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March 4, 2024 | Premium Service | Last week, a reader of The Institutional Risk Analyst asked if they could not see the bottom 50 banks in the universe behind the WGA Bank Indices. What a wonderfully diabolical idea. Maybe a negative ETF strategy lies down the road? Subscribers to the Annual Plan of The IRA will have access to the WGA 100 each quarter, as discussed below.
What a difference three decades make. Last week we suggested some weekend reading in the form of an important discussion between Bill Nelson of Bank Policy Institute and David Beckworth of Mercatus Center (“Bill Nelson on the Using the Discount Window for Liquidity Requirements and Its Implications for the Fed’s Balance Sheet”). They review a number of issues affecting banks and markets, most particularly the Fed’s desire that any and all banks use the Discount Window.
The Fed's desire to open the Discount Window to wider use is a delicious irony for long-time observers of the central bank. Back in the 1990s, officials of the Fed’s Board of Governors were sneaking around Washington to expand Discount Window lending to nonbanks. They inserted language into FDICIA legislation to allow essentially anybody to borrow from the Discount Window in times of exigency.
Pulitzer prize winner Gretchen Morgenson described how the Fed’s Board tried to prevent Walker Todd at the Federal Reserve Bank of Cleveland from publishing a research report about the provision. “They failed, happily, and the report was published,” Morgensen related. “But it was very, very interesting the degree to which the Federal Reserve Board seemed to want to keep that little amendment under wraps and to keep it from having the sunlight shone on it by this report that Walker Todd had produced.” Indeed not, since the subject language was drafted by the largest banks and then adopted by the Fed staff.
Wind the clock forward to today. Liquidity, not the value of collateral or protecting the taxpayer, is now the Fed’s chief concern. Fed officials have essentially thrown away Bagehot and the Federal Reserve Act, and are today concerned about how to forcibly inject fiat liquidity into the markets in times of sudden and apocalyptic levels of volatility. As the level of reverse repurchase agreements (RRPs) declines, the concern about volatility in the credit markets grows proportionately.
The chart below shows the system open market account (SOMA) in red, RRPs in blue and the mortgage-backed securities (MBS) component of the SOMA broken out in green. Notice that the overall SOMA is falling much faster than the MBS subset, which is now performing like a portfolio of 20-year Treasury bonds due to low prepayment levels.
The worry at the Fed, of course, is that once the level of RRPs falls below ~ $200 billion, the flow of cash out of the Fed and into T-bills will ebb and the visible volatility of short-term interest rates may grow. The flow of cash into T-bills and out of RRPs moderated volatility caused by the ebb and flow of the Treasury’s fiscal operations. Now that the narrative is embracing the idea of no rate cuts at all in 2024, Beckworth summarizes the concern:
“The Fed's Treasury holdings are about $5.8 trillion, now [down] to $4.7 trillion. Reserves are [at] $3.5 trillion, as you said, and they were as high as $4 trillion. Overnight reverse repo is down under $1 trillion, and it was about $2.5 trillion [before]. So, there is a reduction, but everyone's a little, I think, worried that we're going to trip over that point, which throws us back into a scarce reserve system, and what's crazy, scarce reserve at, say, $3 trillion, right? $2.8 trillion may be… oh no, we fell back into a corridor system, which is just so ironic given the enormity of it.”
Ironic is one way to see it. Given the elevated concerns about liquidity, the Fed is desperately trying to find a way to convince banks to use the Discount Window. The acceleration of the potential change in a bank’s deposits illustrated at Silicon Valley Bank last year convinced the Fed that all insured depository institutions must have collateral pledged and ready to go at the Fed’s window. Much like a private repo agreement for dry poolable agency loans, the collateral must be identified and presented to the Fed for review before cash is advanced.
In plain English, in order to borrow from the Discount Window a bank needs to have collateral and the related paperwork in place before the need for cash arises. Like a private repurchase agreement, the loan administrator (in this case the Fed) must approve the collateral and set a haircut before the trade moves forward. Nelson & Beckworth note that the Discount Window has always been intended to finance the most illiquid, problematic collateral in the system, usually loans rather than securities.
Nelson notes that the Standing Repo Facility (SRF) is not a substitute for the Discount Window:
“[T]he reason why the Standing Repo Facility is strictly inferior to the discount window [is], for one thing, [because] there's no prepositioned collateral. You bring your collateral there, and you engage in a repo. But, also, you can only do it once per day, and you can only do it in the middle of the day.”
Maybe it's just us, but perhaps the Fed's Board of Governors ought to expand the hours and operations of the SRF to match the Discount Window? The Fed could mandate that all banks above $100 billion have documentation and whole loan collateral in place to draw funds if needed. And the SRF ought to be priced off the repo market and used by banks every day. Old wine in new bottles. Problem solved.
Perhaps if the members of the Board and the Federal Open Market Committee spent less time on television discussing their personal views of monetary policy, they could focus on important issues like market liquidity and expanding the SRF. Over the weekend, Komal Sri-Kumar published a comment ("Rate Cuts: Fed Talks With Many Voices") noted that members of the FOMC are causing confusion in the financial markets by publicly debating monetary policy in the media. Sri-Kumar:
"The month-to-month core inflation rate was the highest since February 2023. These are the figures that will likely cause Fed officials to deviate even more from Chairman Jerome Powell’s suggestion at the press conference in December that markets should expect rate cuts starting soon. But they were not sufficient to make the various decision makers speak with one voice in providing guidance.”
FRBNY President John Williams illustrates the problem with verbose FOMC members. Williams displays no interest in or concern with market issues, preferring the intricacies of monetary policy. So why is this Fed official disagreeing publicly with the consensus of the FOMC? We have believed for many years that FOMC members should express the consensus of the Committee or otherwise simply resign. President Williams should stay out of the media and focus on his job.
How is it helpful for FOMC members to parade around the media, disagreeing with the legal vote of the Committee? Rather than helping the public, the public comments of Williams and other FOMC members confuse investors and financial markets. If a governor disagrees with the consensus of the Committee, then they should resign.
More often than not, Fed Governors use media appearances to enhance their personal celebrity or job hunt rather than doing the public business. Perhaps appearing forceful on CNBC will help a governor get a nice gig at a big bank after leaving public service? We think that Federal Reserve Board Chairman Jerome Powell should prohibit media appearances by FOMC members and deputize one governor every month to express the consensus of the Committee in public. That's it.
Subscribers to The IRA Annual Plan login to view the WGA 100 Banks as of Q1 2024. Notice that New York Community Bank (NYCB) dropped from being a top-10 performer earlier last year down into the top 50 in Q4 2023. NYCB will likely fall further once Q1 2024 results are released.