US banks face trillion dollar reverse repo headache

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – The trillions of dollars in overnight cash piled up daily at the Federal Reserve could turn into a big headache for banks that could squeeze their balance sheets and hurt their ability to lend.

The Fed’s reverse repurchase facility (RRP) has attracted a wide range of market participants, helping to eliminate excess liquidity in the financial system. Led by money market funds, volume in the reverse repurchase window has topped $2 trillion for 39 consecutive days.

The Fed is paying a record 2.3% reversal rate after raising rates by 75 basis points last week. Barclays expects daily reverse repo levels to range between $2.8 trillion and $3.0 trillion by the end of the year.

Investors are essentially taking deposits out of banks and putting them into government money market funds, which invest primarily in bonds and repos. These funds, in turn, funnel cash into the Fed’s overnight window.

Buyback allocations from government money market funds have risen to almost 40% of their assets currently, from around 30% at the start of the year, Barclays said.

The Fed will shrink its balance sheet by $95 billion a month starting in September, accelerating “quantitative tightening,” which began in June. The concern is that the outflow of deposits from banks to money market funds could deplete bank reserves at a rapid pace that could hamper lending to financial markets and the broader economy.

GRAPHIC: Fed Balance Sheet and Bank Reserves (https://fingfx.thomsonreuters.com/gfx/mkt/byprjwzxbpe/Fed%20balance%20and%20bank%20reserves.PNG)

The decline in bank reserves could also lead to a rise in the repo rate and the real Fed Funds rate similar to what happened in September 2019, when bank reserves fell due to large withdrawals for tax payments and the settlement of its markets Public in auctions. This forced the Fed to provide additional reserves to the banking system.

“Moving reserves into money market funds and away from banks is moving money away from financial markets,” said Matt Smith, chief investment officer at Ruffer Asset Management in London, which has $31 billion in assets under management. dollars.

For now, bank reserves are still considered ample at $3.3 trillion, but the decline has been rapid, some market players said. From a peak of nearly $4.3 trillion in December last year, bank stocks have fallen by about 23%. In the Fed’s previous quantitative tightening (QT), $1.3 trillion in liquidity was withdrawn over five years.

To be sure, there are other factors that have contributed to the decline in bank reserves, such as asset reallocations and loan demand, analysts said.

CASH ASSET MONEY SHOPPING

Assets of government money market funds were fairly flat on July 27 at $4.025 trillion, up about 0.1 percent from the previous week, according to data from the Investment Company Institute. Shifting deposits to money funds was a slow process.

“The Fed’s QT will quickly shrink its balance sheet. But bank reserves are going to decline much faster as cash shifts from bank deposits to government-only money. We expect money funds to put that cash into the RRP.” , wrote Joseph Abate, chief executive of Barclays, in a research note.

Expectations that the U.S. Treasury will increase Treasury issuance for the 2023 fiscal year, which begins in October, could help reduce the glut of inflows in the reverse repurchase window, analysts said.

Abate estimated that bank reserves will fall to $2.3 trillion this year, dangerously close to banks’ “minimally ample level” of $2 trillion, as deposit outflows begin to weigh on their balance sheets.

However, for many large banks, these deposits are unwanted anyway.

As the Fed’s balance sheet grew with quantitative easing during the pandemic, so did bank reserves deposited with the central bank. Once reserves reached a level at which banks were unwilling to absorb the regulatory costs on their balance sheets, they began to move away from deposits.

The Fed in April 2020 temporarily excluded bond and central bank deposits from the supplementary leverage ratio (SLR), a measure of capital adequacy, as excess bank deposits and Treasuries increased banks’ capital requirements to what are considered safe assets.

However, the Fed let this SLR block expire and the big banks had to continue to hold an extra layer of loss-absorbing capital against government bonds and central bank deposits.

“Banks are still reluctant to raise deposits due to regulatory costs in the absence of SLR relief and want to de-leverage their balance sheets,” said Imran Siddiqui, portfolio manager at Mosaic Capital. “In a subtle way, they’re sending a message to the Fed to offer some form of permanent SLR relief.”

If the Fed modifies the SLR and gives banks breathing room on regulatory costs, this will prompt these financial institutions to accept more deposits and help stabilize reserves. The Fed earlier this year said it would review that leverage ratio, but has yet to publish a proposal.

(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Leslie Adler)

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