The FT, the Fed and the FRRP

An article in the FT on 21 March reported that “The Federal Reserve has assumed a much bigger role in a key funding market that had long been a prime component of the unregulated shadow banking system, reflecting central bank concerns that it poses a systemic risk”. The market, identified only as the repo market, is in fact the US tri-party repo market.

What the Fed has done is to introduce its Fixed-Rate Reverse Repo Program (FRRP). Through the FRRP, the Fed periodically offers to take deposits against collateral at a fixed deposit rate, not only from its usual primary dealer counterparties, but also (and unusually) from large money market mutual funds.

The FT article sees the FRRP as a tool to tackle the severe systemic risk in the US tri-party repo market by disintermediating the primary dealers. They have traditionally been the main borrowers in the tri-party market, intermediating funds from tri-party investors such as money market mutual funds and securities lending agents to the rest of the market. The FT article said, “Now with the central bank taking a more central role in this crucial funding market, the shadow banking system stands to have greater official support during the next financial crisis.”

This is news indeed! It is also news that will have come as a great surprise to the Fed. But, even at first glance, it is highly improbable. The whole thrust of regulatory reform since 2008 has been to eliminate the moral hazard created by implicit official support for regulated banks considered too big to fail. Consider the special capital requirements on SIFIs (Systemically Important Financial Institutions), the requirement for “living wills” and the new bank resolution regimes. So, how likely is it that, having done so much to try to wean regulated institutions off public support, regulators would they now extend such support to unregulated ‘shadow banks’?

In fact, the Fed is not insuring shadow banks through its FRRP. The FRRP is a monetary policy tool. It was created to give the Fed better control over interest rates at a time when the market is awash with liquidity (which the Fed has provided to ameliorate the post-2007 financial crisis). The specific aim of the FRRP is to provide a tool to drain this liquidity and guide rates higher. In theory, it is only being tested but it has already proved useful in setting a floor under money market rates to stop them becoming negative under the weight of money being pumped into the market by the Fed’s continuing Quantitative Easing (QE) programmes.

The inclusion of money market mutual funds as counterparties to the FRRP reflects another problem affecting monetary policy implementation at the moment. The usual channels of monetary policy transmission, which flow through primary dealers, have been impaired by the balance sheet constraints on these institutions and their own heightened risk aversion. These traditional intermediaries have become less able and less willing to arbitrage central bank money to the rest of the market. Money market mutual funds have been drafted in because they play a key role in recycling cash to the banking sector. And they are keen to use the FRRP, because banks are borrowing less from them, particularly at the end of reporting periods.

It may be that the FT has confused the FRRP with the Fed’s attempts to persuade the US tri-party market to underwrite itself by providing a collective guarantee to undertake the orderly liquidation of collateral in the event of a major default in that market in order to prevent a fire sale of assets (this now looks likely to involve the introduction of a CCP).

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