Eventually, the mutual confidence returned. By the end of 2020 this re-use ratio had risen to 2.5 times, still below the heady days of 2007.

Unfortunately, we only get this trend data retrospectively. So we must infer what is going on today from market prices for Treasury bills and other popular sources of collateral.

But there is another complication. The publicly available supply of Treasury bills has declined. A debt ceiling imposed by the US Congress has limited issuance. Moreover, the Fed’s asset purchases and demand from major banks have also reduced supply. As an indication, yields on one-month Treasury bills have fallen this year.

This suggests more demand for pristine collateral. Though we do not have the data yet, the relending ratio may be contracting again as institutions worry more about counterparties, suggesting tightening credit conditions.

Market oddities, such as the August 10 gold price plunge, hint at system tension. Some gold market and central bank experts believe a sudden liquidation of gold collateral occurred when an institution could not provide enough Treasury bills.

I would suggest an extra agenda item for Jackson Hole. The Fed should commit to lending the market some of its holdings of $326bn of Treasury bills in the event of an autumn collateral shortage. That would provide some extra liquidity for the world’s financial plumbing.


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