Fed must watch Reverse Repo Facility closely
29 May 2014 New York
Image: Shutterstock
The Federal Reserve Bank of New York’s Reverse Repo Facility could encourage further development of the shadow banking system, according to president and CEO William Dudley.
Dudley warned the New York Association for Business Economics in a speech on 20 May that setting the facility’s overnight rate close or equal to the interest rate on excess reserves (IOER), without caps, could lead to a shift of funds out of banks into money market funds.
The Reverse Repo Facility was tested between 23 September 2013 and the end of January of this year. It saw 139 counterparties, including money market funds and banks, exchange cash with the Fed for securities, overnight at a fixed rate.
The Fed has varied the Reverse Repo Facility rate from 1 to 5 basis points during testing and the usage cap has gradually been increased to $10 billion. “As expected, narrower spreads to comparable money market rates and larger caps have led to greater usage,” said Dudley.
“Although the testing process is still ongoing, early results suggest that the overnight Reverse Repo Facility will set a floor under money market rates. Treasury repo rates have generally traded no more than a basis point or two below the overnight Reverse Repo Facility rate. Thus, the early evidence suggests that this facility would help strengthen our control over money market rates.”
But the Fed is worried about the effect that the facility could have on the flow of money into money market funds, which regulators are watching closely as they assess the ‘shadow’ banking system.
Dudley said in his speech: “To the extent that the overnight Reverse Repo Facility rate were set very close or equal to the IOER without caps, then this might result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility.”
“This could encourage further development of the shadow banking system. If this were deemed undesirable, this would argue for a wider spread between the overnight Reverse Repo Facility and the IOER in order to reduce the volume of flows into the facility.”
Considerable testing, analysis and discussion will be necessary to reach firm conclusions about the appropriate course of action, said Dudley. “My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term rates.”
Dudley warned the New York Association for Business Economics in a speech on 20 May that setting the facility’s overnight rate close or equal to the interest rate on excess reserves (IOER), without caps, could lead to a shift of funds out of banks into money market funds.
The Reverse Repo Facility was tested between 23 September 2013 and the end of January of this year. It saw 139 counterparties, including money market funds and banks, exchange cash with the Fed for securities, overnight at a fixed rate.
The Fed has varied the Reverse Repo Facility rate from 1 to 5 basis points during testing and the usage cap has gradually been increased to $10 billion. “As expected, narrower spreads to comparable money market rates and larger caps have led to greater usage,” said Dudley.
“Although the testing process is still ongoing, early results suggest that the overnight Reverse Repo Facility will set a floor under money market rates. Treasury repo rates have generally traded no more than a basis point or two below the overnight Reverse Repo Facility rate. Thus, the early evidence suggests that this facility would help strengthen our control over money market rates.”
But the Fed is worried about the effect that the facility could have on the flow of money into money market funds, which regulators are watching closely as they assess the ‘shadow’ banking system.
Dudley said in his speech: “To the extent that the overnight Reverse Repo Facility rate were set very close or equal to the IOER without caps, then this might result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility.”
“This could encourage further development of the shadow banking system. If this were deemed undesirable, this would argue for a wider spread between the overnight Reverse Repo Facility and the IOER in order to reduce the volume of flows into the facility.”
Considerable testing, analysis and discussion will be necessary to reach firm conclusions about the appropriate course of action, said Dudley. “My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term rates.”
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