Up until April this year, US banks had a nice little earner.
As Freakonomics explained, big banks were able to borrow cash from the Fed funds or repo market for say, 15 basis points, posting US Treasuries as collateral, and then deposit the cash received with the Federal Reserve overnight at 25bps, earning some 10bps. The FT has estimated that since late 2008, this risk-free arbitrage may have netted America’s banks as much as $200m in profits.
The arbitrage-opp came to an end in April, however, when the US Federal Deposit Insurance Corporation’s (FDIC) introduced a new fee on banks, essentially eliminating the 25bps-grab.
Small problem. It seems the new FDIC rules don’t apply to many non-American banks. And foreign banks, we should all know by know, also have access to the repo markets and federal funds.
Can you see where we’re going? Here’s Michael Cloherty’s RBC Capital:
… we think a large part of the jump [in reserve balances] is due to foreign banks arbitraging the spread between short rates and the 25bp interest rate the Fed pays on reserves (IOER). Because the FDIC started charging a deposit insurance fee on total bank assets, banks that have FDIC insured deposits are limited from expanding their balance sheets to arbitrage IOER. That reduction in arbitrage activity has driven most short rates lower—the FDIC fee has effectively acted as a partial Fed ease.
However, foreign banks that do not take FDIC insured deposits do not have to pay the FDIC fee. With short rates lower, it is now even more attractive for them to raise money by issuing CD or CP, lending Treasuries or MBS in the repo market, etc., and leave that cash at the Fed to collect 25bp. There is little data to indicate how much of the growth in US branches of foreign banks’ reserve balances are due to this arbitrage activity, but we presume that it is a meaningful percentage of the jump.
Cloherty also points out that the reported assets of US branches of foreign banks are up 250 per cent since the end of last year, now making up a whopping 48 per cent of their total assets. Basically, foreign banks have absorbed all of the growth in reserve balances in 2011 — which may be one reason why money market rates like Libor haven’t moved very much, even in the face of the eurozone debt crisis.
So should we be worried about foreign banks arbing so-called IOER? Cloherty thinks not:
While the notion of foreign banks arbitraging the Fed may be slightly unsettling, it is bank arbitrage that makes Fed policy effective. If excessive limits on bank arbitrage were set up, then Chairman Bernanke’s statement that the Fed could tighten in 15 minutes would become null and void.
In normal times, the Fed targets the rate that banks lend overnight to other banks. Banks arbitrage between this rate and other short rates, pulling those rates toward the Fed target. That change in short rates impacts longer rates, which then influences borrowing patterns and investment flows. Bank arbitrage of short rates is the mechanism by which Fed policy is transmitted to the broad economy.
Since the FDIC fee limits US banks ability to drive other short rates towards the Fed’s target (in this case the 25bp rate the Fed is paying on reserves), then foreign banks become much more important in the policy transmission process. As the decline in repo, CP, and other short rates indicates, foreign banks have not been completely successful in keeping rates near the Fed target. But if there were limits on foreign bank arbitrage, the Fed’s policy transmission mechanism would become significantly weaker.
Which sounds fine — but arbing IOER doesn’t come without consequences. As Cloherty also points out, the practice basically inflates banks’ balance sheets. In the face of eurozone turmoil, foreign banks — especially European ones — might want to clean-up their balance sheets, not embellish them.
In which case…
The Fed is the only entity that can create or destroy reserves, so if a European bank stops arbitraging IOER over quarter-end, then those reserves will flow to another bank, with a US bank being the most likely recipient. A flow of reserves from foreign banks to US banks would inflate US banks’ balance sheets, and presumably make those US banks much more aggressive about shrinking their balance sheet elsewhere. We think this will lead to much less capacity in the repo market and lower rates as there is a drop in CD and CP supply and less collateral being lent.
If we see the quarter-end disruptions that we fear, it would indicate that sharp swings in reserve demand will make it very difficult for the Fed to control the funds rate as long as there are large amounts of excess reserves in the system. This will create more pressure on the Fed to drain reserves. And since the Fed cannot be sure that massive reverse RP [repurchases] and term deposits will have unexpected effects, asset sales also will play a prominent role in the Fed exit.
The repo carry trade – Big Picture
Fed funds rate & excess reserve arbitrage eliminated – Duffminster Times
The need for an IOER-fed funds spread – FT Alphaville