Among many other advantages it enjoys when it comes to influencing the course of monetary reform, the Fed has that of being able to shift the constraints that determine whether a proposed reform is or isn’t possible. If existing constraints don’t stand in the way of some reform Fed officials would rather not see happen, they can always put up a new one, tailor-made for the purpose.
The Fed seems prepared to do just that as part of its campaign to keep the “floor” system of monetary control it set-up in October 2008 around for good. Considering the floor system’s many disadvantages compared to a “corridor” system, should the plan work we may all live to regret it. Those disadvantages include:
- A considerable increase in the share of financial-institution intermediated credit that gets shunted into the Fed’s coffers;
- A moribund interbank fed-funds market, with correspondingly reduced incentives for interbank risk monitoring;
- A less-reliable monetary control mechanism, as evidenced by the failure of changes in the IOER rate to result in like changes in market-determined interest rates; and
- A Fed balance sheet made ripe for political abuse by the fact that it’s size is no longer a determinant of the stance of monetary policy.[1]
For the most part, Fed officials have tried to justify the floor operating system by ignoring its shortcomings whilst harping on its supposed advantages, including the fact that it enhances banks’ liquidity by encouraging them to stockpile reserves, and the fact that the new arrangement dispenses with the need for routine open-market operations.[2] Those officials are also inclined to avoid any public discussions of the topic, which, according to some press reports at least, is not to be among those addressed during the next summer’s Fed outreach program aimed at gaining public input concerning the “strategies, tools, and communication practices it uses to pursue its mandate of maximum employment and price stability.”[3]
But just in case these means for assuring the survival of the Fed’s floor system should prove inadequate, Fed officials have an ace up their sleeve: if hard-pressed on the matter, they can insist that switching from the current system to a corridor system is, not just undesirable, but impossible.
How so? The argument has to do with Basel’s LCR (Liquidity Coverage Ratio) requirements, first applied to U.S. banks in 2015. Those requirements call for banks to keep a substantial amount of “High Quality Liquid Assets” (HQLAs) on hand at all times, with the precise proportion depending on the extent and volatility of banks’ nonoperating wholesale deposits.[4] Because excess reserves qualify as HQLAs, banks have been able to use them to meet the LCR requirements. In contrast, the floor system’s champions point out, switching to a corridor system would mean not having enough excess reserves in the system with which to meet those requirements.
The wrinkle is that, although excess reserves qualify as HQLAs, so do Treasury securities, Ginnie-Mae mortgage-backed securities, other non-MBS agency securities, and deposits at the Fed’s Term Deposit Facility. Because the same Fed asset sales that serve to reduce the stock of excess reserves increase the outstanding supply of Treasury securities by a like amount, even an unwind complete enough to force a switch to a corridor system would leave the banks with all the HQLAs they need to meet their LCR requirements. And though banks would rather meet their LCR requirements with excess reserves than with Treasuries so long as excess reserves earn higher returns, as they did until recently, under a corridor system excess reserves would yield less then even the shortest-term Treasuries, so that banks would prefer Treasuries. In short, contrary to what some experts have claimed, Basel’s LCR requirements don’t in themselves mean that we’re stuck with a floor system.
It’s here that the Fed’s special powers come into play. For although the published LCR requirements don’t themselves make it necessary for banks to stock-up on excess reserves, the Fed has been bending the rules to change that. In a Bank Policy Institute Research Note published in late November, BPIs Bill Nelson explains how:
In principle…banks could hold Treasury securities rather than excess reserves to satisfy their LCR. However, while the LCR regulation treats reserves and Treasury securities the same, Fed supervisors have reportedly instructed banks through the examination process that they must hold a certain, not publicly known, fraction of their HQLA as excess reserves. The Fed’s “LCR Reserve Requirement” creates an added function that only excess reserves will be able to satisfy.
Bill goes on to note how, when directly asked about this after a panel discussion at the Hoover Institution’s May 4th, 2018 Policy Conference on “Currencies, Capital, And Central Bank Balances,” Fed Vice Chair Randal Quarles “acknowledged that [Fed] supervisors have indicated to banks that there is an expectation that some HQLA be held in the form of excess reserves.”[5] And if you think there’s any difference between what Fed supervisors “expect” banks they supervise to do, and what those banks are bound to do to avoid getting in hot water, you don’t know how bank regulation really works in this country![6]
If the Fed’s extra-legal maneuvers somehow made either banks subjected to them or the general public better off, those maneuvers might perhaps be justifiable. But there’s no good reason to think so. On the contrary: the written rules are more than capable of keeping banks adequately stocked with reserves, and would remain just as capable were the Fed to switch to a corridor system. Indeed, the U.S. is now among a small minority of advanced economies that combine LCR requirements with minimum statutory reserve requirements particularly aimed at guarding against reserve shortages. Relatively modest IOER payments, such as would be consistent with a corridor system, would suffice to keep banks from using “sweep” accounts to evade those reserve requirements, as banks tended to do when reserves bore no interest at all. Also, in a corridor system a revived fed funds market would usually be a reliable source of extra reserves to any subset of sound banks that needed them. Finally, because Treasuries can serve as collateral for secured overnight and term borrowing, solvent banks that used them to meet their LCR requirements could also turn to secured lending markets, or to the Fed’s discount window, to make up for reserve deficiencies. In short, in treating Treasuries as equivalent to reserves for meeting banks’ liquidity needs, the Gnomes of Basel have (for once) gotten things right.
Make no mistake, if Fed supervisors are prepared to stick their thumbs on the HQLA scale to compel banks to meet some of their LCR requirements using reserves rather than Treasuries, it’s for one reason only: to allow Fed officials to claim, with implicit reference to their self-imposed constraint, that a floor system is the only monetary control game in town. Some people may call this clever strategizing. I call it abusing the Fed’s supervisory powers for the sake of thwarting worthwhile monetary reform.
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[1] For more on these and other disadvantages of the floor system see my recent Cato book, Floored!: How a Misguided Fed Experiment Deepened and Prolonged the Great Recession.
[2] While it’s pleasant for the New York Fed staff not to have to expend effort on managing routine open-market operations, whether the economies that this change is supposed to achieve will be realized through either a reduction in that staff or a corresponding increase in the quality or quantity of other Fed services remains to be seen. I, for one, am not holding my breath.
[3] According to a November 15th Bloomberg report, although “Virtually everything the Fed does in pursuit of its congressionally mandated goals will be on the table” during its summer policy review, which includes a June 2–4 “research” conference to be held at the Chicago Fed, “the review is not expected to include a look at how the Fed mechanically controls short-term interest rates, which is being discussed internally.”
[4] Nonoperating wholesale deposits include any such deposits apart from those held for clearing, custody, or cash management purposes.
[5] The published version of Quarles conference remarks is here. The full transcript, including the referred to question and answer, is, unfortunately, only available on the gated WSJ Pro site.
[6] I refer here particularly to how regulation works for all save the big Wall Street banks. For them, the situation is often reversed, with the bankers intimidating their supervisors rather than the other way around.
