US Fed Reserve Worries About Liquidity Squeezes Beyond Money Markets

LAGOS (Capital Markets in Africa): Federal Reserve Chairman Jerome Powell and his colleagues have long recognized that some of the post-crisis rules that make the banking system safer also could end up making the financial markets more brittle.

That’s a risk that was highlighted by last year’s turmoil in the money markets and was flagged as far back as 2014 — at a Fed board meeting that approved tough liquidity requirements to make banks more secure and which Powell attended as a governor.

The Fed’s concern is that cash may not flow to where it’s needed most in a crunch — just as seemingly occurred in September when interest rates on repurchase agreements spiked even though some big banks had ample reserves to lend.

Two potential future flashpoints: the mortgage market, which is now dominated by shadow lenders dependent on short-term bank credit lines that could be pulled in a crisis; and corporate bond funds, whose holdings include illiquid assets that would be hard to sell to meet a rush of redemptions by spooked investors.

Fed Criticism
Powell has had to defend the Fed from sharp criticism for failing to take steps to anticipate the September strains in the money market and has been forced into bulking up the central bank’s balance sheet to try to ensure such tumult doesn’t happen again.

In a Feb. 6 letter to Powell, Democrat Senators pressed him for an explanation of what lay behind last year’s agitation in the money markets and the Fed’s response.

The lawmakers, including presidential candidate Elizabeth Warren, raised questions about whether the banks had gamed the market in hopes of winning some regulatory relief.

Read more: Democrats Query Powell on Regulatory Response to Repo Blowup

Powell told reporters on Jan. 29 that the Fed was well along in its review of the repo uproar, including looking at the possible role of regulations and supervisory practices.

“We’d be prepared to adjust those in ways that might encourage liquidity to flow more easily in the system, as long as it didn’t undermine safety and soundness,” he said.

Stress Tests
In a speech in New York on Thursday, Vice Chairman Randal Quarles outlined a number of potential steps the Fed could take, including tweaks to banks’ internal liquidity stress tests and a change in the time frame for calculation of their capital surcharge.

“Some fine-tuning does seem likely,” said Lou Crandall, chief economist for Wrightson ICAP LLC.

The repo ruckus came in the wake of other disruptions that raised questions about whether post-crisis regulations designed to make banks more secure also may have made financial markets less liquid.

Outgoing Bank of England Governor Mark Carney suggested in December that last year’s money-market turbulence in the U.S. could be symptomatic of deeper difficulties for the financial system.

“While it may be tempting to conclude this is an isolated incident, there have been others,” he said in a Dec. 17 speech. “These could signal a broader problem of discontinuous market liquidity in stress.”

Diminishing Depth
Market participants are certainly worried. A third of 650 professional traders surveyed by JPMorgan Chase & Co. toward the end of last year said diminished market depth was their biggest daily concern. It’s at least the second year in a row a lack of liquidity has been the number one source of anxiety among the group, who primarily buy and sell currencies.

Some market pros have pointed to the bank liquidity requirements that the Fed board adopted in 2014 as a potential culprit in last year’s turbulence in the repo market.

Policymakers don’t buy it.

In a Nov. 8 letter to North Carolina Representative Pat McHenry, Powell and New York Fed President John Williams said: “the liquidity coverage ratio likely did not play a significant role in the strains in money markets in mid-September.”

Cash Hoarding
But that doesn’t mean that Powell is oblivious to worries that the requirement — which is designed to ensure that big banks can survive a crisis — might have some unintended consequences.

The concern voiced by Fed policymakers back in 2014 — and now — is that the rule could have the negative side effect of encouraging banks to hoard cash in an emergency, depriving the rest of the financial system of funding when it’s needed most.

“I do worry about the situation we’re in now where everybody may feel required by the regulators, the markets or both to just sit on these big pools of liquidity, starving the system of the liquidity it needs under stress,” said Harvard Law School professor Daniel Tarullo, who was the central bank’s point person on regulation at the time.

The liquidity coverage ratio requires big banks to stockpile enough high-quality liquidity assets — reserves held at the central bank, for example — to survive for 30 days during a financial emergency. If an institution’s ratio falls below 100% for three straight business days — that is, it doesn’t have enough liquid assets on hand to fully cover anticipated cash outflows in the event of a pinch — it must submit a plan to regulators showing how it will correct that.

Run Risk
While supervisors might want the banks to allow that ratio to drop below 100% in a crisis in order to provide the rest of the system with cash, the financial institutions themselves might be unwilling to do so. Why? Because they’d be afraid that such a step would spook investors into thinking they were hemorrhaging liquidity and end up triggering a run.

“Our member firms have been very clear with officials, which is, if you say our LCR is this and we need to hold this much liquidity, that’s what we’re going to hold,” said Tim Adams, president of the Institute of International Finance, which includes the world’s biggest banks. “If in times of crisis you think we’re going to deviate from that, we’re not.”

That reluctance is at the heart of the issue.

“The problems in the repo market by themselves were no big deal but they highlight a risk,” said Mark Zandi, chief economist at Moody’s Analytics Inc. “Liquidity can shut down in an instant. It’s a major fault line” for the economy.

Source: Bloomberg Business News