Reverse Repo and the Federal Reserve

November 6th, 2009 10:44 pm | by John Jansen |
–Fed Debating Need for Reserve Draining vs. Interest on Reserves
By Steven K. Beckner
(MNI) – After growing somewhat frustrated with the feasibility of
doing large-scale reverse repurchase agreements with non-traditional
counterparties, the Federal Reserve has begun to focus more on doing
these reserve-draining operations with the primary dealer community when
the time comes, Market News International understands.
The Fed has been informed by dealers that they would be willing to
enter into very sizable amounts of reverse repos with the Fed, if asked
to do so, provided they could get some relief from Tier I capital
constraints, MNI also understands.
No decision has been made about employing reverse repos and/or
other tools as part of an “exit strategy” from quantitative easing. The
timing and trigger is still a matter or study and debate, which
continued at the Nov. 3-4 Federal Open Market Committee meeting.
There is known to be disagreement as to how much it will be
necessary to reduce excess reserves through reverse repos, asset sales
or other means in order ultimately to tighten credit and normalize
interest rates.
Some officials believe that the Fed’s payment of interest on excess
reserves
will suffice to accomplish the purpose, contending that if the
Fed can effectively raise interest rates the amount of reserves is not
that important.
Others put more emphasis on the need to shrink the balance sheet
and reduce reserves and the monetary base. And there are those who
believe that some mixture of the two approaches will be required, but
there is no agreement on the appropriate weight that should be given to
interest on reserves and reserve draining at this time.
Reverse repos, in which the Fed sells securities with an agreement
to buy them back at a slightly higher price at a later date, have been
used by the Fed in the past and have been under discussion for months.
For example, on April 3, Fed Chairman Ben Bernanke said the Fed
“can conduct reverse repurchase agreements against its long-term
securities holdings to drain bank reserves or, if necessary, it could
choose to sell some of its securities.”
Unlike asset sales, reverse repos would not necessarily reduce the
size of the balance sheet or extinguish reserves on a  permanent basis.
But as a practical matter, the Fed could continuously roll over the
reverse repos until the underlying asset matures, thereby effectively
making a permanent reserve drain.
Some officials believe the Fed need not resort to large reverse
repos or asset sales, arguing that its ability to pay interest on excess
reserves will set a floor under the federal funds rate and also enable
the Fed to disincentivize banks from lending the reserves into the
economy if necessary.
For example, San Francisco Fed President Janet Yellen, an FOMC
voter, said recently that “paying interest on reserves is of itself a
completely adequate tool to tighten monetary conditions.” Others feel
the same way.
But there is doubt among FOMC members and Fed staff whether
interest on reserves will be completely adequate given the failure of
that program so far to keep the funds rate from trading below target.
What’s more, even though shorter-term Fed liquidity facilities have
been shrinking due to less demand, longer term asset purchases promise
to continue expanding the balance sheet. This has raised concern among
other Federal Reserve presidents who argue that the Fed needs to manage
down the size of reserves and the monetary base.
And so the Fed has been looking closely at using other tools to
drain or immobilize reserves. Reverse repos have been a particular focus
of advance preparation.
On Oct. 19, the New York Fed confirmed that it “has been working
internally and with market participants on operational aspects of
reverse repos to ensure that this tool will be ready when and if the
Federal Open Market Committee decides they should be used.”
And it said “the focus of recent work has been to expand our
existing capability to conduct reverse repos with Primary Dealers to
include ‘triparty’ settlement. This has involved working with the
triparty clearing banks and Primary Dealers to implement the necessary
changes and updates.”
“We have recently begun testing this capability with all involved
parties and systems, and it is likely that the Federal Reserve will
engage in additional tests in the future,” the New York Fed said.
The New York Fed statement also raised “the possibility of
expanding the set of counterparties the Desk might employ for conducting
reverse repos beyond the Primary Dealers.”
After initially hoping to be able to do a sufficient quantity of
reverse repos with the dealer community, the New York Fed found it
necessary to cast a wider net and entered into discussions with money
market funds and government sponsored enterprises as potential
counterparties.
But Market News understands that the technical and legal challenges
of transacting with such non-traditional counterparties has proven
somewhat daunting, leading the Fed to return its focus more on the
dealer community.
When the Fed sells securities to the dealers as part of a reverse
repurchase agreement, it has the effect of reducing their capital to
asset ratio below regulatory minimums, limiting the amount of reverse
repos the dealers are able or willing to do.
But if the Fed and other bank regulators were willing to grant an
exemption from Tier One capital requirements for the reverse repos, the
Fed has been informed that the dealers would be willing to do much more
than they originally said — perhaps up to $1 trillion.
The Fed is said to be very receptive.
Be Sociable, Share!
  1. 8 Responses to “Reverse Repo and the Federal Reserve”

  2. By GYSC on Nov 6, 2009 | Reply

    JJ,
    all due respect and I love your reasoned writing but please square, :
    “The Fed has been informed by dealers that they would be willing to
    enter into very sizable amounts of reverse repos with the Fed, if asked
    to do so, provided they could get some relief from Tier I capital
    constraints, MNI also understands”
    , with the FED activities are all good and the banks are just being innocent banks.

    I thought the FED was all about money markets for repos?

  3. By John Jansen on Nov 7, 2009 | Reply

    That piece was written by well respected reporter Steven Beckner of Market News International. Some one sent it to me. I think I left his name clearly visible. I dont want to take credit for something which is not mine.

    i think the point of the article os that if some of the primary dealers did reverse repo with the Fed in the amount that an “exit strategy” will necessitate the dealer (s) would eat up all of its balance sheet leaving the dealer with no balance sheet for its primary purpose which is the creation of a bonus pool.

  4. By Al on Nov 7, 2009 | Reply

    no one wants that toxic sh*t back on its balance sheet. as simple as that.
    I think all the banks should add Bubblenanke on their bonus bills. he’s the virtuous creator of this idiocy of transferring the trash from banks to the FED.
    but now the genius is scared to death to be audited because of that. his myopic ‘competence’ is truly unbelievable.

  5. By John C. Lately on Nov 7, 2009 | Reply

    “creation of a bonus pool”
    Very clever.

    John,
    Who assumes the default risk in a reverse repo
    situation?

  6. By jck on Nov 7, 2009 | Reply

    with all due respect, the fed doesn’t regulate primary dealers and has no authority to adjust the tier 1 capital of those primary dealers that are banks.

  7. By Cedric on Nov 7, 2009 | Reply

    hehe. I have my own theory of how the Exit Strategy works, but still am curious about how the Fed thinks the “The Plan” (Grand Experiment) works.

    Since the Fed seems to be cognizant of the fact that draining liquidity and raising interest rates are really two different, tho somewhat related things, I’ll split it into two options depending on what they decide to “target”.

    Option 1:
    The Fed decides to raise interest rates. (They say they do this by paying interest on excess reserves. Hopefully their balance sheet is generating enough yield to have the cash to do that.)

    Result: The financial world implodes because all asset values, from stocks to bonds to commodities are pumped up to bubble levels due to ZIRP, and almost by definition they would “deflate” with an increase in interest rates.

    Option 2:

    The Fed decides to drain liquidity. (They say they do this by either shrinking the balance sheet by…oh my god… asset sales, or alternately avoid selling assets by creating reverse repo paper which somehow has to vacuum up all the liquidity that got out into the world. (apparently the primary dealers are saying they didn’t end up with all the “liquidity”….best laid plans of mice and men…)

    Result: The financial system implodes. Since this is unacceptable, the Fed is considering loosening up primary dealer capital requirements. Just when we thought maybe capital requirements were already loose enough and maybe we should be headed the other way for financial system “stability”. So now we end up with both relaxed “mark to market” rules for banks, and relaxed Tier One requirements for primary dealers. We will call this “financial reform” in order to maintain everyone’s confidence in the system.

    There is a Stealth Option 3.

    Do nothing and see if we get inflation along with asset bubbles, and does inflation really solve all our problems, the way some economists claim inflation can.

    We will have to stay tuned and see how the story goes!

  8. By GYSC on Nov 7, 2009 | Reply

    “i think the point of the article os that if some of the primary dealers did reverse repo with the Fed in the amount that an “exit strategy” will necessitate the dealer (s) would eat up all of its balance sheet leaving the dealer with no balance sheet for its primary purpose which is the creation of a bonus pool.”

    John, please tell me Tyler has not assumed your name! Too funny.

  9. By Joe Schmoe on Nov 8, 2009 | Reply

    I am having trouble understanding the following:

    >>
    Some officials believe the Fed need not resort to large reverse repos or asset sales, arguing that its ability to pay interest on excess
    reserves will set a floor under the federal funds rate and also enable the Fed to disincentivize banks from lending the reserves into the economy if necessary.
    >>

    That money isn’t being loaned into the economy NOW. Excessive reserves is a phrase where the emphasis is on the first word, not the second. There is debate about willingness to lend vs absence of borrowers, but that debate is irrelevant to this question of QE exit strategy. Why is there any consternation. If the Fed wants to drain reserves, drain them. They aren’t being loaned out anyway.

Sorry, comments for this entry are closed at this time.