The Federal Reserve Bank of New York is examining why banks with excess cash failed to lend to the overnight money market, following a week that revealed cracks in the US’s financial plumbing.
John Williams, president of the New York Fed, on Friday questioned the hesitance of the banks in an interview with the FT. “The thing we need to be focused on today is not so much the level of reserves [held at the Fed],” he said. “It’s how does the market function.”
Overnight borrowing rates rose as high as 10 per cent on Tuesday morning, prompting the New York Fed to intervene in the overnight repurchase, or repo, market for the first time since the financial crisis, injecting cash in an effort to unblock the system.
It has since repeated the operation every morning, helping ease pressure in the market, and announced on Friday that it would also offer up to $90bn in two-week long loans to further reduce strain ahead of the end of the third quarter.
Some market participants have claimed that the week’s volatility arose from a shortage of cash in the financial system, stemming in part from the unwinding of the Federal Reserve’s post-financial crisis intervention. However, Fed officials are focused on the role of the banks.
Mr Williams and Lorie Logan, senior vice-president in the markets group at the New York Fed, said officials were looking at why cash failed to move from banks’ accounts at the Fed into the repo market, where banks and investors borrow money in exchange for Treasuries to cover short-term funding needs.
Ms Logan pointed to the concentration of excess cash at a small number of banks as one potential issue.
“Reserves are concentrated, the excess reserves relative to the minimum level each bank is demanding is concentrated,” she said. “And the key question is how those reserves, as the level was coming down, would get redistributed, and how smooth that redistribution process would be.”
Fed officials expected some pressure in the market this week as a result of corporate tax payments and Treasury settlements, which would drain cash out of the system. As it monitored short-term lending markets, the New York Fed paid particular attention to the amount of reserves available.
Ms Logan said the expectation had been that as repo rates rose, banks would withdraw excess cash held at the Fed and lend it into the repo market to earn the higher rate of interest. Instead, the New York Fed had to step in to provide that cash as banks remained on the sidelines.
In recent years, the markets desk at the New York Fed has been conducting surveys and holding regular conversations with banks to determine their “lowest comfortable level of reserves”. In a speech this year, Ms Logan flagged the difficulty of making such estimates, and the possibility that reserves could be distributed inefficiently among banks.
On Friday, the New York Fed said that it would expand its interventions beyond overnight loans after the lending rate for two-week funds rose sharply — to 2.7 per cent, up from 2.35 per cent in previous days.
Analysts described the spike as an indication that investors were anticipating a fresh financing squeeze at the end of the quarter, when companies and traders settle their accounts. The new two-week loans will be offered by the New York Fed next week in three operations on Tuesday, Thursday and Friday.
Friday’s overnight repo auction by the New York Fed saw a lower level of demand from borrowers than the previous two days. Bids came in at $75.6bn, down from $84bn on Thursday and $80bn on Wednesday. On Tuesday, the first day on which the $75bn overnight repo facility was offered, the New York Fed saw $53bn of bids.
The overnight repo rate receded to 1.95 per cent on Friday.