Investors are zeroing in on key parts of the market for short-term dollar borrowing to determine if and how signs of systemic stress might be emerging after the biggest US bank collapse in over a decade.
The failure of Silicon Valley Bank has stirred concern additional banks might also be in danger of a funding shortfall. Yet while the stocks of a number of purportedly at-risk firms such as First Republic Bank and Western Alliance Bancorp have taken a record beating and there have been some notable movements in parts of funding markets, the broader system appears to be holding firm for now.
That may change though.
Here are some of the funding-market indicators to look at for potential signs of pressure and areas to be contemplating for possible knock-on effects.
This past weekend saw US authorities introduce a new backstop for banks that Fed officials said was big enough to protect the entire nation’s deposits. The Bank Term Funding Program allows banks to monetize their underwater hold-to-maturity portfolio without creating losses because it will provide funding for par value of securities pledged.
Borrowing from the emergency bank facility will be disclosed weekly in the Fed’s regular balance sheet update, but individual borrowers won’t be named for two years. Usage of the Bank Term Funding Program will be published every Thursday. Money-market watchers and bank investors will be monitoring closely in the coming weeks to see what the take-up is like, and what that might mean for the system.
The facility will offer one-year term funding at 10 basis points over the one-year overnight index swap rate, which, according to Wrightson ICAP, is cheaper than what’s offered by Federal Home Loan Banks, another key source of funding for lenders. If banks migrate to the central bank facility, demand for FHLB advances may dwindle. Conversely, it’s yet to be seen if participants regard this new facility as having a stigma, despite the relatively advantageous terms it offers.
One facility that is often said to carry a stigma is the Fed’s so-called discount window. Like the new backstop it offers term funding, but for a shorter period, providing dollars for up to 90 days. Unlike the new facility, the cash that borrowers have historically gotten is less than 100% of the collateral they put up. This so-called haircut is imposed by the Fed to insure itself against risk. As part of its most recent measures, the Fed has also eased terms on the window, although the reputational impact associated with it is likely to persist.
At the end of 2022, balances at the Fed’s discount window, normally a last-resort funding source, had already risen to the highest level since June 2020. Combined with an increase in US banks’ borrowings through other channels, that suggested the deposit loss was accelerating. Demand did retreat after that, but there’s a chance usage has since rebounded on the back of regional bank strains, and all eyes will be on whether that’s the case.
Standing Repo Facility
One other facility the Fed has to provide banks with dollars is its standing repo facility, an outlet that allows approved counterparties to swap Treasuries overnight in exchange for cash. The rub with this facility though is that there are only 16 banks eligible to deal with it, none of which are regional ones. Unsurprisingly, with pressures focused on those smaller lenders, the Fed facility received no bids on Monday.
This facility evolved after bank reserves shrank rapidly during a previous episode of Fed balance-sheet reduction — also known as quantitative tightening. That imbalance in late 2019 sparked upheaval in repo markets and prompted the Fed to restart overnight operations for the first time since the 2008 crisis. Those daily interventions morphed into the SRF, which was officially introduced in July 2021 to prevent short-term rate markets from blowing up.
Some Wall Street strategists were skeptical that such a facility would actually address any strains, and the most recent Senior Financial Officer survey showed SRF was rated the second to least likely to be used, next to the discount window.
Federal Home Loan Bank Advances
The Federal Home Loan Banks provide funding to commercial banks and other members via so-called advances. These tend to be short-term loans secured by mortgages or other assets. Banks had little need to resort to this channel while they were flush with cash, but with higher interest rates putting a squeeze on cash, that has shifted. The latest turmoil has the potential to turbocharge that demand.
In a highly unusual move, FHLB banks on Monday tapped the floating-rate note market for an extra $88.7 billion to bolster their own cash pile, suggesting members are already — or soon will be — clamoring for funding from the institution. That sum came on top of its overnight raising of $67.55 billion, as well as around $22.87 billion in term discount notes issued by the institution.
The total amount of advances to members, which is published quarterly, had already more than doubled last year as the Fed sent interest rates spiraling higher and deposit balances came under pressure. They reached $819 billion at the end of December, above their 2020 pandemic highs, and this latest episode may push them higher still.
Fed Funds Market
The official data for FHLB advances is, unfortunately, only released quarterly and with a delay, so on a more real-time basis investors can only estimate through proxies. One way to potentially gain insight is via the federal funds market, one of several avenues that banks can get hold of overnight money.
The Federal Home Loan Banks are the biggest lenders in that market, allocating more of their excess cash into fed funds as opposed to alternatives such as the repurchase agreement market. Reduced activity in fed funds could therefore be indicative of the institution corralling cash — which in turn may point to expectations for higher dollar demand by members.
At the beginning of 2023, trading volumes in the fed funds market had reached the highest level in at least seven years, and were close to that again in the middle of last week. But Friday saw a significant drop, meaning lenders in the market had fewer dollars to offer.
Bank reserve levels are another key indicator to watch. These have been declining throughout much of the past year as the Fed has raised interest rates and engaged in balance-sheet reduction, or quantitative tightening.
The reduction in the Fed’s own securities holdings has directly drawn cash out of the system, while boosting the attractiveness of money-market rates relative to banks has sapped deposits. The latter is in part reflected in the increased usage of the Fed’s reverse repurchase agreement facility, an attractive risk-free place for money funds to park their dollars.
Current turmoil around banks could have the effect of pushing even more cash into money funds, not only for their yield but also their perceived safety, which in turn could exacerbate bank funding pressures. Some say that may compel the Fed to bring to an end its QT program earlier than it had intended — especially if it intends to press on with inflation-busting rate hikes.
One of the most eye-catching consequences of the recent turmoil has been the huge shifts in rates of short-term instruments, driven by a combination of haven flows and a repricing of expectations of monetary policy. The one-day decline in Treasury two-year yields on Monday, for example, was the largest since Paul Volcker was in charge at the Fed, and the market pricing of central bank policy has been totally upended from where it was less than a week ago.
A lower overall rate structure could of course relieve some pressures — albeit too late for the likes of Silicon Valley Bank — but it is how the various types of short-term rates compare with one another that provide an insight into funding strains.
As noted above, rates that remain relatively high versus bank rates could continue to put pressure on deposit flows.
The rate on overnight general collateral repo has so far held relatively steady compared with other gauges, suggesting strains remain in check. And rates on commercial paper, a form of corporate IOU, have actually been tightening relative to risk-free alternatives, showing investors still have dollars they want to put to work.
In contrast, cross-currency basis swaps have whipsawed and the gap between direct floating-rate agreements and index-tied ones — often used as a measure of the difficulty banks have in getting access to funds — has swelled.
Broader Financial Conditions
On top of all of this is the backdrop of major market turmoil that’s fueled a huge tightening of financial conditions. Bank equity prices have plunged and financial credit spreads have flared wider. A Bloomberg index of financial conditions on Monday showed its biggest one-day tightening since the early months of the Covid pandemic in 2020.
The increasing stricture in financial markets, in turn feeds back into the real economy and is a major factor driving the repricing of Fed expectations. As a result, the prospect for further policy moves could very much hinge on whether this tightness — and the risk of financial strains — remains entrenched.
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