Tuesday, April 4, 2017

Spikes

Jon Hartley, writing in Forbes, offers a great graph of the overnight Federal Funds rate,


This graph  mirrors nicely the graph I posted last week, from "Deviations from Covered Interest Rate Parity" by Wenxin Du, Alexander Tepper, and Adrien Verdelhan:


What's going on with these quarter-end spikes?


As Jon, and Wenxin, Alexander, and Adrien explain, European bank regulators assess capital requirements based on a snapshot of balance sheets at the end of the quarter. American regulators assess capital requirements based on an average of the balance sheet over the entire quarter. Thus, at the end of the quarter, European banks unwind positions that require capital, such as FX arbitrage,  for a few days, and stuff the results in assets requiring less capital, like reserves at the Fed.
Even the reverse repo facility's take-up is impacted on quarter-end days, seeing enormous spikes in the amount of assets being put into the facility in month end.
[Reverse repo is how large non-banks, or foreign banks, can invest in interest-paying reserves at the Fed.]

US banks have an opposite incentive (disclaimer, this now is me, not their opinions). If spreads open up at end of quarter, then US banks can take on a huge amount of risk for a few days, and capital requirements only apply to the rest of the quarter.

So the sloshing back and forth of who holds risky positions is a nice little arbitrage of the different regulations for both sides, not just the Europeans. When analyzing financial markets, always remember that for a seller there must be a buyer, and someone is holding the position.

What's the moral of the story? The title of Jon's piece is "Hindering The Fed's Ability To Raise Interest Rates." (Titles are often not under the writer's control.) I'm not convinced. The spikes are in the Fed's band. If the Fed wants to raise the band, I don't see why it can't. US banks seem happy to take the other side of the game (less reserves, more FX for a few days), for a profit.

I see it as one more indication of the problems caused by capital requirements that hinge on capital relative to risk-weighted assets. Assets are hard to measure, risk weights are often wrong.  I prefer capital requirements that measure only bank liabilities:  market value of equity divided by face value of short-term debt, with the limit measuring volatility by equity option prices. (see "A way to fight bank runs—and regulatory complexity" and longer blog post version). This capital ratio uses no regulators or accountants at all to measure assets. And there would be no end of quarter vs. quarter average window dressing.

I see it as an indication of how banks are not very competitive.  This does not happen in competitive markets, especially ones in which nimble new competitors can enter FX or overnight debt markets and remove arbitrages.

I also see it as a success of the Fed's large balance sheet, interest paying reserves, and reverse repo programs. I emphasize that because the reporting out of the Fed is now suggesting a desire to "normalize," i.e. go back to the system that worked so well in 2007, and get rid of these innovations.

Given the regulatory snafu -- and there will be endless regulatory snafus like this in the future -- and the consequent desire for big portfolios to shift around at quarter end, the miracle is that interest rates only move a tenth of a percent or so each quarter. That's because the quantities Jon mentioned can slosh around. European banks can get reserves for a day or two, and then slosh out again. If the overall quantity of reserves were smaller, or fewer institutions were able to get them (if reverse repo were closed), then the price swings would be even larger. It makes the case more strongly for my "reserves for all" proposal, that the Treasury should offer fixed-value, floating-rate debt, just like bank reserves, to anyone, not just "banks."

Update: Jon corrects me. In fact, some of the spikes did fall below the Fed's lower bound. As treasury rates have often been below the lower bound. There is a potential problem with the Fed's ability to lower rates. The Fed pays more interest to banks on excess reserves. Why don't the banks just say "thank you for the present," earn the extra interest on reserves, pay nothing more on deposits, and nothing else changes? Well, competition. Banks should be competing for deposits, and thus raising the deposit rate as the interest they receive on reserves goes up. That this is manifestly not happening tells you something about bank competition. Banks should be trying to sell treasury portfolios to get more reserves, putting downward pressure on treasury prices and raising treasury interest to the interest on excess reserves. Happening sort of, the treasury rate is also often below the lower bound. Money market funds should be selling treasuries and buying reserves through the reverse repo mechanism. As you can see, there is some doubt whether higher interest on reserves will percolate through the economy. (I wrote a whole paper on this). The Fed does not do the one thing that would guarantee this arbitrage -- open up the balance sheet. Bring us treasuries, we give you reserves in any quantity.

In sum, yes, the lower bound on Fed funds rate is breached, as treasuries are often below that bound. There is some issue whether banks are competitive enough to let interest on excess reserves move on to other rates with a fixed balance sheet. But I still don't see the regulatory arbitrage of european banks buying reserves at quarter end as a key mechanism limiting widespread higher interest rates.

8 comments:

  1. If you really do want to get rid of risk weights and look only at bank liabilities, then surely you will want to segregate the amounts deposited at the central bank as reserves (indeed this is one of your earlier proposals). These deposits add to short-term debt of banks yet contribute nothing to their risk, and would drag down your ratio if not segregated. The way to arbitrage this regulation would be to sell assets to the central bank, and we can forget about normalization.

    Really the problem in our time is how to handle the excess demand for deposits in advanced countries that is driving equilibrium rates so far down. The only solution in my view is greater integration of banking across the world so that these deposits have some way out of their home countries. Bank safety doesn't seem such a difficult problem to solve when we have simple options like extended liability for shareholders.

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    Replies
    1. Anwer,

      "If you really do want to get rid of risk weights and look only at bank liabilities, then surely you will want to segregate the amounts deposited at the central bank as reserves (indeed this is one of your earlier proposals). These deposits add to short-term debt of banks yet contribute nothing to their risk, and would drag down your ratio if not segregated."

      Reserves kept at the central bank are treated as Tier 1 capital in the same way that equity (and retained earnings) are treated as Tier 1 capital.

      https://en.wikipedia.org/wiki/Tier_1_capital

      "Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of COMMON STOCK and DISCLOSED RESERVES (or retained earnings), but may also include non-redeemable non-cumulative preferred stock."

      The money that a private bank receives for it's sale of equity shares is considered Tier 1 capital. That money is an asset (not liability) of the private bank. When a capital ratio is calculated, the sale price of the shares (not their market value) is used.

      Likewise, the money that a private bank keeps in reserve (either at the central bank or in it's own vault) is an asset of that private bank - not a liability and certainly not short term debt owed by the private bank.

      Hence, reserves are NOT deposit liabilities for a private bank, they are an asset of a private bank in the same way that money obtained during the sale of shares is an asset of the private bank and the same way that retained earnings are an asset of the private bank.

      Delete
    2. Yes, the risk-weighting system treats central bank reserves as a riskless asset. But Prof. Cochrane doesn't like the risk-weighting system for various reasons, and wants to replace it by a simple ratio of debt to equity funding, using market values. My point is that his leverage ratio rule would disqualify a narrow bank as too risky (with an extremely high leverage ratio). Likewise with the part of a bank that would approximate a narrow bank, if we were to segregate the funds deposited at the central bank - as described in his November 21, 2014 post on "Segregated Cash Accounts".

      There are bank supervisors who feel that deposits that are forwarded to the central bank, and kept there as reserves, should be excluded from leverage ratio calculations. Given Prof. Cochrane's proposal for segregated accounts, he would also appreciate this idea, though he might want the rest of his proposal applied as well i.e. actual segregation with bankruptcy remoteness for that cash.

      My points above were that this special treatment of central bank reserves would spell the end of policy normalization prospects. Perhaps that is not so bad, as we want a new structure for Federal debt anyway, converting it all to money. But it also means that the effect of the leverage rule is smaller than it might appear at first. We cannot make society hold a larger fraction of bank equity in its collective portfolio than is dictated by preferences of the representative holder of assets. An attempt to do that, like the one in this post (as I understand it) will simply lead to some form of regulatory arbitrage. Society will look for some Modigliani-Miller help, to get the actual leverage ratio it wants, from an entity not subject to this rule, and that does not want the yield on bank deposits to fall too low (below zero).

      The central bank steps in to play this role, because its mandate aligns perfectly with the need to maintain sufficient (positive) yields on bank deposits, and it produces - via asset purchases - a perfect substitute for bank money. We do gain safety for the private system, which relies on leverage ratios limited by rules, but the central bank must step in to pick up the slack in the production of deposits, by buying up an ever-increasing share of the economy.

      The leverage ratio rule is not a long-term solution to the downward trend of real interest rates, which is the real problem facing the financial system. The real solution is to forget about monetary sovereignty for the US and come up with a new international monetary architecture.

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    3. I agree -- narrow deposit taking that allows deposits, backed by reserves or treasuries, with no capital -- should be allowed, and encouraged. Better, the Treasury should issue fixed-value, floating-rate debt directly so we all can have reserves and don't have to go through banks charging us 74 basis points for the privilege. Then risky investment is financed by high capital banking. If you allow zero capital reserve-based deposit taking, and insist on high capital for banking, we will naturally get a separation between narrow deposit taking and equity financed banking.

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    4. Anwer,

      "But Prof. Cochrane doesn't like the risk-weighting system for various reasons, and wants to replace it by a simple ratio of debt to equity funding, using market values."

      See above from John: "I prefer capital requirements that measure only bank liabilities: market value of equity divided by face value of short-term debt,..."

      I agree that the face value (not market value) of debt should be used, but defining exactly what is meant by "short term" requires some additional clarification - see my post below.

      "The leverage ratio rule is not a long-term solution to the downward trend of real interest rates, which is the real problem facing the financial system."

      Agreed. But this problem is ultimately a fiscal one when the central bank has to decide between bailing out the sovereign and maintaining a positive real interest rate.

      "The real solution is to forget about monetary sovereignty for the US and come up with a new international monetary architecture."

      The last time that was achieved (Bretton Woods) took two World Wars to get there - I will pass on that idea.

      John,

      "Better, the Treasury should issue fixed-value, floating-rate debt directly so we all can have reserves and don't have to go through banks charging us 74 basis points for the privilege."

      First, the interest that the central bank pays on reserves is simply the interest that it receives on it's government bond holdings. And so, your argument that "we should all be able to collect interest on reserves" is nonsensical - if you want interest on reserves simply log on to Treasury Direct's website and submit your own bid for government debt when it is auctioned.

      Second, I don't agree that the federal government (Treasury) should issue any debt at all. This goes to Anwer's stipulation that "downward trend of real interest rates is the real problem facing the financial system".

      See my post on government equity here to show how you get private borrowers at positive real interest rates and simultaneously reduce the federal debt:

      http://johnhcochrane.blogspot.com/2017/01/corporate-tax.html#comment-form

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  2. John,

    "I see it as one more indication of the problems caused by capital requirements that hinge on capital relative to risk-weighted assets. Assets are hard to measure, risk weights are often wrong. I prefer capital requirements that measure only bank liabilities: market value of equity divided by face value of short-term debt, with the limit measuring volatility by equity option prices."

    I tend to agree with the sentiment, but let me bring up some issues. First and foremost, the term structure of all debt (except for perpetuals) ensures that any debt classified as long term will eventually become short term. Likewise, trying to pick a dividing line between short term and long term is fairly arbitrary - 1 year is short term but a year and a day is long term?

    I think where you really want to go is to measure a private bank's sensitivity to changes in in the overnight interest rate set by the central bank, so let me say this.

    Why do we need volatility in the overnight rate? The central bank's stated mission is to set the overnight rate equal to something economists call the "natural rate of interest". Does the natural rate of interest really look something like this:

    https://fred.stlouisfed.org/series/FEDFUNDS

    Notice the period from 1995 to 2000 - the fed funds rate barely moved. Of significance, the amount of federal debt outstanding was shrinking during that time.

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  3. Great read, however, remunerating IBDDs induces non-bank dis-intermediation (an outflow of funds or negative cash flow). It retards money velocity (actually savings velocity) where savings are matched with non-inflationary, real-investment, outlets. This is the direct and sole cause of both secular strangulation and stagflation.

    All savings originate within the commercial banking system. And savers never transfer their savings outside of the banking system unless currency is hoarded or converted to other national currencies. Monetary savings, funds held beyond the income period in which received, can never be "activated" and put "back to work" unless they are redirected thru non-bank, savings-investment, conduits.

    From the standpoint of the macro-economy all bank-held savings are thus un-used and un-spent. They are lost to both consumption and investment. Commercial bank deposits’ financial innovation plateaued in 1981. Thus, contrary to Lester V. Chandler’s theoretical conjecture, there stopped being a monetary offset. Chandler’s theoretical explanation was: (1) that monetary policy has as an objective a certain level of spending for gDp, and that a growth in time (savings) deposits involves a decrease in the demand for money balances, and that this shift will be reflected in an offsetting increase in the velocity of demand deposits, DDs.

    From the standpoint of the entire system, commercial banks never loan out, & can’t loan out, existing funds in any deposit classification (saved or otherwise), or the owner’s equity, or any liability item. Every time a DFI makes a loan to, or buys securities from, the non-bank public, it creates new money - demand deposits, somewhere in the system. I.e., deposits are the result of lending and not the other way around. The NBFIs are the customers of the DFIs.

    ReplyDelete
  4. Great read, however, remunerating IBDDs induces non-bank dis-intermediation (an outflow of funds or negative cash flow). It retards money velocity (actually savings velocity) where savings are matched with non-inflationary, real-investment, outlets. This is the direct and sole cause of both secular strangulation and stagflation.

    All savings originate within the commercial banking system. And savers never transfer their savings outside of the banking system unless currency is hoarded or converted to other national currencies. Savings flowing thru the NBFIs never leaves the CB system. Monetary savings, funds held beyond the income period in which received, can never be "activated" and put "back to work" unless they are redirected thru non-bank, savings-investment, conduits.

    From the standpoint of the macro-economy all bank-held savings are thus un-used and un-spent. They are lost to both consumption and investment. Commercial bank deposits’ financial innovation plateaued in 1981. Thus, contrary to Lester V. Chandler’s theoretical conjecture, there stopped being a monetary offset. Chandler’s theoretical explanation was: (1) that monetary policy has as an objective a certain level of spending for gDp, and that a growth in time (savings) deposits involves a decrease in the demand for money balances, and that this shift will be reflected in an offsetting increase in the velocity of demand deposits, DDs.

    From the standpoint of the entire system, commercial banks never loan out, & can’t loan out, existing funds in any deposit classification (saved or otherwise), or the owner’s equity, or any liability item. Every time a DFI makes a loan to, or buys securities from, the non-bank public, it creates new money - demand deposits, somewhere in the system. I.e., deposits are the result of lending and not the other way around. The NBFIs are the customers of the DFIs.

    ReplyDelete

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