Banks’ Balance-Sheet Costs and ON RRP Investment

Gara Afonso, Marco Cipriani, Catherine Huang, and Gabriele La Spada

Each day funding on the Federal Reserve’s  Overnight Reverse Repo (ON RRP) facility elevated from a number of billion {dollars} in March 2021 to greater than $2.3 trillion in June 2022 and has stayed above $2 trillion since then. On this submit, which relies on a current staff report, we focus on two channels—a deposit channel and a wholesale short-term debt channel—by which banks’ balance-sheet prices have elevated funding by cash market mutual funds (MMFs) within the ON RRP facility.

Banks’ Steadiness-Sheet Prices

In response to the COVID-19 pandemic, the Federal Reserve quickly expanded its steadiness sheet, sharply growing banks’ reserve balances and subsequently tightening the constraints primarily based on the dimensions of their steadiness sheets. Certainly one of these constraints is the Supplementary Leverage Ratio (SLR), the U.S. implementation of the Basel III leverage ratio, which grew to become efficient in January 2018. The SLR limits banks’ leverage by requiring them to carry capital higher than a hard and fast proportion of their belongings. Like all capital ratios, the SLR disincentivizes banks from increasing their steadiness sheets by issuing extra debt, both within the type of deposits or within the type of wholesale funding; in different phrases, the SLR introduces a value for banks primarily based on the dimensions of their steadiness sheets. Because the SLR treats all belongings in the identical approach no matter their riskiness, a balance-sheet growth turns into significantly pricey whether it is used to finance very secure belongings with low returns, corresponding to reserves and Treasuries.

To facilitate monetary intermediation by banks through the COVID-19 disaster, beginning in April 2020 for financial institution holding firms and in June 2020 for depository establishments, the Federal Reserve excluded central financial institution reserves and U.S. Treasury securities from the SLR calculation. The short-term measure diminished regulatory strain on the dimensions of banks’ steadiness sheets. When the measure expired on March 31, 2021, Treasury securities and reserves have been once more included within the SLR calculation, growing banks’ balance-sheet prices relative to the reduction interval. Our analysis reveals that these tighter balance-sheet constraints elevated MMFs’ funding on the ON RRP facility by a deposit channel and thru a wholesale short-term debt channel.

Banks Push Deposits Towards Affiliated MMFs

Following the expiration of the SLR reduction, banks topic to the SLR had an incentive to answer the rise in balance-sheet prices by pushing deposits towards their affiliated MMFs (for instance, MMFs sponsored by an asset supervisor belonging to the identical bank-holding firm). These affiliated MMFs ought to have subsequently seen higher inflows after March 2021 in comparison with MMFs that aren’t affiliated with banks topic to the SLR. Certainly, the chart under reveals that after the SLR reduction expired, MMFs affiliated with banks topic to SLR grew bigger relative to different MMFs.

MMFs Affiliated with Banks Topic to the SLR Skilled Higher Inflows after the SLR Aid

We exploit the variation within the SLR calculation launched by the 2020-21 reduction program to determine, by a set of regressions, the impact of banks’ balance-sheet constraints on MMFs’ belongings beneath administration (AUM). We discover that, on common, an MMF affiliated with a financial institution topic to the SLR grew $2.7 billion greater than a non-affiliated MMF after the SLR reduction interval. The impact is stronger for presidency funds (that are nearer substitutes for financial institution deposits than prime funds) and for funds eligible to spend money on the ON RRP (which may simply accommodate massive inflows by putting money on the facility). To spotlight how the tightness of the SLR constraint impacts inflows to MMFs after the SLR-relief interval, we moreover present that MMFs affiliated with banks nearer to their SLR requirement skilled higher inflows.

Banks Cut back Borrowing from MMFs

Banks’ balance-sheet constraints additionally restrict MMFs’ funding choices by decreasing banks’ incentives to borrow within the wholesale funding market. Banks and particularly sellers affiliated with financial institution holding firms are key intermediaries within the repo market, acquiring a major proportion of their funding from MMFs. From the attitude of MMFs, banks’ repos are an necessary funding possibility. If tighter balance-sheet constraints incentivize banks to scale back their issuance of wholesale short-term debt securities, together with in a single day repos, MMFs could flip to different, but related, funding alternatives, such because the ON RRP. Certainly, the following chart reveals that, whereas MMFs’ ON RRP utilization elevated considerably after the expiration of the SLR reduction, MMFs’ holdings of Treasury-backed non-public repos—that are primarily issued by banks and sellers affiliated with financial institution holding firms—decreased.

After the SLR Aid, Non-public Repos In MMF Portfolios Declined, whereas ON RRP Funding Elevated

To determine the impression of banks’ balance-sheet prices on MMFs’ ON RRP funding by the wholesale short-term funding channel, we exploit the truth that a discount in banks’ provide of repos impacts authorities funds greater than prime funds, since authorities funds can solely lend to personal counterparties by way of repos. This portfolio restriction, in apply, constrains authorities funds to solely lend to banks and their affiliated sellers as banks and sellers are the principle repo debtors among the many set of MMF counterparties. Prime funds, in distinction, can even lend to non-financial firms and native governments. In a regression setting, we present that the share of ON RRP funding within the portfolio of presidency funds elevated by 19 proportion factors greater than that of prime funds after the SLR reduction ended. If we measure MMFs’ dependence on non-public repos primarily based on their precise portfolio allocations earlier than 2020, we discover a related consequence: a 10-percentage-point enhance within the share of personal repos in an MMF’s fourth-quarter 2019 portfolio will increase the share of ON RRP funding within the fund’s post-relief portfolio by 3.9 proportion factors. Each regression outcomes level to the impression of banks’ balance-sheet constraints on the funding decisions of MMFs.

Summing Up

On this submit, we discover how banks’ balance-sheet constraints impression MMFs’ funding within the ON RRP facility. We determine two channels: a deposit channel and a wholesale short-term debt channel. By means of the deposit channel, constrained banks push extra deposits into affiliated MMFs, inflicting a rise within the measurement of the MMF trade and, subsequently, in its ON RRP utilization. By means of the wholesale short-term debt channel, constrained banks additionally scale back their demand for wholesale short-term borrowing, inflicting MMFs to switch their non-public repo lending to banks with ON RRP funding.

Gara Afonso is the pinnacle of Banking Research within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.

Marco Cipriani is the pinnacle of Cash and Funds Research within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.  

Catherine Huang is a analysis analyst within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.

Gabriele La Spada is a monetary analysis economist in Cash and Funds Research within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.   

Learn how to cite this submit:
Gara Afonso, Marco Cipriani, Catherine Huang, and Gabriele La Spada, “Banks’ Steadiness-Sheet Prices and ON RRP Funding,” Federal Reserve Financial institution of New York Liberty Avenue Economics, Could 18, 2023, https://libertystreeteconomics.newyorkfed.org/2023/05/banks-balance-sheet-costs-and-on-rrp-investment/.