- The Ghosts of Failed Banks Have Returned
by Alasdair Macleod, https://mises.org/
Recently, something unusual happened: instead of the more normal reverse repurchase agreements, the Fed escalated its repurchase agreements (repos).
For the avoidance of doubt, a reverse repo by the Fed involves the Fed borrowing money from commercial banks, secured by collateral held on its balance sheet, typically US Treasury bills. Reverse repos withdraw liquidity from the banking system. With a repo, the opposite happens: the Fed takes in collateral from the banking system and lends money against the collateral, injecting liquidity into the system. The use of reverse repos can be regarded as the Fed’s principal liquidity management tool when the banks have substantial reserves parked with the Fed, which is the case today.
Having inflated its balance sheet following the Lehman crisis by buying US Treasury bonds — thereby increasing bank reserves — from 2011 the Fed started to increase its reverse repo position until 2017. In other words, it was taking liquidity out of the banking system, having previously injected massive amounts of it by means of quantitative easing following the Lehman crisis. From early-2017 to October 2018, outstanding reverse repos then halved, implying liquidity was being added. Since then they have increased by roughly half to $325bn, reducing liquidity1.
What spooked market commentators was the unexpected increase in the repo rate, which on Tuesday 17 September suddenly jumped from the previous Friday’s level of 2.19% to as much as 10%. By escalating its repo position, a targeted liquidity injection from the Fed followed as it struggled to maintain control over the repo rate, taking its outstanding repos from less than $20bn to $53bn. The Fed cut its Fed Funds Rate to a target of 1.75-2.0% the following day.
On Wednesday, 18 September the Fed’s repo position increased again from $53bn to $75 bn. Furthermore, on Thursday and Friday respectively the Fed’s repo position remained elevated, reaching $105bn last Monday. Interestingly, overnight dollar Libor declined slightly, in line with the reduction in the Fed Funds Rate, apparently unaffected by the higher repo rates in the US, confirming it is specifically a US problem involving the large banks.