It was an exciting week in financial markets, including some dramatic central bank interventions in short-term money markets.
First, a little background on what we're talking about here, focusing on the U.S. system with which I am most familiar. Banks that are members of the U.S. Federal Reserve System hold accounts known as Federal Reserve deposits. These deposits play a fundamental role in interbank financial transactions. If a bank wants more currency, it can obtain it by converting its Federal Reserve deposits to cash. Checks are often cleared by debiting the Federal Reserve deposits of the bank on which the check is drawn and crediting those for the receiving bank. Wire transfers are also implemented by a transfer of deposits between banks.
If you followed an individual dollar of Federal Reserve deposits, you would find it moving between banks a very large number of times each day. However, none of these interbank transactions would change the total value of Federal Reserve deposits. New deposits can only be created by an act of the Fed itself, either in the form of an open market operation (in which the Fed credits a particular bank with new deposits in exchange for receipt of another asset of equal value) or a discount window loan (in which the Fed loans deposits to the bank, holding other assets from the bank as collateral).
Banks try to hold as few of these deposits as possible, since they do not pay interest. However, banks are required to hold minimum levels of deposits based on the dollar value of checking accounts issued. Banks could alternatively meet some of these requirements by holding physical cash instead, and the sum of this cash plus deposits is known as reserves.
The banking system as a whole usually holds only a small amount of reserves in excess of what is required. A bank that ends up with extra reserves would find it advantageous to loan Federal Reserve deposits overnight to a bank with a deficit in what is called the federal funds market. The interest rate on these overnight loans is usually very sensitive to the quantity of excess reserves in the system, so the Fed could change this rate by adding or subtracting deposits through open market operations. The Fed simply announces the rate it intends to maintain, with the current target being 5.25%, and the announcement is credible because all participants know that the Fed will be adding or draining reserves as necessary to keep the rate near the target.
Not all loans will take place exactly at the target rate, however. These loans are unsecured, and though their very short-term nature makes the risk small, it is not zero. Small banks will often pay a slightly higher rate to borrow fed funds than will big banks, and an individual bank will have a maximum amount it is willing to lend to any given other bank. If a bank has a really big outflow of reserves, or its usual sources for borrowing short-term funds dry up, it may need to offer a rate well in excess of 5.25% in order to maintain a positive level of reserves.
This was the case on Friday, on which the fed funds market opened with some trades at 6%, some 75 basis points above the rate that the Fed has declared it will defend. So, the Fed used open market operations in the form of repurchase agreements to create new reserves, evidently in the amount of $38 billion. One can put this number in perspective with the following graph of what Federal Reserve deposits usually turn out to be over a two-week period. This was a huge intervention, on a par with the remarkable measures taken September 11, 2001, when the interbank loan market faced severe disruption from the physical destruction of a large number of the key institutions that make these markets. Again this week it seems that banks suddenly desired a huge volume of reserves in excess of the amounts they are required to maintain.
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What exactly was the nature of the disruption this time? The problems apparently started in Europe, where Germany's IKB Deutsche Industriebank found that because of problems with its investments based on U.S. subprime mortgages, some of its usual lenders stopped extending short-term credit. In addition, France's BNP Paribas SA suspended withdrawals from three of its investment funds. Lenders of short-term funds became more cautious lending to a number of other institutions, and banks scrambling for funds bid up the overnight rate. To prevent a spike in short-term interest rates, the European Central Bank ended up injecting 94.8 billion euros, or more than 3 times the size of the U.S. intervention.
Some analysts have interpreted the Fed's action as "bailing out the banks", and are particularly troubled by the fact that the assets purchased by the Fed through the open market operations apparently involved mortgage-backed securities. I too was a little surprised that the Fed would consider buying anything other than Treasury bills, though I agree with Calculated Risk that since the reserves were injected in the form of a 3-day repurchase agreement,
unless the banks go under in 3 calendar days, they will pay the loan back with 3 days of 5.25% interest. No big deal.
More sound analysis was provided by Felix Salmon, King Banian, Paul Krugman, and Mark Thoma. And here's William Polley:
A lot of entities holding mortgage backed securities needed liquidity. They were willing to borrow at a higher overnight rate to get that liquidity as evidenced by the spike in the funds rate early in the morning. The Fed, quite understandably, did not want the funds rate to spike, and so they loaned these banks reserves accepting mortgage backed securities of the highest quality as collateral (the Fed was NOT bailing them out by buying distressed subprime loans). This kept anyone from unloading good quality assets at fire sale prices just to get liquidity. That would have been disastrous. The agreement is that on Monday the banks get their securities back and the Fed takes back the reserves.
The bottom line is that the Fed was doing exactly what it needed to do. But the fact that this was needed is a very troubling development.
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