Via Financial Times

Stress tests designed to make banks more stable might have exacerbated a spike in short-term borrowing costs that forced the Federal Reserve to step in to calm markets earlier this year, according to the lead banking regulator in the US.

Randal Quarles, the vice-chair of the Fed, said on Wednesday that banks’ own internal stress testing may have led them to hoard cash rather than lending it in the overnight repurchase — or repo — market. 

He listed these liquidity stress tests, typically carried out under the supervision of regulators stationed at the banks, as one potential cause of the crunch in September, when overnight interest rates suddenly soared. The incident prompted the Fed to inject tens of billions of dollars into the banking system.

Mr Quarles and other regulators have spent the last few months examining whether the rules put in place following the financial crisis might have contributed to the market turmoil. 

“There were a complex set of factors that contributed to those events in September,” Mr Quarles told a congressional hearing in Washington. “I think we need to examine them, particularly among them, the internal liquidity stress tests that we run that create a preference — or can create a preference — at some institutions for central bank reserves over other liquid assets including Treasury securities.”

Treasurers and bank executives say the most pressing liquidity requirement they have to deal with is the liquidity coverage ratio, which requires banks with more than $50bn in assets to hold enough cash to cover 30 days of outflows at times of stress. 

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Banks must also fulfil a range of other standards that are set by their supervisors based on their business models and other criteria. Those requirements include compelling banks to hold a certain amount of cash that can be immediately accessed. 

This cash cannot be offered in the repo market, where loans are made for a fixed period overnight and cannot be called back if the lending bank immediately needs it. 

One bank managing director told the Financial Times in October: “The [one-day] liquidity requirement is massive. There is no way banks can hold anything but cash for that.”

Mr Quarles did not say he was considering changing those requirements, however.

Over the past two years, the Fed has made a series of changes to banking regulations, including reducing the number of stress tests it conducts on regional banks and reducing the amount of capital it requires some institutions to hold. 

The Fed says these changes have tailored regulations more closely to the companies being regulated, though critics have accused Mr Quarles of chipping away at the foundations of post-crisis safety system.

“Our goal through this intense period of regulatory activity has been to faithfully implement Congress’s instructions,” the Fed vice-chair told lawmakers, citing the Crapo Act passed last year to reduce reporting and capital burdens on some banks.

“Those instructions also speak to a broader need, and one central to our ongoing work, which is to ensure that our regulatory regime is not only simple, efficient, and transparent, but also direct and effective financial regulation.”

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