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Big-bank surcharge may lead to year-end money market volatility

The Federal Reserve's monthly purchases of $60 billion in short-term Treasury securities may not be sufficient to quell volatility in the money markets as the end of the year approaches.

But the Fed's planned asset purchases should tamp down some of the pressure that very short-term funding markets typically experience at year-end, a period when large banks pull back on their lending in repo markets and contribute to a funding crunch, analysts say.

They are likely to do so again in December, when a key regulatory reporting date will likely prompt major banks to hold onto their reserves instead of lending out to other financial institutions seeking short-term cash.

Similar pressures emerged in mid-September, when cash drained out of the U.S. banking system and interest rates spiked in overnight borrowing markets, which function as the plumbing for much of the financial system. As a result of the money market turmoil, the Fed's benchmark federal funds rate temporarily breached the top of its 25-point target range.

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The central bank has been making temporary liquidity injections into the banking system since, and it announced a more permanent fix this month, saying it will buy up Treasury bills and therefore boost bank reserves until at least the second quarter of 2020. The purchases are starting at a pace of about $60 billion a month and are a more aggressive response than analysts expected.

The Fed is signaling "it will do whatever it takes to control rates in the money markets," but it is unclear whether its actions will fully resolve the issue, JPMorgan Chase fixed income strategists led by Alex Roever wrote in a research note.

"While the Fed has taken steps to inject liquidity, we still think funding pressures could resurface as we head closer to year-end, particularly in December," the strategists wrote.

The issue partly goes back to major euro area and Swiss banks, which have a tendency to ease up on their U.S. repo market activity near the end of the year. The shift away from U.S. repo markets makes their balance sheets smaller and appear a bit less risky, a factor that is critical when regulators determine their capital requirements for the coming year.

The practice of managing down balance sheets around regulatory reporting dates is known as "window-dressing," and it appears to be "material" in repo markets, the Bank for International Settlements said in its 2018 annual economic report.

Window-dressing in repo markets is more evident among euro area and Swiss banks, which report their leverage ratios to regulators for a single date at the end of a quarter ⁠— rather than the average over the entire quarter, as U.S. and U.K. banks do. The latter reporting structure smooths out the data and helps remove "strong incentives to compress exposures around regulatory reporting dates," the BIS said.

Megabanks that regulators deem riskier are placed into a higher "bucket" of global systemically important banks, or G-SIBs. Those in a higher G-SIB bucket are subject to a higher G-SIB surcharge, meaning the amount of required capital they keep as a safeguard will be larger for the coming year.

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And since the G-SIB buckets are determined on a relative basis — meaning that one G-SIB's de-risking makes another bank look riskier — institutions will generally decrease their exposures at the close of the year.

"Many banks at year-end will attempt to actively manage down into a lower G-SIB bucket because they are aware ... that whatever G-SIB bucket they fall into will apply to them for the rest of the year," said Bain Rumohr, senior director of North American Banks at Fitch Ratings.

On their third-quarter earnings calls, JPMorgan Chase & Co. and Citigroup Inc. executives indicated they will look to manage their balance sheets during the fourth quarter to avoid being placed into riskier buckets. The two banks, along with the six other U.S.-based G-SIBs, are subject to a Fed-determined surcharge framework that tends to be tougher than the international standard.

JPMorgan executives "fully intend" to stay in their current G-SIB bucket next year, CFO Jennifer Piepszak told analysts.

Meanwhile, Citigroup CFO Mark Mason said being placed in their current G-SIB bucket again in 2020 "absolutely matters" for the bank, since it has implications for their capital rules.

"Where it makes sense to put on higher-returning assets, we're doing so. And where it makes sense to reduce those that are lower-returning, we're doing so," Mason said. "And it's that dynamic that we'll manage ... to get to where we need to be for the end of the year."