Sheila Blair, former head of the FDIC and now head of the private, nonpartisan Systemic Risk Council wrote an article in the July 24th Wall Street Journal “The Federal Reserve’s Risky Reverse Repurchase Scheme”. She has joined a group of regulators and former regulators who have some hesitation about the Fed’s RRP program.
“…The Fed began the program in September as a way to test a potential new tool for raising interest rates whenever that day arises. Obviously, no counterparty would be willing to lend funds into the market at a rate cheaper than that paid by the Fed. So by raising the overnight reverse repurchase rate, the Fed can raise the floor rate at which their counterparties are willing to lend to other, less safe, borrowers…”
So far, so good. The RRP program cleverly created a way for the Fed to initially put a floor on overnight rates and then a mechanism to move rates up as and when. With banks in a massive surplus reserve position, Fed Funds becomes a meaningless policy tool and RRP can step in. Should the system-wide reserve surplus go away, Fed Funds might work for the Fed, but we are not holding our breath (especially with IOER at its current above market level). The Fed is not going into wholesale QE liquidation mode anytime soon, so the reserves, which the QE purchases generated, will be some time before they are drained. But all that liquidity sloshing around the system makes managing interest rates pretty difficult.
It also puts additional funding discipline on the banks, knowing that cash could move to the RRP and catch them short.
But there are detractors who fear some unintended consequences, including Blair:
“…The mere existence of this facility could exacerbate liquidity runs during times of market stress. Borrowers in the short-term debt markets will have to compete with it for investment dollars and all, to varying degrees, will be viewed as higher risk than lending to the Fed. Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers.
Nonfinancial companies could find themselves unable to find buyers for their commercial paper. Banks could confront a sudden outflow of deposits, particularly those that are uninsured. Even the U.S. Treasury—traditionally viewed as the safest harbor—could see its borrowing costs spike as investors decide that the Fed is even safer…”
This part confuses us. In a crisis, investors will be scrambling for safe assets. We really don’t think that is ever going to change. Is the argument that investors should not venture far from the safe asset class so in a crisis there is no need to make a mad dash back? That is going to have long term effects on the economy that are not positive. We are not suggesting that investors should depend on getting bailed out when they buy risky investments. But the RRP program really isn’t about that.
Saying that the system may destabilize by virtue of access for “shadow banking” entities like money market funds & the FHLB to a place to park cash seems hard to swallow. Regulations, including the most recent MMF rules, have imposed significantly greater risk management discipline on cash investors. Having a risk-free investing option like the Fed RRP when other short-term safe assets (such as T-Bills that are a shrinking percentage of Treasury issuance and) are harder to find is a good thing. Is the premise that fire sales by investors of assets that become risky need to be prevented by taking away safe investment alternatives?
As an aside, we read all the time about the spikes in RRP use over statement dates. That is much more worrying if the RRP is being used to camouflage risk taken by participants. Decent risk reporting should be in place to allow investors to know that, hey, not all of your money all of the time is at the Fed.
This is a healthy debate and we look forward to it continuing.
We also suggest you to read our July 7th post on Zoltan Pozsar’s paper “Shadow Banking: The Money View” (July 2, 2014). He had some very smart ideas on how the RRP program could be used to control Shadow Bank leverage.
Apologies if the WSJ link isn’t working. It is behind their paywall.