Analysts described last month’s spike in repo rates—from about 2% to 10% on Sept. 15—as “wild” and “seismic,” sowing “shock and confusion.” Some blamed high cash demand to pay estimated taxes and settle Treasury bond auctions. More-esoteric explanations included a holiday in Japan, the “glut” of safe assets overwhelming scarce cash reserves, the Federal Reserve’s foreign-repo program for non-U.S. lenders and central banks, and even the recent attack on Saudi oil facilities.
The risks of another credit collapse that surfaced last month spurred forceful intervention by the Fed. For the first time since 2008, the central bank directly and repeatedly made repo loans. In response to criticism of the Fed’s failure to foresee the problem, Chairman Jay Powell asserted that the Fed understood repos as well as anyone and observed that market participants had also been surprised. New York Fed Chief John Williams declared that the Fed was “consistently and constructively supporting stability” in repo markets.
Critics who assert that the repo snafu marked an “unequivocal” breakdown in the Fed’s control of monetary policy have demanded forceful and permanent changes in repo policy. Some bankers have argued that the Fed should intervene in the repo market routinely, not only during emergencies, and particularly at the end of financial quarters, when banks’ cash requirements surge.
But does the repo market really warrant “constructive support” from regulators? Markets in physical commodities provide valuable price signals: A rise in the price of tin encourages miners to increase production and users to reduce consumption of the metal. But the Fed produces cash as if out of thin air and requires banks to hold this cash through its reserve requirements. Routine Fed examinations also encourage a ritualistic charade that increases the volatility of repo borrowing: Every three months banks scramble for cash to pass end-of-quarter checks of their reserves. The Fed’s monetary policies affect the availability of Treasury bonds used as repo collateral. And regulators set the rules for the repo market: Intraday borrowing, for instance, is prohibited.
Fiat money, macromonetary policies and bank reserve requirements interact with factors that regulators cannot control—such as tax payments, Japanese holidays and drone-and-missile strikes—to make the repo market complex and unstable. Complexity tends to beget more complexity. Temporizing fixes would only increase the repo market’s complexity and expand the power of insiders who claim to know what’s going on. As we know from 2008, byzantine complexity can cause financial systems to collapse.
Simplifying how banks borrow would make the banking system more resilient. The Fed could routinely offer unsecured short-term loans to banks at its target fed-funds rate. Now, the Fed grudgingly lends at its “discount rate” against eligible collateral pledged by banks. Regulators could also decouple overnight borrowing from collateral pledges by explicitly guaranteeing all the short-term liabilities banks hold. To discourage overborrowing, regulators could charge a guarantee fee, as the Federal Deposit Insurance Corp. does.
Free-market purists might regard such guarantees as an abhorrent elimination of market discipline. But there isn’t much market discipline to eliminate. Besides, we already have a parallel system that shows banks can successfully access credit without providing collateral or detailed financial information to lenders—the fed-funds market. Banks lending to each other in that market trust that regulatory examination, the Fed’s safety net, and whatever discipline stock- and bond-holders might provide are sufficient to make the system function properly except in times of acute stress.
Simple, explicit guarantees would reduce the complexity of short-term borrowing by banks. Banks would gain more-stable funding, and all would benefit from a sounder banking system. The way to prevent future repo crises, as in Scandinavia, is to make the market unnecessary.