Zoltan Pozsar, one of our favorite economists, has written a new research piece “Shadow Banking: The Money View” (July 2, 2014). He has some fascinating ideas on the Fed’s reverse repo program and shadow banking.
Pozsar, formerly at the NY Fed and now with the US Treasury’s Office of Financial Research, is one of the few economists who really understand the securities financing world. In the paper he did an excellent job of presenting how the ecosystem works, especially the interaction between banking & shadow banking and public money claims (like US Treasuries) & private ones (like corporate bonds). It is well worth a close read. For example, one quote that caught our eye was:
“…a financial ecosystem increasingly funded by a relatively low number of well informed, very large and uninsured institutional cash pools is bound to be much less stable than one funded by a very large number of uninformed, small and insured depositors. This makes the rise of institutional cash pools a most fundamental, yet underappreciated source of systemic risk today…”
The author had some ideas on how to use the Fed’s RRP program to control shadow banking. We will focus on that part of the paper in this post.
So exactly how could shadow banking entities – and by this we assume he means the mutual funds who now can invest cash via the Fed’s RRP program – be regulated via RRPs?
“…reverse repos, if permanent, could become the basis of a liquidity-requirement regime for shadow banks. Much like banks have a minimum reserve requirement against the demand deposits they issue, minimum reverse repo balances could become the equivalent of minimum reserve requirements for shadow banks against the overnight repo and constant NAV liabilities they issue…Were such minimum reverse repo requirements to become the norm, the safety of shadow money claims would increase for two reasons: there would be more explicit official liquidity buffers backing them, and, operationally, shadow banks would have a standing account relationship with the Federal Reserve. Potential liquidity requirements for shadow banks, coupled with enhanced supervisory powers over shadow banks, could potentially be an important step along the Federal Reserve’s evolution toward becoming a “dealer of last resort”…”
So if the Fed required shadow banks to hold certain balances at the Fed (by executing a certain volume of RRPs), it would mimic the fractional reserve banking regime that (non-shadow) banks operate under. By mandating that shadow banks hold a certain percentage of their assets in repos with the Fed, it will bolster the capital structure of shadow banks – albeit at a cost of lower investment returns.
Is Pozsar also advocating extending the Fed’s “lender of last resort” safety net to the shadow banks on a permanent basis? He would have good company on this from Bank of England’s governor Mark Carney, although Carney stopped short of extending LOLR past non-bank dealers and central counterparties. (See Governor Carney’s June 12, 2014 speech at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London.). We wonder if US politicians are ready though.
“…RRPs could also give the Federal Reserve ability to set minimum haircuts on safe assets such as Treasuries – and the more collateral the Fed gives for the cash it takes in from shadow banks, the more collateral the rest of the ecosystem will have to pledge to shadow banks to lever up. Minimum haircut requirements could become the equivalents of minimum capital requirements for the backing of shadow money claims, and could give the Federal Reserve macro-prudential control over market-based credit cycles – a control it did not have pre-crisis when competition drove haircuts to bare bone minimums…”
The other tool that Pozsar writes about is the RRP haircut. Analysts have looked at the RRP program as a way to put a floor on interest rates, but few have seen it as a tool to manage haircuts. The Fed has an opportunity to set haircut benchmarks by moving haircuts on the RRPs. This could push against the Street’s pro-cyclical tendencies (e.g. in particular lowering haircuts when there is little volatility). It would, presumably, involve the Fed giving the shadow banks a haircut that, in turn, would put competitive pressure on the banks to transact on similar terms. By the Fed using this mechanism, it could sidestep the messy idea of mandating (minimum) haircuts on securities financing trades while still accomplishing the goal.
Do RRPs reduce the inter-connectedness of the financial system? If money market funds, for example, move from lending cash to dealers to just dealing with the Fed, then there is an argument that there is less systemic risk in the market. But if this were to happen each and every day, then the dealers would have to either reduce their balance sheets or find other sources of cash to finance their books. We wonder if this isn’t a case of “be careful what you wish for”?
Pozsar has clearly moved the debate on securities financing and RRPs, in particular, forward with his important paper. Well done.
Last week Oscar Huettner wrote a post in SFM on the Fed’s RRP program. “As spikes increase, is the Fed’s Reverse Repo Program beneficial or harmful to market functioning?” It is worth a read, especially in the context of Pozsar’s paper.