“The idea that there are no excess reserves stems from the fact that new regulatory rules underwrite the demand for a big Fed balance sheet for a long time to come (possibly forever).”
– Zoltan Pozsar (Credit Suisse), in “Global Money Notes #5,” April 13, 2016
For the last few months we have been working hard on the question of the optimal Fed balance sheet size, based on the demands created by regulatory rules. Zoltan’s writings about the essentiality of excess reserves have helped enormously, as have data from Barclays, Bloomberg, and elsewhere. We have discussed the issue with sitting central bankers (Fed, Euro-system, others) and with former ones. We have canvassed some commercial bankers. We have met with credit rating experts. This commentary is the result of several months of research and discussions.
Our conclusion is that many Wall St. pundits have taken their eyes off the ball. They prefer to harangue about the Fed or issue warnings of doom. They are missing a regime change of significant proportions. It is impacting asset prices and altering global flows. So our purpose today in this lengthy commentary is twofold. First, we wish to advise our existing clients as to why their portfolios look the way they do and why we have not succumbed to eight years of Cassandra-like warnings of gloom about the bond markets. Second, we wish to trigger some debate among policy makers who read our notes and others who may receive them via social media links or by forwarding.
We believe that the Fed’s balance sheet may be too small, not too large. Later in this commentary we will argue for it to be about $5.5 trillion and to grow at about $350 billion per year. That rough estimate reflects a number of assumptions that we will recite below. We believe that the outcome of the Fed’s under-sizing its balance sheet is to distort the pricing structures of certain asset classes. Some of these pricing distortions are visible and measurable. We will note a few of them as the commentary proceeds.
Today’s comments owe a debt to seminal work by Zoltan Pozsar of Credit Suisse. He has published analysis on the evolution of the liquidity coverage ratio (LCR) under Basel III. We read his work carefully and credit him with expanding our thinking about LCR. What follows are our own estimates, but we are compelled to give him the credit for planting the original seed about LCR and for offering his own estimates, which have provided a basis for our thinking.
LCR requires large banks to hold specified assets in the forms needed to meet a forward-looking liquidity test. Very large banks, over $250 billion, operate under one set of rules. Banks between $50 billion and $250 billion are governed by a different set, whereas banks under $50 billion are considered too small to be a systemic threat, so the LCR rules do not apply to them. That said, many smaller banks are following the behavioral changes required of the larger banks, as Andy Peters explains in, “Why Banks Are Dumping Fannie, Freddie Debt.”American Banker, May 27, 2016. Web: http://www.americanbanker.com/news/national-regional/why-banks-are-dumping-fannie-freddie-debt-1081242-1.html. The American Banker article (subscription required) demonstrates why and how large American banks have sold their Fannie and Freddie holdings in order to meet LCR. Fannie and Freddie are an 80% qualifier under LCR; US Treasury direct debt, on the other hand, is 100%.
Reserves deposited at the Fed by a bank are the ultimate and lowest-cost qualifier. They are 100% eligible. They require no capital. They meet all LCR tests worldwide. They pay a current interest rate of 50 basis points. So for any American bank or any US subsidiary of a foreign-owned bank, the riskless and costless LCR threshold is the interest rate paid by the Fed on overnight excess reserve deposits (IOER). Every decision a bank makes about its portfolio starts there. While banks under $50 billion in size are currently exempt, some are growing and anticipate crossing that $50 billion threshold soon, so they are complying now. Others feel a “regulatory or surveillance” pressure, so they are moving toward the LCR standard. For the markets, it makes no difference why they are doing so. It is their collective actions that count.
In the case of GSE debt, we have seen some market reaction and expect to see more. Remember that GSE debt is also part of the asset holdings of the Fed. The Fed has held that level constant since the end of QE and has rolled maturities. The Fed ignored the change in GSE debt character with the advent of LCR and did not make it an issue in policy pronouncements. The Fed did discuss the matter internally but didn’t see it as large enough an issue to drive a change in policy. Query for consideration: Would markets have been more stable if the Fed had systematically and transparently acquired additional GSE debt in order to stabilize market transition when federally-backed GSE debt became less than a 100% qualifying item? Now then, we admit we have asked a counterfactual question, and we know there is no answer except to speculate about it. But our purpose is to ask policy makers to think about this issue. As a money manager we were able to take advantage of the change because GSE debt traded cheap to references. So clients saw some federally backed mortgage paper in their portfolios.
A second derivative of LCR rules appeared in the tax-free municipal bond space. State housing agency bonds are not High Quality Liquid Assets under the Fed’s rules. The Fed ignores their AAA credit structure. It is the liquidity situation that is dictating policy, and the Fed believes that these bonds will not be liquid in a crisis. So Fannie and Freddie are at 80%, but a state tax-free bond is at zero and/or it requires capital adjustments for a bank to own it. Add to that the complexity of the income tax code and one sees few state housing bonds being held by banks unless the raw yield is high enough to be attractive. That situation leads to a pricing anomaly.
The state housing bond may be secured by claims on federally guaranteed (GSE) mortgages. Most are partially or wholly secured in this way; thus the security is similar to that of Fannie and Freddie. So the question of creditworthiness is not the issue. Instead, it is the liquidity of trading them in a crisis that is driving the banks and the LCR decisions. Therefore pricing is markedly distorted. While Fannie and Freddie paper was being disgorged by banks because of LCR, state housing bonds were forced to compete with higher yields. They were being marketed at tax-free rates over 100 basis points above comparable and taxable US Treasury securities and also above taxable Fannie and Freddie paper. The market views Fannie and Freddie as US government paper, so it trades with a spread to Treasury debt. We think the Fed ignores this pricing distortion in policy making. We did not ignore it. For Cumberland, the distortion presented opportunity to buy very-high-credit-quality instruments for clients at tax-free rates above 4% when comparable taxable structures were trading below 3%.
A third anomaly results because of the FDIC rules that govern American banks but do not apply to American subsidiaries of foreign banks. Remember that both sets of banks are covered by Basel III rules and the need to meet LCR tests. The Fed is actually becoming more stringent than its national counterparties in other jurisdictions. The Federal Deposit Insurance Corporation (FDIC) charges an American bank 15 bps on total assets. Thus, the American bank receives 50 bps, pays 15 bps, and nets 35 bps.
The large customer of a large American bank knows those details. That customer expects its commercial bank to pass through the net 35 bps as a payment on the company’s cash, with only a slight reduction for costs. If there is an American subsidiary of a foreign commercial bank depositing the same money at the Fed, the FDIC doesn’t charge the 15bps fee. Therefore the customer of the foreign bank’s American subsidiary has a 15 bps advantage over the American-domiciled bank. Were you that customer, which bank would you select to handle the transaction?
We estimate that almost half the excess reserves on deposit at the Fed are placed there by US subsidiaries of foreign commercial banks. About 44% of total reserves are placed at the Fed by foreign-owned subsidiaries. This number allows us to estimate how much of the total reserve is required and then to guess at what is excess. Our guess is that nearly half of the excess reserves deposited at the Fed today originate in the American subsidiaries of foreign banks.
In large banking transactions, 15 bps is a lot of money. Note that this rate difference delivers an advantage to a large commercial banking enterprise housed outside the US versus an American competitor. Also note that 15 bps becomes a pricing factor on the repo structure. Repo is an alternate form of cash management. Remember that the reverse repo (RRP) is a liability of the Fed, just like an excess reserve deposit. Its use is similar, though its settlement timing and pricing are slightly different. And some agents (GSE) cannot legally deposit reserves with the Fed. In the last year, this pricing anomaly caused a significant shift. The big American banks (JPM, BoA, Citi, MS, GS, and Wells) shrunk their money fund Treasury repo by about $20 billion. Meanwhile, Swiss, German, Canadian, Japanese, and French banks grew, along with others. The total shift in one year was about $100 billion (Barclays, Crane’s Data, Federal Reserve).
For details on RRP see the NY Fed website: https://www.newyorkfed.org/markets/rrp_faq.html. A $100 billion shift is not a lot in the scheme of a multi-trillion-sized Fed balance sheet. But the directional trend from domestic banks to American subsidiaries of foreign banks suggests that something is changing. Is it the pricing differential we are thinking about?
Let’s move on.
For the purpose of illustrating how LCR impacts a single bank transaction and why the Fed’s balance sheet may be too small, we are going to simplify this discussion. We will examine a single transaction flow between two companies with two different home currencies (euro and dollar) in two central bank jurisdictions (ECB-Bundesbank and Fed).
Here is some background needed to understand the transaction. A reserve deposit at the Fed is a method of meeting the LCR requirement for that depositing bank. Also note that the payment between two banks is nothing more than a transfer of reserves. Whether denominated in euros or in dollars, the reserves never leave the system. The ownership of the reserve changes, but the total reserves do not change. It takes the expansion or shrinkage of the central bank’s balance sheet asset size to impact the total reserves. This is true whether the bank is an American bank or a foreign bank. Remember that a deposit at the Fed qualifies for 100% treatment under LCR and does not require the depositing bank to find any additional capital to support the reserve deposit as an asset of the bank. The same is true for a German bank or a German subsidiary of a US bank when it comes to a reserve deposit at the Bundesbank. For LCR purposes, the Fed and the Bundesbank are both 100% qualified. Eventually, LCR will be currency-specific, but currently there is an arbitrage inducement, as we will see in an example below.
This LCR computation has the function of turning an excess reserve deposit into a new version of an optional required reserve deposit. The LCR requirement is met by the election of the commercial bank. Each bank, pricing its available alternatives, determines how to comply. Our argument here is that the current worldwide pricing of alternatives favors the use of reserve deposits at the Fed. That explains why about half of the excess reserves at the Fed are placed there by US subsidiaries of foreign banks. Those foreign-owned deposits meet LCR. At the same time those banks are earning 50 bps paid in US dollars instead of paying 40 bps in euro. That 90-bps spread is serious money and may be changing agents’ behavior.