IMF On Central Banks, Hedge Funds And Repos

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High excess reserves may hinder economic recovery

Mammohan Singh notes in his June 2014 International Monetary Fund (IMF) working paper that the Federal Reserve acquired high quality liquid assets (HQLA) such as U.S. Treasuries and mortgage backed securities during quantitative easing to provide liquidity. Sellers were nonbanks, including money market funds, government sponsored enterprises, mutual funds and hedge funds.

Nonbanks deposited their funds at banks which created corresponding reserves at the Fed. Since October 6, 2008, the Fed started paying interest on reserves to banks and the rate is currently 25 basis points. Banks are looking to free up their balance sheets to seek higher returning assets. Since the end of the financial crisis in early 2009, excess bank reserves have increased exponentially.

Central banks such as the Fed are looking to reduce excess reserves. If banks do not lend excess reserves out, the economic recovery process may be hindered as money does not flow back to be used. The central bank may find that it is more difficult to control short term interest rates with substantial excess reserves. If the economy recovers briskly, banks may quickly lend out their excess reserves exerting inflationary pressure.

Reverse repo programs can help reduce excess reserves

The reverse repo program (RRP) allows the Fed to sell HQLA to banks and nonbanks like hedge funds with an agreement to buy it back at a future date. The Federal Reserve Bank of San Francisco notes that reverse repos increase and excess reserves decrease by the same amount within the Fed’s liabilities. Nonbanks use their bank deposits to purchase HQLA freeing up banks’ balance sheets. Banks can also use RRP to purchase more HQLA to use in bilateral repo transactions.

Fed reserve repos

Source: IMF WP/14/111 June 2014

Banks can seek higher returning opportunities with their newly available capital. A nonbank may engage in a bilateral repo with a bank using HQLA. Alternatively, a bank can help a non-eligible RRP entity such as a pension fund obtain high quality collateral.

HQLAs as third party reverse repos are permissible collateral

HQLAs used in third party reverse repos are permissible collateral only to members of the Government Securities Division (GSD) of the Deposit Trust and Clearing Corporation (DTCC). According to Singh’s 2014 IMF working paper, third party repos in the U.S. market help fund broker/dealers and banks using collateral. The Fed stated that the third party repo market is worth approximately $1.8 trillion, down from its peak of about $3 trillion prior to Lehman Brothers’ collapse. The restrictions on RRP and its third party structure enabled the Fed to strengthen the link between bilateral and Triparty repo markets. The Fed established a floor on September 2013 on the repo rate that ranges between 3 and 5 basis points.

Repos rates

RRP is effective in helping the Fed remove excess reserves from the money supply. Singh proposes adopting a varying RRP rate as the Fed Funds rate. The RRP will rise as economic conditions improve and tapering of monetary stimulus can start in a gradual manner.

fed repos


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