US Federal Reserve representatives have floated a tweak to liquidity rules in a closed door meeting with representatives of major investment banks, GlobalMarkets understands, in a shift aimed at preventing a repeat of September’s alarming repo spike.
The central bank resisted calls for a wider relaxation of liquidity and capital rules, which some bank representatives had blamed for causing the repo market disruptions in September. JP Morgan boss Jamie Dimon said on the bank’s most recent earnings call that it would have deployed cash into the market but could not dip into its reserves for regulatory reasons.
“It’s up to regulators to decide if they want to recalibrate the kind of liquidity they expect us to keep in that account,” Dimon said.
The Fed representatives proposed creating a standing repo facility which could be counted as part of banks’ regulatory liquidity limits, in the most attractive category of liquid asset. At a stroke this would improve banks’ regulatory liquidity limits, even if the facility was never used.
Basel III instituted rules that banks must have enough liquid assets to cover 30 days of outflows — clients drawing down loans and counterparties refusing to roll funding. But the exact design of the rule, and particularly which assets and facilities count as “highly liquid”, can have a huge impact on the functioning of markets.
‘Central banking 101’
Many market participants blamed the Fed for allowing the spike in repo rates in the first place. The US central bank had not used open market operations as a main plank of its monetary policy for more than a decade and had been attempting to shrink the size of excess reserves held with it.
“This is what the Fed was created for,” Nathan Sheets, chief economist at asset manager PGIM and a former Fed employee, told GlobalMarkets. “It’s central banking 101, ensuring there’s sufficient liquidity for markets to function. It’s the raison d’etre of the Fed.”
Tobias Adrian, head of the IMF’s monetary and capital markets department, told GlobalMarkets: “The Fed wants as small a balance sheet as possible, but it might have to be bigger than it previously thought in order to allow it to keep running monetary policy effectively.”
Following the repo spike on September 16, the Fed authorised a new $75bn open market operation, and on October 8, Fed chair Jerome Powell said it would buy T-bills, with the aim of expanding the reserves available in the market.
“The question of why they didn’t have an operation ready to go that morning so we didn’t see the spike at all is a big question which I still don’t think we’ve seen the answer to,” said Sheets.