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Why the U.S. Repo Market Blew Up and How to Fix It

Why the U.S. Repo Market Blew Up and How to Fix It

(Bloomberg) -- To keep markets running smoothly at the end of 2019, the U.S. Federal Reserve pumped half a trillion dollars into an obscure but crucial part of the global financial system that suffered a seizure several months ago. But what will it take to keep that funding market, known as repo, out of news headlines in 2020? Remedies from looser bank regulation to a permanent backstop at the Fed are being debated, even as views differ over what caused the ruckus in the first place.

1. What happened?

The repo market is where high-quality securities are swapped daily for trillions of dollars of cash, making a wide range of transactions easier. Repo (short for repurchase agreements, which amount to collateralized short-term loans) jolted Wall Street in mid-September when the amount of cash available dropped just as the demand to borrow it jumped, driving interest rates sharply higher.

2. Why did that matter?

For one thing, it brought back bad memories of the grim days in 2008 when the repo market froze up amid fears of cascading bankruptcies. We’re not in the midst of a credit crisis today -- this situation is more about a scarcity of available cash as the market adjusts to the post-crisis world -- but the implications of a dysfunctional repo market are big. Volatility in short-term lending rates can derail the Fed’s efforts to keep interest rates low and raise questions about its ability to steer the economy. Sustained turmoil can push up the U.S. government’s borrowing costs, which can in turn lift rates throughout the economy and around the world.

3. Why did it happen?

Some believe several catalysts happened to land at the same time and push in the same direction. A big swath of new Treasury debt settled into the marketplace, landing on dealers’ balance sheets just as cash was being sucked out by quarterly tax payments companies needed to send to the government. However, the strains persisted even as the Fed injected liquidity, leading many to suspect a broader issue was at work: cash had gotten too scarce in the financial system. The Fed has since worked to replenish reserves by purchasing Treasury bills. But some observers have also pointed out that big banks didn’t step in to ease the problem.

4. What’s that about?

Typically, such crunches present an opportunity for banks with funds to spare to lend some out, reaping a profit from the higher rates. Federal Reserve Chairman Jerome Powell in October expressed surprise that banks didn’t do more. Jamie Dimon, the head of the biggest U.S. bank, JPMorgan Chase & Co., has argued that post-crisis rules tied his hands.

5. What does Dimon say happened?

He says that rules adopted since the 2008 financial crisis stake too many claims on bank reserves -- their spare cash -- making it hard to put them to more-profitable use. In an October earnings call, Dimon said he believed that the cash the bank had at the central bank was earmarked for meeting those new regulatory requirements. As a result, it couldn’t be plowed into the repo market, though “we’d have been happy to do it,” he said, adding that he believed a lot of his peers were in a similar position.

6. What’s he talking about?

Since the crisis, new rules have curbed banks’ riskiest behaviors on a range of fronts. But the measures that have drawn the most attention in this repo episode are those meant to stop banks from running out of funds if a market shock makes them less willing, or able, to lend to each other. The Fed’s December survey of senior credit officers at the primary dealers -- its inner circle of counterparties, which includes JPMorgan -- highlighted two rules that impose the highest standards on large or globally interconnected banks. The first, known as the supplementary leverage ratio, is a capital rule requiring banks to maintain sufficient cash and stock in proportion to their overall assets. The second, the liquidity coverage ratio, requires them to hold enough cash or cash-like assets to tide them over for 30 days -- in other words, an amount roughly equivalent to the cash outflows they’d expect over that time. Those deemed global systemically important banks (or G-SIBs), of which JPMorgan is the largest, must also hold an extra chunk of capital as a buffer.

7. Is that the only liquidity issue?

No. Powell and U.S. Treasury Secretary Steven Mnuchin have focused on a related issue, something called intraday liquidity. Before the crisis, banks were allowed (under some conditions) to run “daylight overdrafts” in their accounts with the central bank within the course of the day, to cover any gaps between big payments and settlements as they came along. Banks would then net out anything owed around the close of business. Over the last decade, the Fed has nudged banks toward settling those transactions as they arise instead of waiting till the end of the day.

8. How could that have caused the problem?

That intraday settlement, some banks argue, means sharper swings in their reserves during the day, which makes it hard for them to commit cash elsewhere. A more flexible stance from the Fed on overdrafts might help at the margins, but it may not satisfy banks angling for regulators to lower their reserve requirements. Goldman Sachs Group Inc. strategists are among those who see pressures building from “bottlenecks” in the flow of funds through the financial system, temporary shortages that can get worse when banks hoard cash to prepare for regulatory reviews, most notably around year-end.

9. Do others agree?

The answers from outside the banking community range from possibly to absolutely not. Critics say banks are using the repo turmoil to lobby for the rollback of regulations they’ve never liked at a time when Mnuchin and President Donald Trump have focused on loosening the reins on U.S. industry. That’s what Elizabeth Warren, the Massachusetts senator who’s angling to be the Democratic nominee to run against Trump, contended in a recent letter to Mnuchin. But Daniel Tarullo, a former Fed governor who helped put some relevant regulations in place, grants that big banks like JPMorgan and Citigroup Inc. have been asked to be “the liquidity insurers for the entire financial system.”

10. What does the Fed think?

One reason Powell expressed surprise is that the Fed’s survey of the big banks on their liquidity suggested they had more room to maneuver. While only the overall numbers are publicly released, the Fed can see individual submissions, and these from August -- just before the repo chaos -- suggested some of the biggest banks’ reserves weren’t close to strained. Vice Chair Randal Quarles conceded that Fed bank supervisors may have contributed to the strain by creating an impression that lenders should prize cash over U.S. Treasuries when fulfilling regulations, and he said the agency is examining that possibility. Powell declared Oct. 30 that a further rewrite of capital or liquidity requirements was unlikely, but that the Fed’s stance on daylight overdrafts might be worth revisiting.

11. Who gets to decide this?

Mnuchin chairs the interagency Financial Stability Oversight Council, which called on its member regulators in December to gather information about what’s going on with the repo market. One of its members, Powell, arguably has the most on the line here. He’s the head of the institution that’s now single-handedly propping up a market at the heart of the U.S. financial system, injecting hundreds of billions of dollars of temporary liquidity and buying $60 billion of T-bills a month to restock reserves.

The Reference Shelf

  • Former New York Fed President Bill Dudley opines on what the central bank can do.
  • The repo market’s liquidity crisis has been a decade in the making.
  • Recent stories on regulatory rollback so far, here and here.
  • A research paper on post-crisis bank regulations and liquidity.
  • Fed Vice Chair Quarles on the evolution of macroprudential regulation.
  • Former Fed Vice Chairman Stanley Fischer on the resolution framework for banks.

To contact the reporters on this story: Emily Barrett in New York at ebarrett25@bloomberg.net;Jesse Hamilton in Washington at jhamilton33@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, ;Jesse Westbrook at jwestbrook1@bloomberg.net, John O'Neil, Nick Baker

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