The Fed as the borrower of last resort?

Economics textbooks teach that one of the roles of the central bank during a financial or economic crisis is to act as a “lender of last resort” in the short term: that is, when the financial system risks getting stuck in a way that can lead to a vicious cycle of expanding defaults – such as those who cannot get revolving loans are unable to repay others, who also cannot renew their loans, and son on – the central bank offers short-term credit.

When the panic passes, the central bank’s loans of last resort are repaid: indeed, because the central bank was the only one willing and ready to provide large-scale loans during the crisis, it may even end up gaining money. interest money she takes on these loans. Often, some companies will eventually go bankrupt in the aftermath of the crisis, but the goal of a lender of last resort policy is not to bail out specific companies completely or on a large scale. Instead, the goal is to keep the market as a whole from melting away.

Over the past decade or so, the Federal Reserve has transformed the way it conducts its monetary policy, and recently some of the new policy seems to involve acting like a borrower of last resort. Richmond Fed’s Kyler Kirk and Russell Wong explain the situation in “The Borrower of Last Resort: What Explains the Rise of ON RRP Facility Usage?” (Economic Note, December 2021, n ° 21-43).

The starting point here is that when the Federal Reserve conducts its monetary policy, it seeks to control a specific interest rate called the “fed funds” rate, which can be thought of as a rate at which deposit-taking institutions like banks are charged. ready to make very short transactions. – term and low risk loans between them, often with the aim of settling accounts at the end of a business day.

The main method the Fed uses to affect this interest rate is to change the interest rate it pays banks on reserves that banks hold at the Fed. But a secondary backup method is to use the ON RRP, which stands for the Fed’s Overnight Reverse Repo. For an overview of the ON RRP and how it works, here’s a good place to start. But for current purposes, the key is that ON RRP allows large financial players, such as money market mutual funds as well as banks or pension funds, to lend money to the Fed at very low cost. short term and therefore low risk day to day. What is special is that the amount of Fed borrowing via the ON RRP exploded in 2021. Kirk and Wong explain:

The idea is that the ON RRP facility gives short-term funding market participants the risk-free overnight option of lending to the Fed at the guaranteed ON RRP rate. Thus, other lending rates, such as the federal funds rate, will be higher than the ON RRP rate. … In the original design, ON RRP was a safety net, as market participants had to lend to banks or others (via federal funds, pensions, wholesale deposits, commercial papers, etc.) before to lend to the Fed. This was the case at the start of the pandemic: daily use of ON RRP averaged $ 8.7 billion from March 2020 to March 2021. However, use of ON RRP increased steadily after March. 2021 and reached an all-time high of $ 1.6 trillion in September 2021. To an oversupply of non-bank savings that is not intermediated by banks or absorbed by T-bills, which eventually flowed into the ON RRP facility. The Fed becoming the borrower of last resort has raised concerns about the functioning of the US banking system during the pandemic.

In case this drop of text is a bit difficult to read, let me go over the highlights once more. The ON RRP was designed as a safeguard for short-term overnight lending. But from March 2021 to September 2021, that backup grew from $ 8.7 billion to $ 1.6 trillion. Anything from a few billion to over a trillion is a huge deal. Apparently, there is about $ 1.6 trillion in funds that large-scale market participants want to lend on the short term, overnight, and the Fed is the only party in the market willing to be the borrower – l borrower of last resort, if you will. .

Here are some factors going on behind the scenes. Start by considering money market mutual funds. These funds are required to only hold very liquid short-term assets, so that they can easily fund withdrawals. When the pandemic hit the economy in March 2020, more and more investors wanted the security and flexibility of holding assets in a money market mutual fund, so as you can see in the figure below- below, the holdings of these funds increased by more than $ 1 trillion. These additional assets were largely held in US Treasuries, as the upward leap in the green area of ​​the figure shows. But from April 2021 and since then, the holding of money market funds has changed. Instead of holding US Treasuries, money market funds now hold well over $ 1 trillion in the Federal Reserve’s Overnight Repo (ON RRP) facility.

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What is behind this spectacular rise and fall in US Treasuries? The story behind the scenes is that when the pandemic recession hit, the US Treasury felt it needed more liquid assets, in the event of a bank or financial panic. But from spring 2021, the Treasury began to reduce its holdings of these assets. As Kirk and Wong explain:

In particular, the Treasury drained reserve balances from the General Treasury Account (TGA), which is the reserve account maintained by the Treasury to make and receive payments in the banking system. The Treasury reduced this account with the Fed by issuing fewer Treasuries, freeing these reserves into the banking system. Before COVID, the TGA maintained a moderate balance that averaged $ 290 billion in 2019 and varied depending on financial conditions and government spending. However, due to the uncertainty surrounding the COVID-19 pandemic and the scale of the budget response, the Treasury increased the TGA balance from around $ 380 billion in mid-March 2020 to an amount an unprecedented $ 1.6 trillion in June 2020. This rapid increase was mainly facilitated by an increase in the outstanding treasury bill from $ 2.56 trillion in March 2020 to over $ 5 trillion in June 2020 The Treasury maintained the high TGA balance and the supply of T-bills until February 2021 before normalizing through a reduction in the supply of T-bills. Normalization of the TGA took the TGA from over $ 1.6 trillion in February 2021 to less than $ 100 billion in October 2021, mainly thanks to the supply of treasury bills falling from $ 5 trillion to $ 3.7 trillion. This effectively reduced the supply of short-term risk-free assets by $ 1.3 trillion …

So roughly speaking, the US Treasury significantly increased its holdings of short-term Treasuries at the start of the pandemic. As market investors turned to money market funds, the money market fund held more of this short-term debt. But then the Treasury decided to hold fewer short-term Treasuries, and while market investors still wanted a very safe place to store their liquid reserves overnight, they turned to the bank account. Federal Reserve ON RRP. So far, this arrangement seems to be working fine. But as far as I know, no one expected the Fed to become both a lender of last resort in a financial crisis and also a borrower of last resort as the economy recovers.

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