Abundant Cash Is Not Cash Available Abundantly
The pandemic, Fed interest rate policy and bond purchases, restrictive banking
regulations, and banks’ swelling cash balances will have a lingering impact on liquidity
and produce some mind-bending policies to deal with this uncharted territory.
As the pandemic emerged in March 2020, strange things happened:
- Bond markets seized up and investors panicked.
- Bond yields spiked causing severe price declines.
- Credit default swap prices (debt protection derivatives) rose 100x in less than a month.
- The dollar rose and liquidity dropped for U.S. Treasuries, usually the world’s most liquid security.
- There was substantially lower demand at U.S. Treasury auctions.
The Federal Reserve responded with an almost never-ending pile of cash, buying vast
quantities of bonds with newly created cash. It has continued its purchases, at a pace of
at least $120 billion a month.
But this has not resulted in “happy days are here again.” This mountain of dollars is
limiting liquidity and constraining markets. That’s right, read that again if you must – too
much cash can constrain the economy.
It’s Just Never That Easy
A central bank buying a bond for cash sounds like a simple swap of one asset for
another. In reality, it can make the banking system more dysfunctional instead of more
effective. Here’s why.
- When the Fed buys assets in the secondary market from an institutional investor, the Fed cannot pay the investor directly with the electronic money it creates. Only banks can hold these “reserves” – money that has been created by the Fed.
- Instead, the institutional investor gets a newly created deposit at its bank, and the bank gets the newly created reserve at the Fed.
- The bank ends up bigger, with a new liability and a new asset.
The same effect happens when a bank buys securities from the US Treasury.
The bank is issued debt at a Treasury auction, raising funds for Treasury.
The bank sells the Treasury debt over to the Fed, adding cash to the bank.
When the government spends the funds it has raised, the banking system grows because the bank retains its cash, yet Treasury spends the money that has been created.
Are you with me so far?
The chart below shows the results of using both mechanisms during the pandemic. The Fed’s assets and deposits at banks have shot up in tandem (The Economist). For example, J.P. Morgan’s balance sheet grew from $2.7 trillion to $3.4 trillion (26%) in 2020 as deposits rose 35%
Cash Keeps Pouring In.
Since last spring the Treasury has issued more debt than it has needed to fund its
enormous emergency stimulus in 2020. As a result, the Treasury General Account
(“TGA”) – the government’s current account at the Fed (essentially, its checking account)
grew from about $350 billion in early 2020 to about $1.3 trillion on March 11, 2020.
After distributions from the new stimulus program, Treasury forecasts that
the TGA balance will be $500 billion by the end of June 2021. However, the TGA is required by law to limit its balance to $120 billion by August 20, 2021. $400 billion from the TGA will be deposited in banks from Treasury – in addition to funds from the Fed.
What’s an SLR and Why Should I Care?
The Supplementary Leverage Ratio (“SLR”) is the US implementation of the Basel III Tier
1 leverage ratio, with which banks calculate the amount of common equity capital they
must hold relative to their total leverage exposure. Large US banks must hold 3%. Toptier
bank holding companies must also hold an extra 2% buffer, for a total of 5%.
In other words, if these limits are reached, it could effectively grind lending to a halt.
Abundant cash does not equate to cash abundantly available.
Cash abundance has two main effects.
- Lower and lower interest rates
i) The Federal Funds rate (the rate banks charge each other to lend overnight
reserves) is now about 0.07% ( the Fed targets up to 0.25%).
ii) As banks have abundant reserves, there is very little, if any, overnight lending,
and the Federal Funds rate becomes insignificant.
iii) Repo rates (Repo markets provide overnight liquidity and are an essential
engine for the economy) matter much more. These rates are almost negative,
at just 0.01%.
2. Less and less capital to lend
i) Banks are left with a lower ratio of equity capital to assets (loans to
customers), making it harder to comply with minimum capital requirements
set by regulators.
The SLR requires big banks to fund themselves with equity worth at least 5% of their
In March 2020 regulators exempted both cash reserves and Treasuries from equity
capital requirements, easing banks’ requirements. This was recognizing that the source of
these assets came from the Fed’s emergency actions did not represent assets from the
banks’ normal course of business. The exemption is due to expire soon, but that is being
debated. If the exemption expires, banks will have less capability to lend because these
balances will now be included as assets for which equity capital is required.
Smaller SLR equals less lending equals less economic activity. That’s why we care.
Yes, It’s Strange
These two factors, extremely low interest rates, and less capital to lend, are essentially a
“new normal” causing the markets to behave, well, strangely.
Since there is a risk that short-term interest rates go negative, supposedly safe money-market
funds might be forced to “break the buck,” causing investors to lose money on a
money market fund whose capital is thought to be completely safe.
This disastrous scenario reverberated through the markets when it occurred for a large
money market fund during the financial crisis in 2008. If one or more money market
funds “break the buck” today, extreme market volatility and significant losses will occur.
In other words, a market panic.
Facing a change to the SLR, banks are likely to turn away new deposits.
This seems unimaginable, but it was discussed at J.P. Morgan in January 2021. The
alternative is raising capital to fund holdings of low-yielding (or non-yielding) cash. This
would be very expensive capital and a worse alternative than simply turning away
The Treasury market is the biggest concern. Banks shrink balance sheets quickly by
selling assets to investors. If money center banks, such as J.P. Morgan, Bank of America,
etc. were to approach regulatory capital limits and stop purchasing Treasuries, the
Treasury market could potentially dive. This fear has already magnified volatility in the
Treasury market. An example was in February 2021, when, amid a global bond market
sell-off, an auction of seven-year Treasuries suffered record low demand.
Typically, Treasuries are a “flight to safety” during a bond market sell-off, and demand
was expected to be much higher than it was. Regulatory capital limits and lack of
demand from money center banks drove this unusual event. There is probably more to
come, making financial markets quite nervous.
So What Do We Do Exactly?
Several things could be done:
- The Fed could raise the rate it pays on reserves, currently 0.1%.
i) This would ease some of the downward pressure on interest rates. However,
the Fed did not do this after its monetary policy meeting on March 17, 2021,
and it has signaled it has no intention to do so in the foreseeable future.
2. Regulators could extend the exemption of reserves from the SLR.
i) Extending the exemption, however, would be controversial. On February 26,
2021, Senators Elizabeth Warren and Sherrod Brown wrote to regulators
urging them to restore the SLR “as quickly as possible,” fearing that the
pandemic was being used as an excuse to weaken reforms made after the
global financial crisis (Shocking!).
Another constraint is the extra capital requirements that “globally systemically
important” banks incur as they grow. By the end of 2020, J.P. Morgan was on the cusp of
seeing its SLR surcharge rise from 4.0% to 4.5% of risk-weighted assets. This scenario is
typical for most other money center banks and has the potential to limit bank lending.
The uncertainty around the SLR exemption may explain why the Fed has expanded
another of its programs. The “overnight reverse-repo facility” allows investors to park
cash overnight at the central bank in exchange for Treasuries. At its most recent meeting,
the Fed lifted the maximum exchange with each counterparty from $30 billion to $80
billion. If investors park more money at the central bank directly, then banks’ balance
sheets would shrink. The facility is barely being used, but it is clear that the Fed
recognizes that it will become an essential component to maintain liquidity.
You’re Not the Only One with A Headache
It gets worse. Some policymakers believe reducing banks’ liquidity might be precisely
what is needed for financial stability as the economy emerges from the pandemic – the
latest example of mind-bending monetary policy.
There will be more to follow as the global economy enters uncharted territory post-pandemic.
Recent examples include China’s digitized currency, essentially allowing direct funds flows among involved parties (no intermediary banking process) but monitored by the Chinese central bank (and therefore government) in an attempt, among other things, to obviate the U.S dollar (currently 80% of all funds used for international transactions).
And All This Means…
Bank lending will be increasingly limited, interest rates will fluctuate but stay low, policy responses will be uneven and less predictable, markets will be more volatile, and economic activity will bounce back from the pandemic but be less certain. All stemming from the pandemic and its lingering effects.
The US Fed and central banks around the world will be forced to respond. Even more bold and unusual policies will develop as reactions to the pandemic and its side-effects get stranger.