MNI EXCLUSIVE: Powell Sees Substitutability As Key Repo Issue

By Evan Ryser

     WASHINGTON (MNI) - Market perceptions that reserves are more liquid than

Treasuries during heavy trading may be at the heart of why repo markets froze up

last year, Federal Reserve Chair Jay Powell wrote in a letter to Senate Banking

Committee Ranking Member Sherrod Brown.

     The Fed continues to review the September repo crunch including bank

regulation, supervisory expectations regarding liquidity stress tests and

technical requirements of intraday and overnight liquidity facilities, Powell

wrote in the letter obtained by MNI.  

     "Preliminary analysis of reserve demand has led us to focus on the

liquidity treatment of reserves and Treasury securities in regulation and by

supervisors. In particular, when reserves and Treasuries can and should be

deemed substitutable has emerged as a key issue," Powell wrote in the letter

dated Feb. 10.

     Fed staff analysis of supervisory factors affecting demand for reserves

suggests "the stock of reserves held to mitigate this risk may be large, and may

be having an effect on the efficiency of monetary policy implementation."

     Under the liquidity coverage ratio, reserves and Treasuries are treated as

fully substitutable, Powell said. "However, when used by firms to manage

stressed outflows, the different liquidity characteristics of reserves and

Treasuries may matter."

     The potential return for lenders when repo rates climbed as high as 10% in

September did not outweigh the risks lenders perceived, Powell wrote. Other

lenders that might have stepped in were constrained by internal risk limits.

     Liquidating a large stock of Treasury securities to meet large 'day one'

outflows for a firm in stress may be difficult, Powell said. That was the

situation in September with large flows of corporate tax payments and Treasury

settlements, though the volumes at the time weren't that unusual, he said.

     Powell testified Monday at Congress it's important to look at "making the

supervisory treatment really of cash the same as that of Treasuries for this

purpose."

     Senate Banking Committee Democrats, including ranking member Sherrod Brown

and presidential hopeful Elizabeth Warren, wrote to Powell ahead of his Feb. 12

Senate Banking Committee for answers about the Fed's repo actions.

     The senators posed questions about the mid-September episode, including

whether it was being used as a pretext to relax regulations that were put in

place after the 2008 financial crisis.

     "Could a bank use access to this facility to game capital or liquidity

standards, and what steps are supervisors taking to ensure that is not the

case?" the senators wrote.

     The September episode suggested Fed officials had underestimated the amount

of remaining liquidity. They are now pumping hundreds of billions of dollars

into money markets through overnight and term repos and Treasury bill purchases.

     The composition of primary dealer financing has shifted toward increased

term borrowing from the Fed and away from overnight borrowing from banks, money

market mutual funds, and others, Powell wrote.

     "We expect that as our repo operations wind down, dealers will return to

their usual market sources of financing."

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

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