The Federal Reserve’s point person on financial regulation said the central bank is considering changes to its bank-supervision framework to enhance money-market liquidity.
Fed Vice Chair for Supervision Randal Quarles also said current monetary policy was appropriate, but the effect of the coronavirus outbreak would require ‘careful monitoring’ in a speech Thursday.
“In addition to the human toll, the virus also threatens significant economic disruption, particularly for China and its neighbors,” he said, according to the prepared text of his remarks in New York. “I remain optimistic about the outlook, but I am also highly aware that some notable risks still threaten growth, both overseas and at home.”
Much of the speech was focused on a detailed discussion about how the Fed could tweak its supervision of banks to increase the flow of liquidity in money markets.
“We can potentially improve the efficiency of monetary policy implementation by improving the substitutability of reserves and Treasury securities through adjusting our expectations for firms in stress-planning scenarios,” Quarles said.
Fed officials are reviewing regulations put in place in response to the financial crisis after a September flare-up in money markets led bankers to question if the rules were discouraging overnight lending. Democratic senators sent Fed Chair Jerome Powell a letter Thursday asking whether the September episode was being used as a pretext to relax the regulations on banks.
Quarles suggested potential changes in his speech.
The Fed holds banks to internal stress tests to ensure they can ride out times of market strain. In the stress tests, banks have to account for their ability to sell Treasuries to satisfy deposit outflows. Sellers in the Treasury market don’t receive payment on the same day, which potentially leaves banks in a bind if they need to raise cash quickly.
Quarles said the Fed could use its discount window to alleviate the problem. That’s the facility at which banks can pledge Treasuries and other collateral at the Fed in exchange for overnight cash loans.
“This approach would acknowledge a role for the discount window in stress planning, improve the substitutability of reserves and Treasury securities in firms’ HQLA buffers, and maintain the overall level of HQLA that firms need to hold,” Quarles said, referring to high-quality liquid assets. “Such an approach could improve the efficiency of monetary policy implementation, as firms might show a greater willingness to reallocate to Treasury securities, reducing reserve demand and improving market functioning.”
The tweak may help prevent such episodes as the one in September, when a sudden shortage of bank reserves sent some short-term interest rates as high as 10%. Over $100 billion in bank deposits at the Fed quickly disappeared as large corporate tax payments collided with a settling Treasury auction.
It was the first major test of liquidity conditions after the Fed’s partial unwind of its balance sheet, a process which shrank the amount of cash outstanding in the banking system by almost $900 billion between the end of 2017 and July 2019. The September episode suggested the central bank had underestimated the amount of remaining liquidity, and they’ve since pumped hundreds of billions of dollars back into the money markets via a combination of short-term repurchase-agreement loans and outright purchases of Treasury bills.
Quarles said he supported the Fed’s actions to restore ample liquidity but stressed that the balance sheet should not be allowed to endlessly keep growing in proportion to the size of the economy.
“I believe that the viability of balance sheet policies is enhanced if we can show that we can meaningfully shrink the size of the balance sheet relative to gross domestic product following a recession-induced balance sheet expansion,” Quarles said. “Looking ahead, I judge that it is reasonable that we ask ourselves whether it may be possible to operate with a lower level of reserves and remain consistent with the ample framework.”
The Fed vice chair for supervision also suggested changing the way the central bank calculates a year-end “surcharge” of additional capital requirements that the largest banks must fulfill based on the size of their balance sheets.
“Some firms and industry observers have pointed to the surcharge for global systemically important banks, and its partial dependence on year-end inputs, as potentially exacerbating the issues I have discussed today,” Quarles said. “Preliminary analysis suggests that changing those inputs to averages may be helpful. If we were to propose that change, it would not alter the stringency of the surcharge. As such, this option is something that we are actively considering.”
Quarles suggested that the establishment of a standing repo facility for banks — as a backstop against money-market strain — was still a possibility, but he said that the Fed should work first through its existing tools.
