Thursday, August 28, 2014

Liquidity and IOR

Re: the big balance sheet and how it improves financial stability.

Rodney Garratt, Antoine Martin, and James McAndrews at the New York Fed have a very nice post, Turnover in Fedwire Funds Has Dropped Considerably since the Crisis, but It’s Okay.

Before the crisis, banks held about $50 billion of reserves at the Fed. That's not a lot of money. When banks want to pay each other -- say you write a check to me, so my bank has to get money from your bank -- they do it by transferring reserves through the Fedwire.  So, that's why banks keep some reserves there.

But $50 billion is tiny compared to $10 trillion of M2, and banks use reserves to clear financial transactions too. A huge amount must flow by passing around these tiny reserves. How did banks do it? What happens if bank B says to bank A, "send us $10 million" and bank A didn't have $10 million left at that second in reserves?

Answer: "intraday overdrafts." The Fed would lend bank A the $10 million -- just flip a switch and put $10 million in their reserve account, and call the loan an asset corresponding to this liability. A then pays B, and works hard to make sure that it collects $10 million from C and D by the end of the day.

Source: Rodney Garratt, Antoine Martin, and James McAndrews at the New York Federal Reserve



As you can see, such "overdrafts" accounted for 50-60 percent of all Fedwire transactions before the vast increase in reserves.

It's a system that makes a lot of sense, so long as banks never fail and don't abuse it. It allows the system to produce a much higher volume of transactions with less non-interest-bearing assets. Instead of cash in advance for every purchase, settling up once per day means you only need to cover the worst possible daily total flow, not the worst possible intraday flow, like if $10 million goes out 10 minutes before another $10 million comes in.

But now, banks have $4 trillion of reserves. They're sitting around as investments, really. As long as they pay full market interest, there is no reason for banks to go to all this effort to get by with little reserves. And we seen in the graph exactly what you'd expect. If bank A owes bank B $10 million, it just sends the $10 million, no need to borrow it for 10 minutes from the Fed.

The article explains all this well. A few quibbles
The shift in funding away from overdrafts and toward account balances has significantly increased the amount of liquidity needed to fund payments in Fedwire Funds. 
I think reality is the other way. The vast amount of liquidity banks have chosen, and will continue to choose so long as reserves pay market interests, mean they have abundant liquidity to fund payments directly on Fedwire. It is not "needed." (Mistaking "choice" for "need" is a favorite Econ 101 fallacy.) The minute the Fed tries to pay less on reserves than short term T bills pay, banks will choose to go back to the old system.

And turnover -- which they point out has plummeted as in the graph below (ignore the "counterfactual") -- is a totally misleading statistic. Turnover is transactions / reserves. Transactions haven't fallen, reserves have exploded. I presume a graph of the total number of transactions shows little change, or at least no such cliff.

Source: Rodney Garratt, Antoine Martin, and James McAndrews at the New York Federal Reserve

But the closing paragraph is great:
A high turnover ratio is typically viewed as a good thing in a payment system, because more payments can be made with less liquidity. To do more with less is good when resources are scarce. However, reserves don’t have to be scarce. With interest on reserves, the Fed can implement monetary policy even though banks are flush with cash (as we noted in this Economic Policy Review article). And because banks have less need to economize on liquidity, payments are made earlier in the day, which benefits consumers and increases the resiliency of the system to operational outages or participant failures. So the large decrease in turnover should be viewed as a good thing; it is another symptom of how the high level of reserves benefits the payment system.
"Payments are made earlier in the day" is important. Demands for payment earlier and earlier in the day are a key part of failures.

H/T to Torsten Slok's weekend reading email which found the post.

Update: "Interest on Reserves and Daylight Credit" bv Huberto M. Ennis and John A. Weinberg in the Richmond Fed Economic Quarterly (2007) is a nice explanation of how the system worked. Towards the end it sketches how increasing reserves drive lower turnover, not less transactions.

6 comments:

  1. Here’s a conundrum. What’s the state doing paying ANY INTEREST on reserves? That interest benefits those with piles of cash and it’s funded by ordinary taxpayers. Ergo the state should pay no interest to anyone simply for holding a pile of base money (effectively a pile of $100 bills). Warren Mosler and Milton Friedman backed the latter “no interest” idea.

    But if the state does not pay interest (either on reserves or by turning reserves into state debt and paying interest on that), then the state cannot manipulate interest rates. Shock horror. What’s the answer to that?

    My answer is that interest rates should not be used to manipulate demand. My reasons are in section 1.19 of the paper of mine which John kindly featured on this blog a couple of days ago.

    ReplyDelete
    Replies
    1. Ralph,

      "But if the state does not pay interest (either on reserves or by turning reserves into state debt and paying interest on that), then the state cannot manipulate interest rates."

      The state (central bank) could conceivably manipulate bond prices (open market operations on corporate / personal debt if allowed) even if the state (government) never borrowed.

      The state (central bank) could still act as lender of last resort (discount window) and set the interest rate at which they are willing to lend administratively.

      "What’s the state doing paying ANY INTEREST on reserves?"

      One motivation for the central bank to pay interest on reserves would be for the central bank to retain it's independence of fiscal policy. Meaning the central bank could conceivably pay an interest rate higher / lower than the market / auction interest rate on government debt.

      This flies in the face of quantitative easing - central bank buying large chunks of government debt trying to set market interest rate on them - so I am not sure why the central bank is doing both.

      Delete
    2. Ralph
      Maybe this is why the Fed pays interest on reserves? http://seekingalpha.com/article/2484795-u-s-banks-are-now-operating-with-100-percent-reserves-is-full-reserve-banking-the-next-step

      Delete
  2. If there needs to be a bigger buffer why not just raise required reserves?

    Are banks really parking money in excess reserves as an "investment" at 0.25%?

    IOR is money that is not flowing back to the Treasury. It's a secret tax on every citizen.

    ReplyDelete
  3. It seems to me John Cochrane has won the point: The Fed should pay off all the national debt and vastly increase commercial bank reserves. I suspect that Cochrane wants this also to prevent a huge blow out of federal outlays in the scenario of higher interest rates in the future. Cochrane has pointed out the US government may have to spend $900 billion a year on interest and unless we pay it off first.
    So...QE to the moon, pay the national debt.

    ReplyDelete
  4. "Transactions haven't fallen, reserves have exploded. I presume a graph of the total number of transactions shows little change, or at least no such cliff."

    Yes, more or less. I''ve charted Fedwire data out here:

    http://jpkoning.blogspot.ca/2014/07/fedwire-transactions-and-pt-vs-py.html

    ReplyDelete

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