While Federal Reserve Chair Janet Yellen got most of the attention yesterday in her Semiannual Monetary Policy Report to the Congress, Vice Chairman Stanley Fischer also spoke in Washington on the Fed as "The Lender of Last Resort." He discussed liquidity pressures in the "shadow banking" sector and how, in an emergency, the Fed can provide liquidity to the financial markets. We excerpt from this speech below, and we also return to the suddenly hot topic of negative rates, reviewing commentary from RBC Capital Markets' Michael Cloherty and from Fed Chair Yellen. Cloherty says, "Speculation about negative rates is wildly overdone.... [W]e think there are $2.5T reasons why assuming that the US follows Europe is a mistake."
In his speech, Fischer explains, "While we have likely reduced the probability that lender of last resort loans will be needed in the future, we have not reduced that probability to zero. We could, presumably, require financial institutions to fund illiquid assets entirely with longer-term debt and equity or, equivalently, allow them to use short-term liabilities to fund only safe and highly liquid assets. However, such an approach would be costly in terms of reduced lending to American businesses and households."
On shadow banking, he continues, "During a crisis, liquidity pressures can materialize in the shadow banking sector -- that is, the set of nonbanks that use a range of markets and instruments to provide financing to borrowers. At the time of their initial difficulties, both Bear Stearns and Lehman Brothers were in the shadow banking system. To help improve the resiliency of this sector, a few new regulations have been introduced, including the final rule on risk retention in securitization issued jointly by the Federal Reserve and five other agencies in October 2014 and the new money market fund rules issued by the Securities and Exchange Commission (SEC) in July 2014."
He adds, "In addition, the Federal Reserve can, if needed in an emergency, and with the approval of the Secretary of the Treasury, lend through a broad-based facility, including to nonbanks, to provide liquidity to financial markets. Indeed, during the financial crisis -- which can be thought of as an old-fashioned bank run, but on the shadow banks -- the Fed's credit facilities were used in an effort to stop the run in the shadow banking system. Such broad-based facilities were instrumental in ensuring that money market mutual funds were able to liquefy their assets and so meet investor withdrawals, that the markets for critical short-term funding remained open, and that funding remained available for securitizations that were, in turn, funding loans to students, car buyers, small businesses, and others."
Fischer continues, "In several of these interventions, the Fed was lending to increase the liquidity of, or activity in, securities markets, in order to maintain the flow of essential credit to businesses and to households. Had that flow of credit ceased, the financial crisis, the severe recession that resulted, and the consequences for the U.S. economy, and thus every American, would have been far more serious."
He states, "In November of last year, in a revision to its regulations reflecting the changes to the Federal Reserve's emergency lending authority included in the Dodd-Frank Act, the Board spelled out how the Federal Reserve would design and operate such broad-based emergency lending facilities in the future. Among other things, an emergency facility would be designed to provide liquidity to a market or sector of the financial system and not be for the purpose of assisting a specific firm, or group of firms, in avoiding bankruptcy."
Fischer explains, "The Dodd-Frank Act removed the Federal Reserve's authority to lend to an individual troubled institution. Instead, the act required large banks and systemically important nonbanks to submit plans under which they could be resolved under bankruptcy in a rapid and orderly manner if they suffered material financial distress."
Negative rates have been in the news of late after the Bank of Japan joined the European Central Bank in dropping interest rates into negative territory. Could it happen here? We examined the mechanics of it in our Feb. 8 News, "BofA ML on Negative Yields, Fitch on Angst, and Moody's on Anxiety." Earlier this week, Michael Cloherty, Head of US Rates Strategy at RBC Capital Markets, weighed in on the topic in a commentary, "Negative rates? CCAR and the Street Echo Chamber."
He writes, "Speculation about negative rates is wildly overdone. In addition to the legal issues -- an August 2010 Fed memo says, "it is not at all clear that the Federal Reserve Act permits negative IOER rates" -- the market structure in the US is dramatically different than the structure in place in countries that have implemented negative rates <b:>`_. Primarily, US markets are highly reliant on the $2.5T in money market funds, and money fund business models would be under extraordinary stress if rates fell below zero. In addition, today's Fed policy regime relies on money fund arbitrage of the RRP -- rapidly shrinking the money funds would erode the Fed's control over rates."
Cloherty continues, "So if negative rates may not be legal, would cause dramatic shocks to market structure, and would erode Fed control over rates, why is everyone talking about negative rates? We think this all stems from the Fed's 2016 bank stress tests and the Street echo chamber. The "severely adverse market shock" scenario in the 2016 CCAR includes negative rates. That scenario also includes the unemployment rate hitting 10%, Q1 2016 to Q1 2017 GDP running at -5.1%, -7.5%, -5.9%, -4.2%, and -2.2%, the Dow Jones falling to 10395, etc. The severely adverse scenario is designed to ensure that banks can survive even the most extraordinary events -- it is not intended to be a Fed forecast."
The Strategist adds, "But the market became highly focused on negative rates just after the CCAR scenarios were released. The reason seems to be the way information flows around the Street. Modeling the negative rate scenario is extraordinarily difficult, as many of the rates that the Fed provides are not very useful in analyzing bank portfolios or liabilities. It is much more important that banks know what 3m LIBOR is, not the 3m Tbill rate that the Fed provides in their scenario. And predicting how LIBOR would behave in a negative rate environment is a difficult question."
He explains, "As a result, we suspect that there have been many calls from banks to dealer research departments to discuss what LIBOR would look like if Tbill rates fell to -50bp. Typically, when a research person gets a call from four or five clients in a row on the same subject, we assume that this issue is important to everyone, and we write up a report. Clients then see several Street research groups putting out pieces on the same subject, assume that there is fire behind all that smoke, and ask more questions. And the echo chamber begins."
Finally, Cloherty says, "But in this case, the initial phone calls were not because investors were suddenly much more worried about the Fed taking rates negative -- they were asking because there is a regulatory requirement for banks to figure out how the market would react if Tbill rates went to -50bp. So confusion about the CCAR scenario seems to have forced investors to more heavily weigh rates going negative, unsettling the market.... Adding our two cents to the stress test thought-experiment, we suspect that most banks will heavily weight the European negative rate experience in their CCAR estimates. But we think there are $2.5T reasons why assuming that the US follows Europe is a mistake."
Fed Chair Yellen was asked repeatedly about negative rates during her semi-annual report to Congress on Wednesday and played down the idea, saying it's not only unlikely, but probably illegal. CNBC explains in its recap, "Fed's Janet Yellen: Not sure we can do negative rate; rate cut unlikely," "As whispers mount that the Fed could implement negative interest rates as a way to goose economic activity, Chair Janet Yellen said Wednesday the central bank has not completely researched whether that would be legal."
The article says, "During her semiannual congressional testimony, Yellen said the Federal Open Market Committee discussed charging banks to hold excess reserves at the Fed but never fully researched the issue. "We didn't fully look at the legal issues around that," she said. "I would say that remains a question that we still would need to investigate more thoroughly." Asked whether she foresees the Fed cutting rates after just hiking its interest rate target in December, Yellen said she did not expect that to happen anytime soon as she considers the risk of recession low.... "I do not expect the FOMC is going to be soon in the situation where it's necessary to cut rates," she said."
The CNC piece adds, "In the 2010 examination of whether to use negative rates, Yellen said that outside of the legal questions, there was doubt raised over whether it was the right way to go. "We got only to the point of thinking it wasn't a preferred tool," she said. "We were concerned about the impact it would have on money markets, we were worried it wouldn't work in our institutional environment."
