Weekend Economists Deck the Halls Christmas Day 2013

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54. The Fed Doesn't Really Trust the Banks Either

http://www.bloomberg.com/news/2013-12-12/the-fed-doesn-t-really-trust-the-banks-either.html

Here is a Wall Street Journal article http://online.wsj.com/news/articles/SB10001424052702303330204579250582491040034 about how the Federal Reserve is experimenting with reverse repo agreements as a tool of monetary policy. "The Fed traditionally has managed short-term interest rates by shifting its benchmark federal-funds rate, an overnight intrabank rate," but the reverse repo mechanism wouldn't be limited to banks. In the reverse repos, counterparties would lend the Fed money -- secured by Treasuries -- at a rate determined directly by the Fed. (In the experimental reverse repos the Fed is currently conducting, that's 5 basis points.)

There's some stuff on the substance of monetary policy and the Fed's plans for future tightening,1 but I feel like that's the least interesting part. The more interesting part is that "The reverse-repo program extends the Fed's reach beyond traditional banks to Fannie, Freddie and others, and in theory should give the central bank more control over interest rates." Right now, to hear the Fed describe it, banks are in a weirdly lucrative place. The Fed's interest on excess reserves program pays them 25 basis points per annum for depositing money overnight with the Fed. In an efficient competitive market you'd expect them to borrow in size at around 0.25 percent: If they could borrow at 0.24 percent, they'd do that all day long, borrow at 0.24 percent (from whomever) and lend at 0.25 percent (to the Fed), and make riskless profit, which should drive the price of borrowing up to 0.25 percent.

But in fact the fed funds rate -- the rate at which banks borrow reserves -- is around 8 or 9 basis points these days. The reason has to do with who lends the fed funds. It's not banks: Banks can get 25 basis points, so why settle for 8? A New York Fed blog post last week explains that something like 75 percent of fed funds lending comes from the Federal Home Loan Banks, which aren't eligible for interest on excess reserves and so have to lend their excess cash in the fed funds market:

The predominant lending role of the FHLBs helps explain why the fed funds effective rate has largely printed below IOER. As the FHLBs aren’t eligible to earn IOER, they have an incentive to lend in the fed funds market, typically at rates below IOER but still representing a positive return over leaving funds unremunerated in their Federal Reserve accounts. Institutions have an incentive to borrow at a rate below IOER and then hold their borrowed funds in their reserve account to receive IOER and thus earn a positive spread on the transaction.

The Journal article cites a speech from last week by Simon Potter, the executive vice president of the New York Fed's markets group. Here's Potter on why those rates are so different:

Contrary to the dynamics one would expect of an idealized perfect market, however, short-term rates have consistently traded at levels below the IOER rate, and Treasury bill and repo rates have occasionally gone negative, particularly when financial stresses increase the demand for very safe assets. Since IOER is available only to depository institutions holding balances at the Fed, many other money market participants cannot access it, either because they don’t earn interest on Fed account balances (like government-sponsored enterprises, or GSEs) or don’t have Fed accounts at all (like money market funds). Without such access, these institutions may have less bargaining power and may have to leave funds unremunerated at the Fed or place funds in the market at sub-IOER rates. This creates a potential arbitrage opportunity for banks, which can earn a spread between their costs of funds and their earnings on reserves, but not for other cash lenders. However, uncertain or rising balance sheet costs — likely related to new regulatory changes, including higher capital requirements, leverage ratio and liquidity requirements, and changes in the FDIC’s insurance fee assessment scheme — may have altered banks’ cost-benefit evaluations and tempered their willingness to arbitrage the differences in rates. Additionally, banks are reportedly unable to attract substantial funds because of lenders’ concerns regarding credit risks associated with uncollateralized lending and because lenders often distribute their investments among several banks, making their supplies of funds relatively insensitive to the interest rates offered by individual banks. Thus, while banks take some advantage of the arbitrage opportunity, competitive conditions in the unsecured money markets haven’t proven strong enough to narrow the spread between the fed funds rate and the IOER rate to very small and stable levels, and the floor on rates that IOER is meant to provide appears soft.

That is: The Fed is having trouble influencing short-term rates because banks are not the seamless transition mechanism you might once have expected. Nobody trusts the banks, so they can't increase their borrowing in the unsecured market just by raising the price. Regulation makes the banks so creaky and complicated that they actually don't want to make risk-free money by borrowing all they can from the fed funds market and lending to the Fed at IOER rates, because it would mess them up for capital or whatever. Also: Banks are jerks, and keep the spreads wide by borrowing from lenders with "less bargaining power."

MORE--WHAT A MESS!