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There was obviously a ton of discussion of liquidity this week after repo rates rose a lot and the Fed conducted the first large scale repurchase agreements since the Great Financial Crisis. To explain what’s happening, we need to properly discuss Basel 3. THREAD 1/N
To quickly run through monetary policy basics, The Federal Reserve sets the overnight price of settlement balances and lets the quantity float 2/N
Banks need settlement balances to settle various liquidity requirements (a point we’ll get back to!) and settle payments. For payments to clear at par, the Federal Reserve must supply settlement balances **at some price** 3/N
The traditional“liquidity requirement imposed on financial institutions is called a “reserve requirement”. It is a ratio between an unweighted(or weighted) total of the bank’s bank deposit liabilities against the cash in their vault+the amount of settlement balances they own 4/N
This however is a simplification. What reserve requirements check for is the total amount of “reservable liabilities” at a given point in time and then say that a bank’s cash +settlement balances **two weeks in the future** must average to a given “required reserves” amount. 5/N
The reason this matters is that this type of liquidity requirement puts pressure on banks to borrow **end of day** and thus doesn’t prioritize banks having intraday liquidity. Many interpreted this as a bad thing (and indeed it did cause problems in the GFC). HOWEVER 6/N
The advantage of this system is it didn’t lean on hoarding liquidity. This system only ran into problems because of solvency concerns about other financial institutions. The solution was the Canadian system were the BoC serves as a “central counterparty”. INSTEAD 7/N
Anyway, this “limited settlement balance” system was kept stable by active and significant repos conducted by the Federal Reserve each day. This all changed in the GFC. Settlement balances became abundant and thus repos weren’t necessary. Reverse repos took their place! 8/N
A “repo agreement” is just when a central bank buys a treasury and agrees to sell it back to its “counterparty” later. It's a temporary injection of settlement balances. “Reverse repo” is the opposite. (intra-private sector repos happen but we’ll ignore their terminology) 9/N
Now here’s where the tricky part comes in. If all that mattered was the liquidity reserve requirement, we’d still have plenty of excess settlement balances and thus ample liquidity. But there are other liquidity requirements! And they showed up recently in Basel 3 10/N
The first of the two liquidity requirements that matter are the “liquidity coverage ratio”.The good news about these is treasury securities satisfy them just as much as settlement balances. In this sense,Budget deficits inject“LCR reserves”.If this was all we’d still be okay 11/N
BUT, and here’s the KEY: there’s a second sheriff in town. This is called “resolution liquidity”. These apply to “Global-Systemically Important Banks” or G-SIB. Remember the desire to have banks have “living wills”? This is part of that. 12/N
The idea here is that gigantic banks should be able to meet all their own liquidity requirements without borrowing in short term markets for 30 days. This gives time for central banks to respond 13/N
The problem is,by making a requirement based on intraday liquidity “resolution liquidity adequacy” is discouraging gross flows. The big banks are now incentivized to hoard liquidity.14/N
This means not absorbing treasury securities when it would otherwise be profitable. This also means that demand for settlement balances is rising intraday. As the demand for intraday liquidity rises and willingness to absorb treasuries fall, repo markets have been tightening 15/N
This wouldn’t be a problem if the Central Bank stepped in to be “dealer of last resort”. And this is why this week happened.The FRBNY on a technical level wasn’t used to doing large repo transactions to inject liquidity in a timely manner… and they kind of screwed it up 16/N
No big conspiracy theory, just … some technical hiccups. What really matters from this episode is it illustrates that just because settlement balances are “excess” relative to “reserve requirements” doesn’t mean they are excess against Basel liquidity requirements. 17/N
Since we’re returning to a “limited settlement balance” world, The Fed has two choices on its plate. Modify the resolution liquidity requirements to discourage the hoarding of liquidity (defeating the purpose) or supply settlement balances as needed. 18/N
Since the demand for settlement balances is more volatile in a world that hoards intraday liquidity, the best way to do this is “cap” repo rates by having the Fed set a max interest rate at which it will enter repo agreements.IOW, introduce a repo facility. 19/N
TLDR there isn’t “excess liquidity” anymore.We’re back to a“settlement balance limited”world.Basel 3 has imposed liquidity requirements that encourage hoarding and discourage buying treasuries.The Federal Reserve is still behind the curve at becoming“Dealer of Last Resort” 20/20
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