U.S. banks face trillion-dollar reverse repo headache By Reuters

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – The trillions of {dollars} in in a single day money tucked away each day on the Federal Reserve may flip into a significant headache for banks that would squeeze their stability sheets and impair their skill to lend.

The Fed’s reverse repurchase facility (RRP) has attracted a wide selection of market individuals, serving to mop up extra liquidity within the monetary system. Led by cash market funds, quantity on the reverse repo window has topped $2 trillion for 39 straight days.

The Fed is paying a document reverse repo charge of two.3% following its 75-basis-point rate of interest hike final week. Barclays (LON:) expects each day reverse repo ranges to hit between $2.8 trillion and $3.0 trillion by the tip of the 12 months.

Traders are successfully taking deposits away from banks and placing them into authorities cash market funds, which make investments primarily in Treasuries and repos. These cash funds, in flip, funnel the money to the Fed’s in a single day window.

Repo allocations from authorities cash market funds have elevated to just about 40% of their property at present, from round 30% in the beginning of the 12 months, Barclays stated.

The Fed will shrink its stability sheet by $95 billion per thirty days from September, accelerating “quantitative tightening,” which began in June. The priority is that the outflow of deposits from banks into cash market funds may cut back financial institution reserves at a fast tempo that would hinder lending actions to monetary markets and the broader economic system.

GRAPHIC: Fed Steadiness Sheet and Financial institution Reserves (https://fingfx.thomsonreuters.com/gfx/mkt/byprjwzxbpe/Fedpercent20balancepercent20andpercent20bankpercent20reserves.PNG)

The decline in financial institution reserves may additionally result in a spike within the repo and efficient fed funds charge much like what occurred in September 2019 when financial institution reserves dwindled on account of heavy withdrawals for tax funds and settlement of Treasury purchases at auctions. That compelled the Fed to offer further reserves to the banking system.

“The drift of reserves into cash market funds and away from banks represent motion of cash away from monetary markets,” stated Matt Smith, funding director at asset supervisor Ruffer in London, which has $31 billion in property underneath administration.

For now, financial institution reserves are nonetheless thought of plentiful at $3.3 trillion, however the decline has been fast, some market individuals stated. From a peak of practically $4.3 trillion in December final 12 months, financial institution reserves have declined about 23%. Within the Fed’s earlier quantitative tightening (QT), $1.3 trillion in liquidity was withdrawn in 5 years.

To make sure, there are different components which have contributed to the decline in financial institution reserves, akin to asset re-allocations and mortgage demand, analysts stated.

MONEY MARKET FUND ASSETS

Authorities cash market fund property have been pretty regular as of July 27, at $4.025 trillion, up about 0.1% from per week earlier, information from the Funding Firm Institute confirmed. The shift of deposits to cash funds has been a gradual course of.

“The Fed’s QT will shrink its stability sheet rapidly. However financial institution reserves are set to fall a lot quicker as money shifts out of financial institution deposits to government-only cash funds. We count on cash funds to place this money within the RRP,” wrote Joseph Abate, managing director at Barclays, in a analysis be aware.

Expectations that the U.S. Treasury will improve invoice issuance for fiscal 12 months 2023, which begins in October, may assist ease the surfeit of inflows into the reverse repo window, analysts stated.

Abate estimated that financial institution reserves will fall to $2.3 trillion this 12 months, perilously close to what he termed banks’ “minimally ample stage” of $2 trillion, because the exit of deposits begins to weigh on their stability sheets.

But for a lot of large banks, these deposits are undesirable anyway.

Because the Fed’s stability sheet elevated with quantitative easing through the pandemic, so did financial institution reserves deposited on the central financial institution. As soon as reserves reached a stage at which banks weren’t prepared to soak up the regulatory prices on their stability sheets, they began turning deposits away.

The Fed in April 2020 briefly excluded Treasuries and central financial institution deposits from the supplementary leverage ratio (SLR), a capital adequacy measure, as an extra of financial institution deposits and Treasury bonds raised financial institution capital necessities on what are seen as secure property.

However the Fed let that SLR exclusion expire and large banks needed to resume holding an additional layer of loss-absorbing capital towards Treasuries and central financial institution deposits.

“Banks are nonetheless not eager to extend deposits on account of regulatory prices within the absence of SLR reduction and need to liberate their stability sheet,” stated Imran Siddiqui, portfolio supervisor at Mosaic Capital. “In a refined means, they’re sending a message to the Fed to offer some type of everlasting SLR reduction.”

Ought to the Fed tweak the SLR and provides banks respiratory room on regulatory prices, that ought to push these monetary establishments to just accept extra deposits and assist stabilize reserves. The Fed earlier this 12 months stated it might evaluate this leverage ratio, however has but to publish a proposal.