(Bloomberg Opinion) -- People have drawn a lot of far-reaching conclusions from last month’s brief bout of turmoil in money markets. They see implications for bank regulation, for benchmark interest rates and even for the way the Federal Reserve implements monetary policy.
Actually, not much needs changing. But there are steps the Fed can take to make markets function more smoothly.
Here’s a recap of what happened. On a Monday in mid-September, a sudden shortage of cash — related to corporate tax payments and the settlement of a big Treasury auction — caused interest rates to spike sharply in the “repo” market, where participants such as banks, hedge funds and money-market mutual funds borrow and lend money against the collateral of securities. This, in turn, briefly pushed rates in the separate federal funds market, where banks lend money to each other, above the Fed’s target range.
The issue was easily addressed. First, the New York Fed stepped into the repo market, providing the cash needed to bring interest rates back to normal. And now, the central bank is purchasing $60 billion in Treasury bills each month, a policy that automatically increases the reserves that banks have on deposit at the Fed. This differs from quantitative easing, a stimulus policy that also involves buying securities, in that the Fed is focusing on short-term securities, rather than on buying longer-duration assets with the goal of driving down long-term interest rates. The Fed will purchase T-bills until it restores a buffer well above what banks need to meet their liquidity requirements.
Despite the Fed’s effective response, people keep talking about what went wrong. Bank executives — such as Jamie Dimon, CEO of JPMorgan Chase & Co. — say they couldn’t lend due to new liquidity rules, which require them to keep enough cash or easy-to-sell assets on hand to get through a crisis. Others say the incident casts doubt on the Fed’s plans to transition from Libor — the famously prone-to-manipulation benchmark interest rate used for loans and derivatives — to the secured overnight funding rate, which is based on actual trades in the repo market. Finally, some in Congress are calling into question the Fed’s monetary policy framework, in which the central bank sets interest rates more broadly by adjusting the rate it pays on bank reserves.
Let’s first consider the issue of bank regulation. As long as the Fed ensures that banks have plenty of reserves, liquidity rules shouldn’t cause any distortions. More importantly, they make the system safer and facilitate the resolution of big banks should they get into trouble. So they absolutely should not be rolled back.
That said, there is a problematic link between reserves and a separate regulatory requirement — that banks have a minimum ratio of loss-absorbing equity to total assets, including cash. When the Fed seeks to stimulate the economy by increasing reserves, the added cash can cause banks to inadvertently bump into this minimum leverage ratio, constraining their ability to lend and undermining the stimulus. This could be fixed by removing reserves from the calculation of the ratio — with an upward adjustment in the required ratio (excluding reserves) to ensure that the change didn’t weaken the system by reducing bank capital requirements.
As regards benchmark interest rates, it’s true that the repo turmoil made the secured overnight funding rate more volatile. The Fed has already addressed this problem by injecting more cash into the market. But it can do more: Set up a standing repo facility, which would lend against Treasury collateral at a rate slightly above the normal repo rate. This would establish a ceiling on rates and preempt any panicked scramble for cash by reassuring market participants that funds would always be available. As a result, SOFR would be more stable. This would help to ease the transition away from Libor, a deeply flawed benchmark that the U.K. Financial Conduct Authority has committed to phasing out by the end of 2021.
Finally, there’s the broader question of monetary policy. Once upon a time, the Fed managed interest rates primarily by adjusting the amount of reserves that banks had available to lend to each other in the federal funds market. That changed after the 2008 financial crisis, when it gained the power to pay interest on reserves. This allowed it to put a floor on the rates at which banks would be willing to lend, no matter how much cash they had on deposit at the central bank.
The new regime has three important advantages. First, it’s much easier to operate. The Fed doesn’t have to adjust the supply of reserves every day to keep the federal funds rate close to its target. It needs only to ensure that banks have plenty of cash. The interest rate on reserves will do the rest.
Second, it allows the Fed to provide as much cash as needed to combat financial stress. Under the old regime, the Fed couldn’t credibly commit to such an open-ended backstop, because the added liquidity could push the federal funds rate below its target – that is, the central bank could lose control of monetary policy. Now, with the interest rate on reserves acting as a floor, the Fed no longer has that constraint.
Third, it makes the banking system more efficient and safer. As long as the Fed provides ample reserves, banks will always have plenty of cash to facilitate payments. They also won’t need to do much lending and borrowing of reserves in the federal funds market — an activity that, under the old regime, created a lot of counterparty risk without much benefit.
To head off concerns in Congress and elsewhere, Fed officials should explain why the central bank pays interest on reserves, how the current monetary policy framework works and why it is superior to its predecessor. The more people understand, the less they’ll clamor for responses that won’t actually make the banking system and monetary policy work better.
To contact the editor responsible for this story: Mark Whitehouse at mwhitehouse1@bloomberg.net
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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