At a crucial point in the pandemic recovery when the Fed is trying to engineer a “soft landing” amidst unsuspected banking turmoil, a prominent tool of monetary policy, the reverse repurchase agreement, may be adding to such banking stress in the eyes of some analysts. Reverse repurchase agreements, otherwise known as reverse repos, entail the Fed buying government securities from primary dealers, then selling the same government securities back the next day at a slightly higher price. Doing this en masse enables the Fed to reduce the amount of liquidity circulating in the primary market, thus raising interest rates and tightening monetary policy. The opposite of this, easily enough, is the repurchase agreement, and is usually executed by the Fed when it desires an expansionary monetary policy.
Source: Federal Reserve Board of Governors
Of course, the Fed has been resorting to reverse repos as a means of quelling persistent inflation, with over $2 trillion in funds being parked in its reverse repo facility since mid-2022 alone. This sheer volume of cash is, in turn, largely the product of the Fed’s $1.5 trillion quantitative easing program during the pandemic as well as the growing rate of interest paid on reverse repos relative to treasury yields over the last few months. Although certainly not the product of these two factors alone, lower interest rates and massive amounts of liquidity in the banking system have guided large swaths of credit, including 40% of money-market fund assets, into the reverse repo facility that is currently offering rates at around 4.8%, about the same as the current federal funds rate but “well above the rates on offer at most banks,” according to the Wall Street Journal’s Eric Wallerstein and Nick Timiraos.
With funds being absorbed into the facility, some banking analysts now worry that there’s a large opportunity cost involved as banks try to pan off the flames of turmoil ignited by previous collapses in March. While allowing funds to circulate around the banking system may obviously help usher in some much needed liquidity for banks to fall back on in case of a fear-induced increase in withdrawals, “What’s different this time,” in the words of former Federal Reserve Bank of New York President William Dudley, “is the money-market funds aren’t really as good at recycling money back into the banking system.” This is because of what’s known as the “supplementary leverage ratio,” a reserve requirement for banks in which a certain percentage of reserves must be held relative to their total leverage exposure. What the ratio means is that if the liquidity from reverse repos were to be recycled back into the banking system, no bank would be willing to hold on to some of it as excess reserves, as banks are already required to hold on to a great deal of reserves under the supplementary leverage ratio (SLR) that has been standing in place over the last decade.
In total, while money has been drawn in from money-market mutual funds into the reverse repo facility where it sits and earns interest, because of both the high interest that the facility pays as well as banks’ lack of demand to hold on to additional liquidity thanks to the SLR, the invisible hand may not be in full function in the banking system. Banking turmoil would suggest that banks would want to hold on to excess reserves, but instead, a hefty opportunity cost remains in place that prevents them from doing so.