Karen Shaw Petrou’s memorandum to the Federal Financial Analytics Clients on the BOE goes wilde, agrees nothing succeeds like excess.
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
Morningstar Investment Conference: Using Annuities In A Portfolio For Added Stability
DATE: August 5, 2016
The BOE Goes Wilde, Agrees Nothing Succeeds Like Excess
With its back against the Brexit wall, the Bank of England (BoE) yesterday not only dropped rates, but also departed from the global consensus and took excess reserves out of its leverage rule. This thus cuts British banks a bit of a break, one that would surely be greeted by fear and loathing in the U.S. about the “watering down” of rules on “TBTF banks.” U.K. parliamentarians did not cry for Mark Carney’s head following the LR revision and U.S. Members of Congress need to know why: excess reserves are critical to effective monetary-policy transmission. Every day a bank opens its doors, deposits come in. If deposits can’t go into loans – hard to do in a recession – or into no-risk assets like Treasuries – hard to find due to accommodative policy – excess reserves are the only resort. Without them, banks either shut their doors to new depositors – putting the financial system into freefall – or a wild scramble begins for any kind of assets at any price, pushing rates below the zero lower bound and igniting inflationary fires along the way.
Two recent FedFin papers go into depth on the nexus between excess reserves, the leverage rule (LR), and effective monetary policy. The Bank of England’s action validates our conclusions in both of them: imposing the risk-blind leverage rule on risk-free excess reserves has perverse, even dangerous consequences.
To understand why, it’s vital to recognize that – powerful though central banks are – they don’t yet run the world. Other factors have a huge impact on the environment into which monetary policy and prudential rules must fit if they are to do their job. Sometimes, this environment is created by other rules – for example, the new MMF ones from the SEC driving at least $500 billion from prime funds into “govvies” that have very different cash-deposit requirements. Sometimes, these factors come from geopolitical stress events and financial-market strains in other countries that starve the market of no- or low-risk alternatives to excess reserves. And, of course, there’s the unique impact of prudential rules in the U.S., which are making non-banks an ever greater presence in financial markets and vastly complicating both the conduct of monetary policy and the stability of a fast-changing financial system.
With all these exogenous factors in mind, we looked in 2015 at the excess-reserve question with a particular eye on how the LR in the context of other post-crisis rules affects the ability of large U.S. banks, especially custody ones, to accept cash deposits. The paper lays out the monetary-policy and financial-stability impact when the billions that asset managers want to put in a safe store of value like a bank are forced to go elsewhere. One thing banks are still better at than everyone else: taking cash and keeping it safe from loss or operational risk. As a result, when cash doesn’t go into a bank, its depositor takes on considerably more risk. When these other places do not fuel financial intermediation, macroprudential consequences are compounded by macroeconomic ones.
We built on this analysis in May, 2016 with a paper that looked more broadly at the impact of the new regulatory framework – LR very much included – on the FRB’s ability to transmit monetary policy and ensure effective macroprudential regulation. A critical issue is the interplay between the LR and the liquidity-coverage ratio (LCR). Common initials notwithstanding, these rules collide with destructive force despite the good intentions underlying each of them. We will lay this out in more detail in a forthcoming paper, looking in particular at what happens when banks are forced by the LCR to hold huge balances of no- and low-risk assets under the LR’s heavy thumb.
Does paying interest on excess reserves (IOER) offset the LR when it comes to holding excess reserves, providing a rationale for the leverage rule despite all the opprobrium Congress now heaps on IOER? IOER gives banks a bit of an incentive to hold excess reserves, but nowhere near enough to counteract the cost of holding these funds when the cost of a three percent LR (U.K) or a six percent U.S. SLR is considered. This isn’t rocket science – an asset that costs the bank six percent in terms of capital (on which investors expect a ten percent return) earns it back 0.50 percent. Even if the funds for that asset cost nothing – generally true these days for cash, the equation is a big, big loser. Remove the LR and excess reserves still cost the bank, but nowhere near as much making it far easier for them to continue to accept deposits.
Still, some say that IOER is a big-bank subsidy. The excess-reserve equation demonstrates not only that banks – big ones most of all – lose money every day they house funds at the FRB, interest on them or not. Take away the interest and retain the LR and the excess-reserve equation turns into one in which banks have no choice but to turn away not only the funds already being declined from asset managers desperate to find safe places for the hundreds of billions fleeing prime MMFs, but also all the rest of us. If banks stop taking deposits, we’ll have to start finding our mattresses. No wonder the Bank of England did what it did. No question that the FRB should follow its lead.