Recent dislocation in the U.S. repo markets suggests regulations have effectively trapped big banks' liquidity and prevented them from taking advantage of the opportunity to lend at attractive rates.
Volatility erupted in the money markets in mid-September, with short-term borrowing rates spiking several hundred basis points above the target fed funds rates due to liquidity shortages. Goldman Sachs Group Inc. saw an opportunity to provide liquidity to clients by lending in the repo markets. But market observers have suggested that compliance with regulations such as liquidity stress testing and resolution planning kept other large banks on the sidelines even though they boast massive cash balances, low loan-to-deposit ratios, and stockpiles of high-quality liquid assets such as Treasurys and reserve balances held at the Federal Reserve.
JPMorgan Chase & Co. Chairman and CEO Jamie Dimon said on his company's third-quarter earnings call that the firm has $120 billion in cash held at the Fed, but he believes that balance is required under resolution, recovery and liquidity stress testing.
"Therefore, we could not redeploy it into [the] repo market, which we'd have been happy to do. And I think it's up to the regulators to decide they want to recalibrate the kind of liquidity they expect us to keep in that account," Dimon said on the call. He later addressed how liquidity regulations restrict not just the use of reserves held at the Fed, but also Treasurys and other liquid funds. "The banks are at the point now where they will not be able to redeploy a big chunk of that $500 billion that we have in all the markets when the time comes," Dimon said.
Dimon's comments might be surprising given the level of liquidity at JPMorgan and in the whole banking industry. The industry boasted a loan-to-deposit ratio in the low 70s at mid-year 2019, more than 15 percentage points lower than the level seen before the financial crisis. At mid-year 2019, JPMorgan, meanwhile, reported a loan-to-deposit ratio in the low 60s and a liquidity coverage ratio — which measures high-quality liquid assets over net cash outflows during a thirty-day period — of 113%.
The Fed also found in an August 2019 survey of senior financial officers that the industry seemed to think it had adequate reserves. In the survey, which covered 43 domestic banks and 34 U.S. branches of foreign banking organizations, institutions said the lowest comfort level for bank reserves would be $652 billion. That was notably lower than the $1.152 trillion in reserves that those banks held at the time. In the months that followed that survey while the markets were in turmoil, reserves held at the Fed only declined modestly.
Institutions in the senior financial officer survey have maintained that liquidity regulations are one of the most important factors when determining their comfort level for reserves, but most have shown a willingness to lend cash against high-quality liquid assets like Treasurys at rates above the level paid on excess reserves. Greg Hertrich, head of U.S. depository strategies at Nomura, highlighted in a recent note to clients that nearly 70% of respondents in the Fed's February 2019 senior financial officer survey said they would be willing to lend against HQLA in a range from as low as zero to as high 100 basis points over the interest paid on excess reserves.
The opportunity to lend at far more attractive rates presented itself in mid-September when benchmark rates such as the Secured Overnight Financing Rate, or Sofr, spiked to over 5%. Other repo rates reportedly almost hit 10%, offering lenders in the repo market outsized returns. But some banks remained on the sidelines even though economic conditions remained benign.
"The fact that individual entities are engaged in varying calculus around decisions related to funding is obvious, but it is also becoming clear that the maximization of trade economics is not the sole determinant for bank managers," Hertrich wrote.
This seems particularly true for the nation's largest institutions, which face higher levels of scrutiny over their liquidity. Regulations mandate that they determine how to generate cash in times of stress. Large banks prefer to meet that requirement by holding more reserves, as opposed to planning to sell hundreds of billions of dollars of other hiqh-quality liquid assets, including Treasurys, if the need arises.
The Fed seems to have recognized this much and has taken steps to inject liquidity into the market to bring funding rates back near target levels. The New York Fed has responded with overnight repo purchases of more than $50 billion per day on average between mid-September and Oct. 22.
On Oct. 11, the Fed announced plans to buy roughly $60 billion in Treasury bills each month starting in mid-October. The Fed plans to continue T-bill purchases through the second quarter of 2020.
Those announcements seem to have calmed the short-term funding markets for now, but further Fed intervention might be required to maintain future stability. If dislocations occur again, some market observers question whether banks will return as liquidity providers.
"We expect banks to adopt a cautionary stance, especially in instances of sudden and sharp volatility," Hertrich wrote. He added that changes to the interest rate paid on excess reserves likely would have a marginal impact on banks' willingness to be liquidity providers in the repo market given regulatory constraints. "The reluctance will be heightened at period-end (leverage ratio reporting) and year-end (GSIB surcharges are based on year-end balance sheet figures)."
If further dislocations occur and reserves held at the Fed decline, results of the Fed's senior financial officer survey suggest banks would look to replenish the reserve balances in the short term by increasing advances from Federal Home Loan Banks. In that scenario, banks that are more reliant on the FHLB for funding could feel more pressure as institutions look to refill their coffers.