The Federal Reserve has taken an extraordinary amount of actions over the past two weeks (most of which have happened over the course of 8 days from March 15th to March 23rd) to calm financial markets and sustain the flow of credit to households and businesses to respond to the coming Coronavirus-induced depression. By my count, they’ve made 15 significant announcements which are directly related to fighting the crisis breaking out (including 2 yesterday). In this respect, their response has been far superior to the Great Financial Crisis of 2007-2009 where they announced programs slowly and hesitantly, reversed themselves periodically and generally resisted strong responses for fear of causing a panic themselves. They have clearly learned the lesson that it builds far more confidence to respond aggressively and early than to extend and pretend.

However, that doesn’t mean what they have announced is our ideal response to a depression and more generally it is hard to understand why they are doing what they are doing. In this series (which is currently 3 posts long and will run to the end of the weekday) I’ll be covering the 14 significant actions the Federal Reserve has already taken, how those actions are supposed to work and what they are meant to accomplish.

Before I begin covering these details it's important to cover the basics of monetary policy. Banks, foreign governments and certain government sponsored enterprises have “reserve accounts” with the Federal Reserve. Reserve accounts are basically checking accounts. They contain what I’ll refer to here as “settlement balances”, which are liabilities of the Federal Reserve. Banks can use these settlement balances to settle payments with other banks, the government or foreign governments. I use the term “settlement balances” over the term “reserve balances” because the term “reserves” gets used far too often in financial economics and I want to use it for other things. Additionally, settlement balances are more descriptive for what they actually do and is the term of art in Canada, Australia and in Europe. Central banks are generally called “the bank to banks” because of how they provision checking accounts (and liquidity) to banks just as banks provide checking accounts and liquidity to us.

Settlement balances are created when the Federal Reserve spends or lends them to another entity. They are the main form of money that the Federal Reserve creates and are at the center of how the Federal Reserve conducts monetary policy. Because the Federal Reserve has an interest rate target and a commitment to preserve the stability of the payments system, it must supply settlement balances at its target interest rate in order for payments to settle. It can adjust its interest rate target, but it still must supply settlement balances at some price. The demand for settlement balances is generally determined by the need to settle payments today and the desired buffer of settlement balances by banks to clear payments in the future. That desired buffer can be influenced by a number of factors, but the main factors that determine it are generally the liquidity requirements that banks are subject to. Historically those were “reserve” requirements, which required banks to hold settlement balances in proportion to their average level of liabilities over the past two week period. Since 2008 there have been major new liquidity requirements introduced by the international regulatory working group the “Basel Committee on Banking Supervision” which is headquartered in Switzerland.

The major one, Liquidity Coverage Ratios (LCR) applies to banks with more than 250 billion dollars in assets or more than 10 billion dollars of potential exposure to movements in foreign exchange rates. It says that these banks have to have enough “high quality liquid assets” to meet 30 days of net payment outflows (money immediately coming in minus money immediately coming out) based on a “stressed” scenario. The “Tier one” High Quality Liquid Assets (HQLA) are treasury securities and settlement balances. Additionally, Basel (as well as the U.S. financial reform act Dodd-Frank) requires plans for putting large banks into receivership with minimum disruptions. Dodd Frank refers to this as “living wills”. Regulators in the United States implemented these rules by creating an additional liquidity requirement called “Resolution Liquidity Adequacy and Positioning” (RLAP). This liquidity requirement, in contrast to LCR, seems to have a preference for settlement balances, especially as implemented by U.S. bank examiners.

It is suspected (though still not completely confirmed) that “Repo Madness” last September (where interest rates on overnight borrowing secured by treasury securities surged) was a result of this bank examiner preference. What’s key here to understand in the context of Coronavirus is that there have been lingering concerns about liquidity in the U.S. banking system and the Federal Reserve’s ability to conduct monetary policy quickly and effectively given these liquidity requirements so whatever the Federal Reserve’s response would be, they would be very concerned about eliminating any of these concerns during the crisis itself.

March 9th

The first major announcement from the Federal Reserve related to Coronavirus arrived March 9th. This announcement is standard for “natural disasters”. It simply loosens restrictions on banks and requires waiving certain fees for customers so that they can sustain flows of payment services and credit to affected areas. In other words, as of a little over 2 weeks ago the Federal Reserve was not yet treating this as a systematic (let alone global) financial crisis. We don’t get another announcement from the Federal Reserve related to Coronavirus until almost a week later on March 15th

March 15th

The March 15th announcement was pretty dramatic, at least as dramatic as technical policy changes by a central bank can get. It lowered its interest rate band target to between 0 and 0.25 percent- effectively zero. Consequently, they set the interest rate they pay on “required and excess” settlement balances to 0.1 percent. Required and excess are terms referring to whether the settlement balances are being held to meet “reserve” requirements, or are in “excess” of the amount needed to meet reserve requirements (we’ll return to this point tomorrow). It buys 500 billion dollars of treasury securities and 200 billion dollars of government guaranteed, mortgage backed securities. This injects settlement balances- ensuring there is sufficient banking system liquidity and likely Federal Reserve officials are thinking about lowering interest rates on these securities (especially in order to keep mortgage interest rates down). The “implementation note” says that these purchases should be made “at a pace appropriate to support the smooth functioning of markets for Treasury securities and agency MBS” so they are clearly concerned that the financial crisis will cause these markets to malfunction and are trying to preempt that. They also greatly expanded their own repurchase agreements i.e. lending secured by treasury securities to financial markets. These also inject settlement balances, albeit on a temporary basis.

Last, but certainly not least, the Federal Reserve lowered the rate at which banks could borrow “at will” from the Federal Reserve- known as the discount rate (or technically, the “primary credit rate”- to 0.25 percent. This is important because the functioning of the discount window has been disrupted over the past 35 years (but especially since the Great Financial Crisis) as borrowing is seen as stigmatized and there is increasing worry about the political fallout from being seen as “needing” Federal Reserve credit. By lowering the discount rate to where their interest rate range is, the Federal Reserve is clearly trying to “break the stigma”. The following day the rest of the Federal Reserve Regional Banks followed through on lowering their “primary credit rate” to 0.25 percent. It isn’t especially significant for this crisis but it is still remarkable that technically each reserve bank has its own discount rate policy, and inevitably they all implement discount window borrowings differently. These differences can be significant.

To sum up in simpler terms- the Federal Reserve lowered interest rates, bought government securities, lent against collateral to financial markets, providing banking system liquidity and tried to encourage banks to seek liquidity directly from the Federal Reserve in the future. My main criticism of this intervention would be their insistence to continue operating in quantities. Do you want long term interest rates to be lower? Say you’ll buy as much as necessary to keep interest rates below x target. Nonetheless, they are clearly responding to the situation like it's a crisis by this point.

March 17th

Two days later, we got a flurry of Federal Reserve announcements. In the morning we got a joint announcement with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency that essentially says regulators are easing up on banks in order to encourage them to continue to lend to households and businesses.This statement in large part is confirming that other bank regulators are on board with the Federal Reserve’s march 9th statement. However, there are important new details. One is that they are explicitly encouraging banks to use their “capital and liquidity buffers”. That is, regulations for the past decade have encouraged banks to greatly increase the high quality liquid assets they hold and to increase their capital levels. Essentially, they are trying to implement the suite of financial regulations that we have countercyclically.

To put some teeth to this encouragement, they have changed the definition of “eligible retained income”. Previously, eligible retained income was defined as net income over the previous 4 quarters minus taxes and “distributions” over that time period. Distributions are simply stock buybacks, dividend payments and bonuses. The “problem” with this definition is that as net income falls in a recession (or a crisis) this definition eliminates Banks ability to pay discretionary bonuses or conduct stock buybacks/dividend payments as well as discourages bank lending. This effect is worsened if at the same time “stress capital buffer requirements'' (basically supplementary capital requirements based on risk) rises because of measured risk changes. Thus, they are looking for a definition that reduces distributions “gradually” and encourages banks to continue lending to households and businesses.

The new definition is simply the previous 4 quarters of net income, eliminating the measurement of taxes or “distributions” all together. The new definition accomplishes their new regulatory goal but doesn’t really make sense. The portion (or entirety) of net income paid out as buybacks, dividends or bonuses can’t reasonably be considered “retained income”. More generally, it's absurd that banks aren’t required to retain at least a minimum percentage of net income for future contingencies and that “distributions” aren’t suspended during stressed scenarios. Supporting lending during recessions shouldn’t be tied to keeping up “capital distributions”.

While that is a lot of detail on this specific rule change, the big picture is clear. They are easing up on Banks in order to encourage them to sustain lending even as it becomes more risky to sustain credit for households and businesses. And this was just the first announcement of three!

With the second announcement, we’re officially back in crisis. What marks financial crises the most is the alphabet soup of facilities announced by central banks. The first facility to return is the Commercial Paper Funding Facility (CPFF). In the 2008 crisis, this facility was announced on October 7th, 2008. It is also the first action taken using emergency 13(3) powers, which requires approval by the Treasury Secretary. These powers were reformed by Dodd-Frank because of what was perceived as overreach by the Federal Reserve. One of the biggest restrictions Dodd-Frank included was that the programs the Federal Reserve sets up must be “broad-based” and not be bailouts of specific entities. It will be an ongoing debate for years whether the Fed’s actions are legal and if they are, whether 13(3) powers need to be reduced further.

The announced facility also brings back one of the Federal Reserve’s favorite tricks- setting up a special purpose vehicle it lends to in order to enter into transactions it itself can’t enter. A special purpose vehicle is basically just a corporation you set up to do what the people who set it up tell it to do. It’s independent existence is a legal fiction. It is simply amazing that this bit of legal engineering wasn’t either eliminated or expressly regulated by Dodd-Frank. The Treasury in turn is using its main discretionary pool of money- the Exchange Stabilization Fund (ESF)- to either provide equity to these Special Purpose vehicles (SPVs) or “credit protection” for the Fed. This is under the theory that it's the Treasury’s job to take losses and the Fed’s job to lend.

That all said, what this specific facility does is finance this SPV so that the SPV can in turn purchase commercial paper (essentially resellable short term IOUs of corporations) directly from corporations. The problem is that corporations have been having increasing trouble borrowing as financial markets freeze up as a result of coronavirus. This can affect their ability to make payroll and meet other important financial obligations. In other words, it's unacceptable to let the commercial paper market go down.

The final announcement of the day- made at 6 pm- was another GFC era facility- the Primary Dealer Credit Facility. To its credit, it shows the speed the Federal Reserve has been acting that facilities launched March 16th 2008 (almost exactly 12 years ago incidentially) and October 7th 2008 were launched the same day early on in this crisis. Primary Dealers are financial institutions licensed by the Federal Reserve to participate in treasury auctions directly. In exchange for this privilege they are required to submit a certain quantity of bids at “competitive rates” in those auctions and thus ensure all treasury auctions succeed. This puts them in a key place in the financial system and means losses and increasing spreads on other assets they act as dealers for can affect their ability to play their important role in treasury markets. More generally, during crises the Federal Reserve is interested in supporting their dealer role for these other assets. In this sense, this facility is serving a similar role to the CPFF we discussed above- relieve stress on markets that provide credit to non-financial corporations. This facility provides liquidity to primary dealers who still must pledge collateral but can pledge a much wider variety of collateral including all sorts of asset backed securities, commercial paper, corporate securities more generally and state and local government debt. These actions help, but they are not nearly enough to fully ease credit conditions.

March 18th

Last wednesday the Fed announced only one facility- the Money Market Mutual Fund Liquidity Facility (MMMFLF). Money Market Mutual Funds are professionally managed “investment pools” which buy a defined set of assets and sell “shares” to individuals and other entities so that they can invest relatively small amounts which are tied to the movement in prices of these much larger denomination assets. Massive amounts of assets are held by Money Market Mutual Funds and their deposit-like nature makes them an important liquid asset for many households and thus makes their portfolio choices important and investor redemption dangerous for market liquidity.

This is the first facility announced which is larger in scope and different from any facility created during the 2008 Great Financial Crisis, though it is very similar to the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility announced September 19th 2008. Again invoking 13(3) emergency, the Federal Reserve will lend to any chartered U.S. bank, any Broker-Dealer which is owned by a bank holding company or U.S. branches of foreign banks which concurrently with using the facility purchases eligible assets from a Money Market Mutual Fund. Those assets are in turn pledged as collateral for those loans. What is also important about these loans is they are “no-recourse loans”. That means that all the Federal Reserve can do in case of default is seize the collateral, they can’t demand any more payment from the users of the facility. In other words, the participants bear basically no credit risk in participating in the program and the Federal Reserve is effectively purchasing these assets.



Very notably, the facility exempts assets purchased from Money Market Mutual Funds financed by this facility from capital requirements (both leverage based ones and risk weighted ones). This effectively means there is no balance sheet cost to participating in this program either, making it far more attractive. Exempting certain asset purchases from capital requirements (especially treasuries) has long been a proposal for provisioning liquidity to specific markets where we’d want financial institutions to act as dealers (especially treasury markets). This may be the most powerful facility announced by this point. Still, it is by no means enough. Finally the Exchange Stabilization Fund of the U.S. Treasury is again used to provide the Federal Reserve 10 billion dollars of “credit protection”.

March 19th

The announcement the following day is simply a new rule announced jointly by the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Federal Reserve to formalize what was announced the day before. In it, it is made explicit that the justification for exempting these asset purchases from capital requirements is that since the loans are no-recourse, participating financial institutions are “not exposed to credit or market risk from the assets purchased by the banking organization and pledged to the Federal Reserve”.

March 20th

Last, but certainly not least, last friday the Federal Reserve announced that it was expanding the Money Market Mutual Fund Liquidity Facility to purchases of state and municipal debt with a maturity of 1 year or less. This is important because state and local governments are bearing the burden of increases in healthcare spending right at the time their tax revenues are falling off a cliff and municipal interest rates are rising. Still, the facility is of limited help because it is limited to maturities of 1 year or less. I hope to write more about the state and municipal debt situation next week.

Conclusion

This brings us up to date as of last week. We still have this week’s domestic Federal Reserve actions to go through and I will be using part 3 of this series Friday to go through the Federal Reserve’s responses to the international liquidity situation. Already this has been a flurry of rule changes to understand. I’d summarize it this way- They began their true crisis actions by lowering interest rates, trying to guarantee liquidity to treasury markets as best they could and making unlimited direct borrowing for banks available and as destigmatized as possible. They then did what they could to ease the constraint capital requirements put on supporting lending to households and businesses. Quickly afterwards they followed through with a set of facilities to direct credit directly to non-financial corporations. That last facility creatively changed capital rules and loan terms to effectively use financial institutions as passthrough entities to purchase government guaranteed securities, short term corporation’s IOUs and short term state & municipal debt from Money Market Mutual Funds. This is already a lot but it is not large enough to deal with the enormity of the credit freeze Coronavirus has created- as their actions this week reflected. See you tomorrow to go through the even larger actions that have been announced this week.



Stay Safe,



Nathan