Forward guidance:? Discount window tidbits

From: Bill Nelson <[email protected]>

Sent: Monday, December 4, 2023 7:19 AM

Subject: Forward guidance: Discount window tidbits

Riskless arbitrage opportunity

?Any bank with securities it owned on March 12, 2023 that the Fed is allowed to purchase in open market transactions that is not already using the securities as collateral to borrow from the Fed’s Bank Term Funding Program has an opportunity to make a little money.? The Fed is allowed to purchase Treasury and agency debt and agency MBS, but it is also allowed to purchase other things including foreign sovereign debt (see section 14 of the Federal Reserve Act). The interest rate on BTFP loans as of Friday is 5.18 percent (the one-year OIS swap rate plus 10 basis points).? The interest rate the Fed is paying on deposits (reserve balances) is 5.40 percent.? The BTFP loans have terms of one-year, the interest rate for each loan is fixed for the term of the loan, and the loans can be repaid early without penalty.? The loans can only be backed by securities the bank owned as of March 12.

So borrow from the BTFP, leave the proceeds on deposit at the Fed, and collect the 22 bp spread.? If the BTFP rate falls further, repay the loan early and take out a new loan.? If the IORB rate falls below the interest rate on your BTFP loan, repay the loan.? A similar arbitrage opened up for AMLF loans in May 2009 and the Fed quickly adjusted the program to close it.

?A window into Fed lending

Two of my colleagues at BPI, Laura Suhr Plassman and Felipe Garcia Rosa, recently published a note with some information about the amount and type of discount window collateral pledged by banks – “Statistics on Collateral Pledged to the Discount Window.”? Each quarter, the Fed publishes information about loans provided in the quarter two-years prior.? For each loan, in addition to the borrower, amount, type of credit, and rate, the Fed publishes the lendable value of the total amount of collateral the bank had pledged.?

Except very rarely, and usually when something has gone wrong, banks do not pledge collateral for each loan.? Instead, they maintain a pool of collateral pledged at all times.? So if a bank takes out an overnight $1 million test loan on March 1 the loan record published by the Fed will report the $2 billion in collateral, say, the bank has pledged, by type of collateral.? If the same bank takes out another test loan on April 1 for, say, $500,000, the loan record for that loan will report essentially the same $2 billion in collateral.

Laura and Felipe looked at the last four quarters of loan data available – 2020Q4 to 2021Q3.? They found that the banks that had borrowed collectively had $917 billion in collateral pledged (lendable value, meaning the amount after a haircut is applied to the fair value of the asset).? Two-fifths of the collateral pledged was consumer loans and one-fifth was business loans, with the remainder spread fairly evenly across asset types.? They also found that the collateral equaled 18 percent of the uninsured deposits of the banks that borrowed.

The amount of collateral pledged by banks that borrowed over the year is, of course, less than the total amount of collateral pledged, because not all banks with collateral pledged borrowed.? The Fed reported in its March 2020 Quarterly Report on its Balance Sheet, that as of February 26, 2020, banks had $1.6 trillion in collateral pledged (lendable value).? See the note to table 5.? As far as I know, this is the most recent number available.

FDIC repays its loans from the Fed

As reported by Lou Crandall in this week’s Money Market Observer, the next H.4.1, the Fed’s weekly balance sheet report, will show that the FDIC has repaid all the $238 billion that the Fed lent to it as receiver of the banks that failed this spring.? The Fed presumably provided the funding because the debt ceiling constrained the ability of the FDIC to borrow the funds from Treasury.?? As of Wednesday, there was $33.9 billion remaining of “other credit extensions,” which is what the Fed calls the loans. ?Friday afternoon, Treasury reported an FDIC outlay on Thursday of $35.3 billion almost surely to repay the loans.? For more information, see here (Fed), here and here.

An important speech about the discount window and liquidity risk management

Vice Chair for Supervision Michael Barr delivered an important speech on liquidity regulations and the discount window Friday.? Here is the summary from BPInsights, BPI’s excellent Saturday news wrap-up email.? (You can sign up for the newsletter here).

From BPInsights:

Barr: Discount Window Readiness a Key Part of Banks’ Liquidity Toolkit

Banks should be prepared to borrow from the Fed’s discount window as part of a range of liquidity resources, and the turmoil this spring demonstrated the danger of being unprepared to use the window, Vice Chair for Supervision Michael Barr said Friday in a speech in Frankfurt. “It is crucial that banks have a diversified range of liquidity options that they are able to access in a variety of conditions,” Barr said. “And in the case of banks that are eligible to borrow from the Federal Reserve, discount window borrowing should be an important part of this mix.” Banks should be ready to borrow from the discount window in normal conditions and under stress, too, Barr said.

• Fighting the stigma: Barr addressed the topic of discount window stigma. "Banks have previously said that they are afraid of receiving negative feedback from their supervisors in the event that their sole grounds for tapping the discount window is that it is the most convenient or cheapest form of funding immediately available to them," he said. "In light of this, we at the Federal Reserve have been underlining the point to banks, supervisors, analysts, rating agencies, other market observers, and the public, through numerous channels, that using the discount window is not an action to be viewed negatively. Banks need to be ready and willing to use the discount window in good times and bad."
• Test run: Banks should test their discount window borrowing access to ensure they are ready to borrow in an emergency, Barr said. Pre-pledging collateral to the window is another aspect of ensuring that readiness, he noted.
• Liquidity regulations: Liquidity measures like the LCR and NSFR have strengthened the banking system’s resilience, Barr said. However, he expressed that “these requirements may not, on their own, be sufficient to stem a rapid run. The speed of bank runs and the impediments to rapidly raising liquidity in private markets that may be needed in hours rather than days suggest it may be necessary to reexamine our requirements, including with respect to self-insurance standards and to discount window preparedness. The lessons from March also indicate that some forms of deposits, such as those from venture capital firms, high-net-worth individuals, crypto firms, and others, may be more prone to faster runs than previously assumed.”
• Closer look: The Fed is studying what variations in discount window readiness among banks may mean for the financial system’s stability, he said.
• Bank runs at sprint speed: The rapid run on deposits this spring has changed perceptions on the potential speed of bank runs, Barr said. “What occurred in two or three weeks or, in some cases, many months in previous episodes may, in the modern era, now occur in hours,” he said. “These issues are top of mind as we review and consider future adjustments to the way in which we should supervise and regulate liquidity risk.”
• Questioning assumptions: Barr called previous assumptions on liquidity under stress into doubt. For example, he said banks may face difficulty selling assets quickly without attracting scrutiny from the market, and private repo markets could become volatile.

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--Bill?

Bill Nelson | Chief Economist | Bank Policy Institute | 1.703.340.4542

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