2 December (Reuters) – Continued massive cash inflows into a key Federal Reserve facility are being driven in large part by a change in bank liquidity regulations from last year, the New York Fed said in a report on Friday.
The Fed’s facility offers reverse repos, which allow eligible companies to park cash with the central bank in exchange for a risk-free return. The rule at play in inflows is a regulation called the Supplementary Leverage Ratio, which determines how much liquidity banks must have on hand.
The SLR standard was relaxed during the most acute phase of the coronavirus pandemic in 2020, when fears about the functioning of the market were high, and restored in late March 2021 to return to a stricter standard.
“After the end of the SLR relief period, banks had less flexibility to expand their balance sheets by increasing their holdings of reserves and Treasuries,” wrote banking economists Gara Afonso, Marco Cipriani and Gabriele La Spada. This had a domino effect on money market funds, the main users of reverse repos, who poured cash into the reverse repo facility.
After the regulatory change, banks became less inclined to take deposits, and that money instead went to the money funds, which had to put that money somewhere, the newspaper said. Meanwhile, banks reduced the supply of short-term debt, limiting what cash funds could invest in. In addition, the Fed’s rate hikes drove more cash into money market funds as financial markets steered a shift in the cost of short-term borrowing to the authors.
The Fed’s reverse repo facility is an important part of the toolbox it uses to manage the setting of its federal funds rate target, which it uses to manipulate the course of the economy to meet its inflation and employment targets. The reverse repo tool offers money market funds and other companies the opportunity to park cash overnight with the Fed and earn a return. It currently stands at 3.8% and is a more profitable investment than many private stocks that carry more risk.
The Fed’s reverse repo facility was largely idle until spring 2021, when inflows rose steadily. Inflows peaked at $2.426 trillion in late September before easing slightly to Friday’s inflow of $2.05 trillion.
Fed officials were optimistic given the massive inflows. Some have argued that inflows into the reverse repo facility should decline over time as the Fed hikes rates and shrinks the size of its balance sheet to combat high inflation. So far, however, it hasn’t really happened.
In the meantime, questions surrounding the correct setting for the SLR are being examined by the tax authorities, who are approaching the subject cautiously. “History shows the profound cost to society when bank capital is inadequate, and therefore how urgent it is for the Federal Reserve to get capital regulation right,” Michael Barr, the Fed’s chief bank supervisor, said on Tuesday Thursday.
Reporting by Michael S. Derby; Editing by Andrea Ricci
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