- There are fewer and fewer deposits at small banks, but the Federal Reserve’s monetary rules have tightened further.
- Increased use of the Fed’s reverse repurchase mechanism used by money market funds is affecting banks.
Within hours the cash of Silicon Valley Bank and First Republic Bank vanished, as did the legendary Credit Suisse in Europe after the run on the banks that led to its intervention and subsequent acquisition by UBS.
The difference with other times is that now, in the digital era, bank customers do not ask for cash in coins and bills, but transfers to other safer banks. When these banks failed, deposits were not cancelled.
Decrease in bank deposits
The volume of deposits in U.S. banks is falling. In 2022 the decline in deposits in commercial banks was $500 billion, 3% of the total. Such a collapse puts the financial system in a fragile position.
Banks need to get smaller to pay deposits. And the question arises, where does that money go? Some of it goes into money market funds, some into low-risk investment instruments such as short-term government and corporate debt securities.
These funds last week reached $121 billion as SVB went bust. Data from the Investment Company Institute, a global association of regulated funds, indicates that by March their assets were USD 5.3 trillion, up from USD 5.1 trillion in 2022.
The thing is that these funds can’t actually receive deposits so money doesn’t go into them. Cash withdrawn from a bank to be deposited in a money market fund is credited to the fund’s own bank account.
The fund, in turn, uses this money to buy commercial paper or short-term government debt in which the fund wants to invest. The cash is then deposited in the bank account of the company or institution selling the asset.
This means that inflows of money into money market funds should circulate the cash in the banking system, rather than pressuring it out of the banking system. That was the traditional way money moved.
The new way of sucking in deposits
But now money market funds have a new way of sucking deposits out of the banking system. It’s through the Federal Reserve’s reverse repo (RRP) or reverse repurchase facility introduced in 2013.
This is a reverse repurchase agreement that takes place at the money desk. It consists of the sale of a security to an eligible counterparty through an agreement to repurchase that same security at a certain price in the future.
The Federal Reserve has about two trillion dollars that are hidden and only available for this type of operation. The problem is that it could be distorting the U.S. banking system.
Initially it was believed that this scheme was harmless and would not affect the conduits of the financial system. However, 10 years later, its effects could be having a profoundly destabilizing impact on banks.
Typically, banks borrow money from their competitors or from the central bank against collateral. In reverse repurchase agreements, however, the opposite is true. For example, a money market fund asks its custodian bank to deposit reserves with the Fed/central bank in exchange for securities.
Growth in the use of reverse repurchase agreements
This novel scheme was intended to help the Federal Reserve find a mechanism to increase the cost of money in the interbank market in light of the ultra-low interest rates being charged.
The thinking was: why would a bank or shadow bank, such as a money market fund, lend to other banks at a lower rate than the one set by the Fed?
The use of this scheme has grown incessantly in recent years, as a result of the financial measures taken during the coronavirus pandemic and the regulatory adjustments that allowed banks to obtain mountains of cash.
When the Federal Reserve purchases a bond from a mutual fund, the intermediary in the transaction is a bank. So the fund’s bank account grows, but so does the reserve account that the intermediary bank has at the Fed.
Banks have had to increase their capital
From the time financial easing and monetary stimulus began in the second quarter of 2020 until its termination in 2022, deposits at commercial banks grew $4.5 trillion. This is about the same growth as the Fed’s balance sheet.
At the beginning of the pandemic with the relaxation of the so-called “Supplementary Leverage Ratio” (slr) rule by the Fed, banks had no trouble coping with the inflows.
Commercial banks were not required to raise more capital as they received more deposits from their customers. Therefore, they were able to confidently use inflows of customer deposits to increase holdings of Treasury bonds and cash.
Banks bought up to $1.5 trillion in Treasury and agency bonds without a problem. But in March 2021, the Federal Reserve did not renew the “Supplementary Leverage Ratio” exemption.
Then the banks found themselves flush with unwanted cash that they could not find a place to put. But, in addition, they shrank from having to decrease their borrowing from money market funds, and instead having to deposit the cash at the Fed.
Growth of money market funds
Last year, these funds accumulated $1.7 trillion deposited overnight in the line of the Fed’s reverse repurchases, while in 2021 it was barely a few billion.
There are now fears that after the financial turbulence of the past two weeks, more small banks will fall. The rise in interest rates to historic levels and the tightening of monetary rules has put it in a very vulnerable position.
The use of money market funds grows along with interest rates, as the Federal Reserve Bank of New York’s management found out. This is because yields adjust faster than bank deposits.
For banks the cost of overnight Fed reverse repo transactions rose from 0.05% in February last year to 4.55%. Thus the scheme is more attractive than the current interest rate for bank deposits of 0.4 %.
Money market funds that are using the reverse repurchase mechanism are more every day. This means that this money is outside the banks and has increased by half a trillion dollars during the period mentioned above.
Smaller banks with less liquidity
Those without a banking license prefer to deposit money through this mechanism rather than in a bank. This practice is leaving smaller banks with less liquidity.
In addition to the higher yield, there is no fear that the money will be lost because the Fed will never fail, but a bank can. In fact, money market funds may eventually become a sort of “narrow bank”.
That is, institutions that back their customers’ deposits with central bank reserves. They are lower-yielding but safer assets. While they are banks that cannot lend or grant mortgages, they are also not exposed to failures.
Fed skepticism about “narrow banks”
Within the Fed there is some skepticism about so-called narrow banks. There are fears that they could end up undermining traditional banks. In 2019 U.S. central bank officials denied an operating license to TBN USA to create a narrow bank.
Another concern of the agency is the opening of its balance sheet to money market funds. One of those who has expressed this concern is New York Fed President Bill Dudley.
When the reverse repurchase mechanism was created Dudley was doubtful about its negative effects with respect to the “disintermediation of the financial system.” He warned that during a financial crisis there could be increased instability with these funds that do not hold riskier assets and are on the Fed’s balance sheet.
For now, banking regulators have acted quickly to stop the bleeding in smaller banks by providing financial relief to institutions that may need it and monitoring the banking system for signs.
But there is an undeniable reality that may at some point create a crisis. There are fewer and fewer deposits as the banking system has contracted. The country’s small and medium-sized banks, which are the ones that support small and medium-sized businesses, are beginning to pay the price.
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