Increases in the interest rate paid on reserves are unlikely to prove a net
subsidy to banks, as the higher return on reserve balances will be offset by
similar increases in banks' funding costs. On balance, banks' net interest
margins will likely continue to decline when short-term rates rise.
Reverse repos as a tool to reduce bank reserves
Bernanke told congress the Fed has also been developing a number of additional
tools it will be able to use to reduce the large
quantity of reserves held by the banking system when needed. Reducing the
quantity of reserves will lower the net supply of funds to the money markets,
which will improve the Fed's control of financial conditions by leading to a
tighter relationship between the interest rate on reserves and other short-term
One such tool is reverse repurchase agreements (reverse repos), a method that
the Fed has used historically as a means of absorbing reserves from the banking
system. In reverse repos, the Fed sells securities to counterparties with an
agreement to repurchase the security at some date in the future. The
counterparties' payments to the Fed have the effect of draining an equal
quantity of reserves from the banking system.
Recently, by developing the capacity to conduct such reverse repos transactions
in the tri-party repo market, the Fed has enhanced its ability to use reverse
repos to absorb very large quantities of reserves. The capability to carry out
these transactions with primary dealers, using the Fed's large holdings of
Treasury and agency debt securities, has already been tested and is currently
available, according to Bernanke. To further increase its capacity to drain
reserves through reverse repos, the Fed is reportedly also in the process of
expanding the set of counterparties with which it can transact and developing
the infrastructure necessary to use its MBS holdings as collateral in these
As a second means of draining reserves, Bernanke said the Fed is also
developing plans to offer to depository institutions term deposits, which are
roughly analogous to certificates of deposit that the institutions offer to
their customers. The Fed would likely auction large blocks of such deposits,
thus converting a portion of depository institutions' reserve balances into
deposits that could not be used to meet their very short-term liquidity needs
and could not be counted as reserves.
A proposal describing a term deposit facility was recently published in the
Federal Register, and the Fed is currently analyzing the public comments that
have been received. After a revised proposal is reviewed by the board, the Fed
expects to be able to conduct test transactions in the spring of 2010 and to
have the facility available if necessary shortly thereafter.
Bernanke said reverse repos and the deposit facility would together allow the
Fed to drain hundreds of billions of dollars of reserves from the banking
system quite quickly. The question has been left unanswered as to under what
economic conditions the Fed would choose to do so. If the conditions include
good employment figures, the Fed's need to use this new option to drain
reserves from the banking system may not arise for a long time.
In the meantime, the scars of the financial crisis remain highly visible in a
key part of the US fixed income universe - the repo market. As a barometer of
borrowing by the financial sector, the size of the repo market peaked in early
2008 at nearly $4.3 trillion, before the demise of Bear Stearns revealed how
much major investment banks had depended on this short-term funding market to
finance their balance sheets.
In April 2010, the overall use of repo at about $2.5 trillion remains more than
40% below its peak. This is evidence showing how, in the wake of the Lehman
failure in September 2008, large dealers have cut back their balance sheets and
are now less reliant on short-term leverage. Instead, they are funding
themselves with long-term debt outside the repo sector. A reluctance by repo
lenders to accept lower-quality assets as collateral has also hit the market.
At the peak of repo activity in 2007 and early 2008, a sizeable portion of
collateral involved securitized mortgages and structured credit securities,
which subsequently collapsed in marked-to-market value as the mortgage and
credit bubble burst and credit markets imploded. The subsequent large drop in
repo usage partly reflects how credit standards have tightened, with only super
good-quality collateral being accepted by short-term lenders of cash.
The current lack of appetite for extending money to lower-quality collateral
via repo helps explain why the use of securitization among banks has not come
roaring back. Another factor limiting the use of repo financing is the current
low level of interest rates, which has resulted in some investors not lending
their holdings of bonds as the potential returns are too low. (See
The repo time bomb redux, Asia Times Online, December 5, 2009.)
Aside from the uncertainty of potential regulatory changes, the repo market
faces new challenges. Before the financial crisis, US investment banks ended
their financial years in November. That meant that the big repo dealers were
divided into two groups, with primary dealers reporting quarterly results one
month behind the big US investment banks. This split in reporting periods meant
that quarterly window dressing by financial institutions, whereby banks cut
borrowings and often buy Treasury bills and notes to shore up their balance
sheets, was spread out over several weeks.
Now, with all banks reporting on the same quarterly schedule, uniform window
dressing by financial institutions has led to a pronounced and coordinated drop
in the use of repo during these periods.
This potentially has big implications for financial markets and institutions in
the future as the financial crisis subsides. As all large banks now operate on
the same reporting schedule, it could leave investors withholding funds and
institutions scrambling for funds, as liquidity declines at the end of each
quarter. This may result in a mini liquidity crunch every three months.
The Fed's other tools
The Fed also has the option of redeeming or selling securities as a means of
applying monetary restraint. A reduction in securities holdings would have the
effect of further reducing the quantity of reserves in the banking system as
well as reducing the overall size of the Fed's balance sheet. But that would
reduce the money supply through quantitative tightening and drain liquidity.
Bernanke admitted that the sequencing of steps and the combination of tools
that the Fed uses as it exits from its currently very accommodative policy
stance will depend on economic and financial developments.
One possible sequence would involve the Fed continuing to test its tools for
draining reserves on a limited basis, in order to further ensure preparedness
and to give market participants a period of time to become familiar with their
operation. As the time for the removal of policy accommodation draws near,
those operations could be scaled up to drain more significant volumes of
reserve balances to provide tighter control over short-term interest rates. The
actual firming of policy would then be implemented through an increase in the
interest rate paid on reserves.
If economic and financial developments, such as expectations of rising
inflation, were to require a more rapid exit from the current highly
accommodative policy, however, the Fed could increase the interest rate paid on
reserves at about the same time it commences significant draining operations.
But Bernanke did not sketch out to congress a scenario that covered how the Fed
would handle stagflation, a very likely prospect in a jobless recovery.
Bernanke told congress he currently did not anticipate that the Fed would sell
any of its security holdings in the near term, at least until after policy
tightening has gotten under way and he claimed optimistically that the economy
is clearly in a sustainable recovery. However, to help reduce the size of the
Fed's balance sheet and the quantity of reserves, the Fed is allowing agency
debt and MBS to run off as these instruments mature or are prepaid over time,
Bernanke said. The Fed is currently rolling over all maturing Treasury
securities, but in the future it may choose not to do so in all cases. Left
unsaid is that while this policy will reduce the Fed's balance sheet, it does
this by adding to the national debt.
Bernanke said that, in the long run, the Fed anticipates that its balance sheet
will shrink toward more historically normal levels and that most or all of its
security holdings will be Treasury securities. Although passively redeeming
agency debt and MBS as they mature or are prepaid will move the Fed in that
direction, Bernanke said he may also choose to sell securities in the future
when the economic recovery is sufficiently advanced and the FOMC has determined
that the associated financial tightening is warranted. Any such sales would be
at a gradual pace, would be clearly communicated to market participants, and
would entail appropriate consideration of economic conditions. All things
considered, the fragile economy is expected to be under the intensive care of
the Fed for a long time.
Bernanke reported to congress that as a result of the very large volume of
reserves in the banking system, the level of activity and liquidity in the
federal funds market has declined considerably, raising the possibility that
the federal funds rate could for a time become a less reliable indicator than
usual of conditions in short-term money markets.
Accordingly, the Fed is reported to be considering the utility, during the
transition to a more normal policy configuration, of communicating the stance
of policy in terms of another operating target, such as an alternative
short-term interest rate. In particular, it is possible that the Federal
Reserve could for a time use the interest rate paid on reserves, in combination
with targets for reserve quantities, as a guide to its policy stance, while
simultaneously monitoring a range of market rates.
The Fed has long advocated the payment of interest on the reserves that banks
maintain at Federal Reserve banks. But such a step would have to be approved by
congress, which traditionally has been opposed to the idea because of the
revenue loss that would result to the US Treasury. Each year the Treasury
receives the Fed's revenue that is in excess of its expenses. The payment of
interest on bank reserves would, of course, be an additional expense to the Fed
and less revenue for the Treasury.
No decision has been made on this issue; the Fed says it will be guided in part
by the evolution of the federal funds market as policy accommodation is
withdrawn. The Fed anticipates that it will eventually return to an operating
framework with much lower reserve balances than at present and with the federal
funds rate as the operating target for policy.
Yet the structural echo of a long duration of high reserve balance coupled with
a zero interest rate will so condition dependency on monetary accommodation
that real recovery may not emerge for decades.
Bernanke told congress that the authority to pay interest on reserves is likely
to be an important component of the future operating framework for monetary
policy. For example, one approach is for the Fed to bracket its target for the
federal funds rate with the discount rate above and the interest rate on excess
reserves below. Under this so-called corridor system, the ability of banks to
borrow at the discount rate would tend to limit upward spikes in the federal
funds rate, and the ability of banks to earn interest at the excess reserves
rate would tend to contain downward movements.
Other approaches are also possible. Given the very high level of reserve
balances currently in the banking system, the Fed has ample time to consider
the best long-run framework for policy implementation. The Fed believes it is
possible that, ultimately, its operating framework will allow the elimination
of minimum reserve requirements, which impose costs and distortions on the
As market conditions and the economic outlook improve, the series of special
lending facilities to stabilize the financial system and encourage the
resumption of private credit flows have been terminated or are being phased
out. The Fed also aimed to promote economic recovery through sharp reductions
in its target for the federal funds rate and through purchases of distressed
Yet the economy continues to require the support of accommodative monetary
policies after 30 months of recession. The Fed claims it has the tools to
reverse, at the appropriate time, the currently very high degree of monetary
stimulus. Sounds a bit like Samuel Beckett's Waiting for Godot.
Next: The Fed's extraordinary Section 13 (3) programs
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.