MNI EXCLUSIVE:Fed Needs Repo Market Review, Bank Regs In Focus

By Evan Ryser

     WASHINGTON (MNI) - The Federal Reserve needs to undertake a comprehensive

review of repo markets including an examination of the effects on liquidity of

post-crisis banking regulation if is to fully restore confidence in its ability

to control short-term interest rates, current and former Fed officials told MNI.

     While Chair Jerome Powell has expressed confidence that the Fed has dealt

with the issues behind September's repo funding squeeze, he has suggested

changes to banking regulations may have caused the overnight market to clog and

pointed to potential changes to the daylight overdraft facility.

     The Fed needs to consider all options, said Bill Nelson, former deputy

director of the Fed's division of monetary affairs, in remarks echoed by other

current and past Fed officials.

     "I think there's a whole range of things that the Fed could do," said

Nelson, who is currently at the Bank Policy Institute and helped design

post-Lehman emergency liquidity facilities, "including increasing

substitutability of cash for Treasury reverse repo, embedded in the supervisory

liquidity assessments that the Fed makes."

     Banks' leverage ratio requirements should also be considered a backstop to

risk-based capital requirements, rather than as binding targets, Nelson said,

adding that the Fed should in addition examine the "extraordinary pressures"

produced at year-end by capital surcharges applied to global

systemically-important lenders.

     In last week's Congressional testimony, Chair Powell said some banking

regulations could be adjusted to allow liquidity "to flow more freely in the

system without undermining safety and soundness." Senator Elizabeth Warren, a

Democratic front-runner in the 2020 presidential election, recently expressed

alarm at how the Fed has had to intervene in the money markets and accused

Treasury Secretary Steve Mnuchin of "already using it as an excuse to weaken the

rules on giant Wall Street banks."

     --DAYLIGHT OVERDRAFTS

     Nelson said Powell's suggestion for letting banks run daylight overdrafts

on their Fed accounts would be ineffective. Whether by means of allowing

overdrafts collateralized solely by Treasuries, a more generous net debit cap,

or decreasing fees, it would have only a marginal effect at best, Nelson said.

     Overdrafts have become rare, making banks reluctant to run them for fear of

prompting unwanted attention from supervisors, he said. Other current and former

Fed officials told MNI they agreed that daylight overdrafts would make little

difference.

     "First and foremost, the Fed should go out and at least try to educate

banks and supervisors ... to let them know that the banks have daylight capacity

that they're supposed to use. So that there shouldn't be any signalling from the

supervisors or misunderstanding from bank management that use of that is a

problem," Nelson said.

     The Fed has said preference for reserves over Treasuries is not prescribed

by regulation and that banks' preference for reserves makes them less nimble in

repo markets. Banks meanwhile report feeling pressure from bank supervisors.

     Neither encouraging trading of reserves nor encouraging lower holdings

would do much to address repo market tightness, said Vincent Reinhart, who held

roles at the Fed over 24 years including director of the division of monetary

affairs.

     "I think those are really measured in basis points, and the unwillingness

to use reserves when there are arbitrage opportunities are much more related

about what bank supervisors will do," Reinhart told MNI.

     Instead, the Fed will have to look to more comprehensive solutions to its

repo travails.

     "I think the Fed is in a tough place, that's why they would be better off

dealing with it by the way they provide reserves rather than count on waving a

magic wand and have banks use them more efficiently," Reinhart said.

--MNI Washington Bureau; +1 202 371 2121; email: evan.ryser@marketnews.com

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