Fall in US bank reserves portends stress for markets

The sharp decline in bank reserves held at the Federal Reserve, which coincides with an expected shortage of US Treasuries because of the country’s debt ceiling battle, has investors worried that potential stress is ahead in financial markets.

Reserves are the funds that the Fed requires banks to hold as balances at the central bank. They are falling due to the impact of the central bank’s program to reduce its balance sheet (quantitative tightening), writes Reuters.

Bank deposits, which are part of reserves, are also shrinking as customers seek higher-yielding alternatives for their money.

The decline in reserves has broad implications for the economy. This limits banks’ balance sheets and inhibits their ability to lend to finance corporate growth and expansion.

The Fed’s balance sheet increased during the pandemic because of its quantitative easing program. Now it is going the other way – draining this stimulus from the financial system.

As of March 8, bank reserves amounted to 2.999 trillion. dollars, according to data from the US Federal Reserve. They fall by over 1.3 trillion. dollars compared to a peak of 4.3 trillion. dollar reached in December 2021.

In the last cycle of quantitative tightening, 1.3 trillion were withdrawn. dollars of liquidity for five years.

“In the event of a liquidity crisis in the markets, the banking system is much less ready and able to deal with these shocks due to the declining level of reserves,” commented Matt Smith, investment director at Asset Manager Ruffer in London.

One such shock was the collapse of SVB Financial Group, a startup-focused bank. The bank’s failure has raised concerns about its impact on the wider financial sector.

The last time the Fed engaged in quantitative easing, it ended abruptly after bank reserves fell in September 2019 below the minimum needed to keep short-term funding markets running smoothly. This caused a spike in repo rates and forced the Fed to provide additional reserves to the banking system.

An expected shortage of Treasuries as the US reaches the debt ceiling and the Treasury must curb borrowing is also seen as a further drawdown on reserves.

The US government has approached its debt limit of 31.4 trillion. dollar earlier last month, prompting the Treasury Department to warn that it may not be able to prevent a default in early June.

“If the Treasury is unable to issue Treasuries because of the debt ceiling, then you get more money in reverse repos and that further reduces reserves,” said John Velis, currency and macro strategist at BNY Mellon in New York.

In a reverse repo, market players borrow money from the Fed overnight at an interest rate of 4.55% in exchange for government bonds with a promise to buy them back. Investors put money into reverse repos or money market funds that have access to these repos, rather than putting the money as deposits in banks. The volumes of reverse repo operations reached 2 trillion. dollar since June last year, even as bank reserves fell.

Interest rates on deposits, currently around 0.2% per year, have not caught up with the rise in the reserve funds rate since the Fed’s rate hike. This leads to leakage of deposits. Deposits have been falling since the second quarter of last year, according to Fed data on bank assets and liabilities.

Joseph Abate, managing director of Barclays, wrote in a research note that excess deposits give banks more power to set deposit rates and determine how aggressive they need to be to compete for funding.

SVB’s problems are the latest example of how deposit outflows can adversely affect smaller banks. California’s banking regulator closed the bank.

“Banks with good liquidity and funding profiles should be able to weather the decline (in deposits),” said Julie Solar, credit officer in Fitch’s credit policy group. “However, banks that rely on non-core funding, have deposit concentrations or large unrealized losses in their securities portfolios may face more pressure in this environment,” she added.

Deposit outflows, reverse repos and bank reserves are interrelated. Deposits find their place in money market funds that invest in reverse repos. Higher use of reverse repos, in turn, effectively reduces reserves.

However, the current level of reserves is still higher than in 2019, when reserves fell to $2 trillion. dollars due to large withdrawals for tax payments. Therefore, the market is not necessarily in a panic situation yet.

The minimum level of reserves in the current quantitative tightening cycle is likely to be higher than the previous cycle because the Fed’s balance sheet has grown significantly due to the massive quantitative easing program. Analysts find it difficult to estimate where the tipping point is.