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Episode 42 – Repo Mania: Has The Fed Bailed Out Wall Street Again? with Nathan Tankus
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If you follow the financial press you’ve probably noticed some recent hysteria about the “repo market.” Since this involves the dealings of the Federal Reserve, it falls under our purview here at Macro ‘n Cheese. Because unraveling the strands of this dense subject requires someone more knowledgeable than we are, we called upon friend-of-the-podcast Nathan Tankus to help us out. Nathan is Research Director at Modern Money Network and can often be found on Twitter, educating the world about MMT.
“Repo” simply refers to the repurchase of bonds. Banks and bond traders sell Treasury bonds back to the Federal Reserve with the understanding that they (the banks) will buy them back the following day. As Nathan points out, this is always spoken of from the point of view of the central bank as buyer; it could just as well be called the resale market.
Why does this matter? Why do the banks sell back their Treasurys for such a brief period of time? When banks buy them back the price is higher due to the interest charged. So why do it at all? It turns out to be the mechanism by which banks ensure that they have enough balance reserves to ensure that their payments clear. To do this they need to deal with liquid assets, which can quickly be bought and sold and converted to “money” (or at least change the balance in their account). Nothing is more liquid than a Treasury bond.
See? Perhaps the banking industry isn’t just lawlessness and anarchy after all? Well, they certainly want us to believe the system is self-regulating so we won’t demand that the lawmakers rein them in and protect the public.
As Nathan explains it, concern about the repo market is much ado about nothing. The central bank has been doing these repurchase agreements since 1917 and during some periods they are a normal part of the Fed’s toolbox. But the 2008 financial crisis put a halt to the practice for a while. In response to the liquidity crisis (ie, the lack of liquid assets), the Fed created trillions of dollars of what most of us think of as bail-out money, which was distributed to all the banks. At that point, banks didn’t need to sell bonds to meet their reserve balances because they all had plenty. Thus, no need for repo.
When repo agreements started up again, some in the media thought that, since it hadn’t been done since 2008, it must be a sign that there’s a new crisis at hand. It doesn’t help that the FDIC, headed by Trump appointee Jelena McWilliams, is investigating the central bank, insisting that the repo market is actually another bank bailout by the Fed. Somehow, people have forgotten that these have historically been normal activities.
In this interview we learn the meaning of the liquidity trap — and liquidity itself. We learn about settlement balances, quantitative easing, and overnight interest rates. We learn of regulations like Dodd-Frank and international banking agreements like Basel III. We learn how these things are connected to such far-flung historical events as Bretton Woods, the Yom Kippur War, and German postwar reparations. We learn why MMT economists have promoted a detailed understanding of monetary operations and argue that the banking system does not serve the public purpose. The next time you get spooked by a headline in the financial press, tune into this episode again. It all makes so much sense when explained by someone who knows what he’s talking about.
Nathan Tankus is Research Director at Modern Money Network. modernmoneynetwork.org
@NathanTankus on Twitter
Macro N Cheese – Episode 42
Repo Mania: Has The Fed Bailed Out Wall Street Again? with Nathan Tankus
November 16, 2019
Nathan Tankus [intro/music] (00:04):
When we say that there is sufficient liquidity in the banking system, what we’re saying is that banks have sufficient access to what they need to make payments. And for the banking system, the ultimate thing is balances in an account at the Federal Reserve. MMT in the narrow economic sense, doesn’t really care whether you’re selling bonds or issuing settlement balances.
Geoff Ginter [intro/music] (00:31):
And now let’s see if we can avoid the apocalypse altogether. Here’s another episode of Macro N Cheese with your host, Steve Grumbine.
Steve Grumbine (01:34):
This is part one of a three part interview with Nathan Tankus, research director of the Modern Money Network. In this episode, we discuss in great detail, the idea of what repos are and what they mean to us as regular citizens. This is deep, it’s extensive, and it’s enjoyable. I hope you enjoy part one of this episode of Macro N Cheese.
Yes. And this is Steve Grumbine with Macro N Cheese and Real Progressives. And today I have my good friend, Nathan Tankus, who is the research director of the Modern Money Network. And Nathan’s going to be talking to us today about something pretty, pretty dicey, and I’m hoping we can make it palatable and easy to understand for everyone.
And that is the essence of the repo market and understanding the role of the Federal Reserve when it comes to the repo market and what all the latest news about repo rates, et cetera, mean to Joe Q public and the economy at large. So without further ado, let me bring on my guest, Nathan Tankus. Welcome to the show, sir.
Nathan Tankus (02:51):
Hi! Thank you for having me, Steve.
Steve Grumbine (02:53):
So first things first. It was great seeing you at the Modern Money Conference here in New York, really nice to see you and really was impressed with the overall production, all the work you guys put out. I just want to tip my hat to you and say, well done,
Nathan Tankus (03:10):
Thank you very much. As you know, like those conferences are a lot of work, but they’re definitely more than worth it.
Steve Grumbine (03:17):
I enjoyed the heck out of it. And in particular, I thought that it was interesting, the breadth of topics that were covered as it expanded into social structures and other dynamics that are frequently left out of the economic conversation. And I just applaud you guys for attacking this from such a 360 perspective.
All right. So let’s get to the meat of this man. I profess right up front. I knew very little about repo markets and I know even less about why this matters to people. Can you start us off, I guess, with, you know, how repo markets even came to be and what they are and what the role of the Fed is in this?
Nathan Tankus (04:01):
Yeah, I can do that. I think the thing to start with isn’t so much repo itself, but the basics of what the Federal Reserve does. The Federal Reserve is about, at a fundamental level, setting interest rates and making sure payments clear. So we all have accounts in different banks and we don’t really think about it; but there’s a lot of work that goes in behind the scenes to make sure that a dollar in one bank is worth a dollar in another bank.
And both of those dollars in turn are worth a dollar of the US dollar, the currency that the federal government issues. So there’s a lot of work that goes behind the scenes. And the essence of what the Federal Reserve does is it makes sure that there’s always access to what are sometimes called bank reserves.
But it’s easier to think about it as settlement balances, you know, balances that are used to settle payments and they make sure that they’re available. And the way that they make sure they are available is essentially for the most part buying government bonds. They buy government bonds from the private sector, including the banking system.
And when they make those purchases, they increase the amount of settlement balances that are circulating in the system and the settlement balances ensure that banks are able to clear payments with each other and the government. And so that’s the essential part of the basics. When now when you get to repos, you know, before I explain what repos is, the basic way you can think about a repurchase agreement is, the alternative the Fed has to repo agreements, is outright purchase and sales.
They can outright buy a bond and outright sell a bond. But given that for many, many decades, the amounts of reserves that the system needed changed on a daily basis, even, you know, potentially on an hourly basis, but especially on a daily basis, it’s kind of cumbersome to constantly be making outright purchases and sales.
So what comes as an alternative is the repurchase agreement. In a basic repurchase agreement, what happens is that a dealer sells bonds to the government and the government provides settlement balances to a bank in the case of a bank, or the dealer’s a bank or provides a settlement balances to a dealer’s bank.
And what they agree in turn is to buy back those government bonds at the end of the end of day. So that’s the basic repo agreement or repurchase agreement is when someone in the private sector agrees to sell the bond to the government and they agree buy it back a day later. So using this terminology, a reverse repurchase agreement is when they buy a government bond from the government or the Federal Reserve, and then they agree to sell it back a day later.
So there’s repurchase agreements and reverse repurchase agreements and what they’re actually doing, you know, any agreement to repurchase something isn’t so complicated, but it can be very complicated to keep it straight in your head, which type is supposed to be the repurchase agreement and which type is supposed to be the reverse repurchase agreement.
Steve Grumbine (07:26):
So let me interrupt you real quick. Why does this matter to the average person? Why would this be making its way on the Jimmy Dore? Why would this be making its way to Dylan Ratigan and all these other folks? They’re predicting the end of days because of repos. So just curious as to understand what the impact is of, just in general, a repo agreement.
Nathan Tankus (07:54):
I think generally the reason it’s gotten to everyone’s headlines is people aren’t used to repurchase agreements, or like when the Federal Reserve is conducting a repurchase agreements. But historically this has been what the Fed has been doing since the beginning, since 1917, the Fed is involved in repo agreements.
It did some in the twenties and thirties. It started really drawing in the 1950s on, but it was a regular part of the Federal Reserves’ toolbox. What changed was 2008, because what happened in 2008 was you had a liquidity crisis, a crisis because you know, the normal system where they inject just enough settlement balances to make sure that payments clear and banks can settle their reserve requirements.
That system broke down because it relies on banks lending settlement balances to each other. It relies on the ones that have too many, to lend to the ones that have too few, but the federal funds market, the market that used to dominate how this all works, that market relied on unsecured lending, lending that wasn’t secured by collateral, and at the very least didn’t involve a government guarantee.
So when every bank looked dicey, each one looked like they were going to get shut down. That market froze up and then the Federal Reserve had to respond; but in the process of the Federal Reserve responding, lending to almost every bank and even some non-banks, they created trillions of dollars of settlement balances.
And thus the banking system had a lot of “excess settlement balances,” quote unquote. So no one needed to really lend anymore because in the normal system the people who had too many need to lend to the ones who have too few; but if everyone has too many, then no one needs to lend anymore. And so basically the market — quote, unquote, “shut down.”
And then after that process happened, what it was followed up with after the banking system stabilized, was quantitative easing, which was just the Federal Reserve outright purchasing lots of government bonds. And they basically just outright purchased so many government bonds that, you know, we basically haven’t been concerned with it for many, many years.
So, you know, a lot of financial reporting people don’t have a deep understanding of this infrastructure, but if you know that repo agreements are things that happen and things that happen regularly, fine. But now this turning point is, well, they haven’t been doing repo agreements since the crisis.
So they had to do it even more. They start to have to do it again. Everyone’s assuming that this is about a crisis that’s about to happen because they don’t understand the kind of intricate workings of the financial system. And also because they’re very complicated.
Steve Grumbine (11:02):
Okay. Fair enough. That makes sense. So ultimately, before I diverted you there, you were in the process of breaking down the repo market itself in general. Let’s see if we can get back to what that process is and how that process is playing out on the stage today.
Nathan Tankus (11:24):
Okay. So, so to fill in a little bit more about how things historically worked. The New York Federal Reserve bank would basically get up each day. They would produce an estimate of the demand for settlement balances coming from the banking system. They would, you know, survey banks, they would ask questions.
They would estimate what was going on with the Treasury’s Federal Reserve account, whether there was a big inflow or a big outflow; they would estimate how much orders for physical cash and coins that were happening from commercial banks. They would put all these estimates together and based on that, they would enter in enough repurchase agreements.
They would buy enough government bonds with the private dealers agreeing to buy them back the next day, to make sure that there was just enough settlement balances in the system that payments would clear, that reserve requirements would be satisfied, and the interest rate would be at the level that the Federal Reserve wanted, because if there was too little settlement balances in the system, then the banks that were short settlement balances would keep on demanding settlement balances.
And they would keep on offering higher and higher interest rates to try to satisfy their demand. And that would interfere with the Federal Reserve interest rate target policy. And there’s been a lot of complications added since the 2008 prices, but it basically works the same way today, except because the system has had so much settlement balances in it, has so much excess settlement balances relative to reserve requirements, they stopped doing that survey process of estimating the demand for settlement balances.
And a couple of years ago, they started what was called quantitative tightening, which is basically just not purchasing more bonds after the bonds that they purchased before matured. You know, they got final repayment and the combination of this factor, which another thing that we’ll talk about, which is the liquidity requirements that came from what is called Basil III, came together such that in the middle of September, suddenly the banking system didn’t have enough settlement balances to satisfy these other liquidity requirements, plus satisfy their payment needs.
And thus, you know, we got back to what is usually considered the normal situation, which is the Federal Reserve needs to conduct repurchase agreements to satisfy the demand for settlement balances.
Steve Grumbine (14:20):
What is liquidity in the macro term here when we’re talking about monetary policy? What exactly does liquidity mean when we say that?
Nathan Tankus (14:30):
It’s a very good question. What I would put as the essence of liquidity is the need to be able to sell an asset or use an asset to make monetary payments very soon. So when we say that there is sufficient liquidity in the banking system, what we’re saying is that banks have sufficient access to what they need to make payments.
And for the banking system, the ultimate thing you use to make payments is balances in an account at the Federal Reserve at the central bank, because you can use that payment to make a payment to any bank or the government and any customer of a bank, which is basically almost everyone.
Steve Grumbine (15:31):
Okay. So basically what it means is in order to clear these payments, there’s gotta be money flowing as opposed to tie it up in an asset. Am I close to that? Is that . . .
Nathan Tankus (15:39):
Yeah. I mean an asset, whether it’s a financial asset or a nonfinancial asset, can have a high degree of liquidity, if you’re able to essentially sell it quickly for money. I mean, so you can think about a house, a house, famously, is not very liquid because if you want to sell it and you want to sell it at close to it’s currently estimated price, you have to put it on the market and you probably have to like, have people visit the house.
And you wait nine months to a year, maybe even longer before you’re able to sell the house at anywhere near what it’s estimated value is. So that is something that has a low degree of liquidity. Whereas, a government bond you can sell very rapidly and get a quote, unquote “cash” or get balances in a bank account or balances at the central bank, if you’re a licensed bank.
So liquidity is like monetary sovereignty in the sense that there’s this hierarchy. And there’s basically almost a series of in this case assets and the other case countries or entities, that fall somewhere along that spectrum. And the interesting thing about the central bank and about markets for settlement balances is since it’s like the ultimate liquid asset in terms of the asset that you can make payments with, there are other assets that seem very liquid, which if the Federal Reserve isn’t standing behind them, isn’t necessarily as liquid.
So, you know, in this case, what was actually happening with the repo markets is that there’s an overnight trade you charge in a repurchase agreement. So when you sell a bond to the government and agree to buy it back a day later, you’re agreeing to buy it back at a higher price. And that the difference between the price you sold it at, and the price you paid, is essentially the interest rate that you’re paying.
And what happened in the repo markets was there was this demand for settlement balances, the need to make payments or satisfy liquidity requirements, which we’ll get to in a bit, and entities with government bonds, try to borrow against them in order to get the settlement balances they needed to make payments.
And there wasn’t anyone out on the other side of those transactions. So they, you know, in the same way that when the banking system is short settlement balances, banks used to offer higher and higher interest rates to try to entice someone to lend to them. The same thing happens with the government security repo markets is this that they started offering higher and higher interest rates to try to attract someone to lend to them.
And because the Federal Reserve has an interest rate target and the overnight collateralized lending, which is essentially what repo lending is, it started to interfere with the overnight interest rate, the federal funds rate, and more generally the Federal Reserves’ interest rate target. So they had to intervene in order to stabilize repo markets and make the interest rate prevailing in repo markets consistent with their overnight interest rate target.
Steve Grumbine (19:22):
You got Jelena McWilliams, who is a Trump appointee, currently serves as the chairwoman of the federal deposit insurance corporation, FDIC, the federal agency responsible for ensuring deposits of commercial banks and savings associations comes out and they’re like trying to investigate why the Fed is bailing out Wall Street again.
So this is the framing that we’re seeing in not only left wing circles, but just the mainstream media. And then of course the alternative media picks these things up and there’s never a way that they can’t spin it that’s not a little bit more conspiratorial, more, you know, shady, now that’s not to say it’s not shady.
It’s just the point of saying that they always add a little extra flavor to it. Can you explain to me why the FDIC would even be bothering investigating this if this is normal monetary operations, or are we suggesting that they genuinely don’t understand their job either? Or is there something that we’re not understanding about this that would push them to investigate?
Nathan Tankus (20:32):
I mean, I think there’s two different elements. I think one is, there’s an obvious political element for . . . there’s people who are always looking for like what the bailout is. And if you don’t really understand the financial system, anything involving banks could potentially look like what quote, unquote, “the bailout is.”
I think the second element with people like the Trump appointed head of the FDIC, Trump is tweeting about Powell, like when he’s not distracted by other crisis or impeachment, he’s tweeting about Powell pretty regularly. I mean, he tweeted about Powell like during Powell’s speech at Jackson Hole, which is pretty unprecedented in terms of president/Federal Reserve interactions.
So it’s not surprising to me that an appointee who probably doesn’t understand the financial system very well, you know, and is much more subject to Trump’s opinions than Chairman Powell is, would get into the act of this is a bailout. I think the other element is what I said before is that repo agreements are old news at this point.
And so when the Fed starts doing repo agreements again on a significant scale, it seems like something’s wrong to people. And third, I think the central element is what was, well, I guess I’ll get to now, is I think people don’t understand the effects that the Basil III Agreements have had on the financial system, so . . .
Steve Grumbine (21:57):
Before you go into that, can you break down what the Basil III Agreements are at all, I mean, just get framework for what that even means.
Nathan Tankus (22:07):
Yeah. That’s definitely the place I was going to start because it’s definitely well outside of how people are generally think about things. So to give you the kind of like broad strokes background. The Bretton Woods System, the system where we talk about all the time of the Nixon closed the gold window and thus moved the US to a floating exchange rate system and moved a lot of other countries to floating exchange rate systems at once happened in the early seventies.
And as a consequence of that, you suddenly went from a system where cross-border financial transactions were very heavily regulated and controlled, and there were fixed exchange rates to a system where those controls had broken down and their floating exchange rates. So there were a whole series of new concerns about how the international financial system worked that were unresolved.
And these were set off, especially with the Yom Kippur War in 1973, a war that Israel was involved with that led to changes in behavior among Middle Eastern countries, which had global financial system affects; and what the Basil Committee started with, first of all, the Bank of International Settlements is what the Basil Committee was based around.
And that’s in the international what’s often referred to as a bank of central banks that was set up in 1930s to deal with the international financial system implications of German reparations to the allies. And so what’s important about that is it’s just, it’s this historical entity to deal with international financial system issues, which became more important in the 1970s.
And basically just a meeting of a bunch of technically sophisticated, mid-levels central bankers, not the chairman or even the vice chairman, but lower level to that got together to talk about international financial system issues and trying to coordinate each other’s behavior. And over time, this expanded into a kind of more official group, which came up in the late 1980s with Basil I, which is as with all these agreements are related to capital requirements, the requirements that you’re going to for how much, how high a bank’s net worth needs to be relative to its assets and liquidity requirements, which is how much does a bank need to be holding certain defined liquid assets relative to their liability.
And Basel has never had a sort of official relationship. It’s not like it’s part of the UN or it’s the product of a treaty between dozens of countries. It’s basically been just a standard meeting place for central bankers to coordinate on financial regulation that’s been taken more and more seriously and kind of treated more and more officially as time has gone on.
And so, whenever there’s a crisis basically, or whenever there’s evolutions that lead to consensus opinion changing for how the financial system is regulated, the Basel Committee gets together to come up with new regulations. So there was Basel I in 1988, there was Basel II, which started to be implemented in 2004.
And then there’s been Basel III, which is basically started to be implemented since 2015. And it’s going to have more implementation up until like 2021. And it’s a meeting of major countries. So what’s ended up de facto happening, even though it wasn’t necessarily the original intention is that you get a bunch of countries together who are the major powers and they come up with these consensus rules, these best practices between them.
And then there’s a lot of pressure on developing countries to follow the financial relation framework that they have set up.
Intermission (26:21):
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Steve Grumbine (27:24):
Okay. So thank you very much. I appreciate that. So we’re going back to the framing of the Basel Agreements in terms of the repo. Let’s get back to how that impacts the other.
Nathan Tankus (27:38):
So the important key piece here is that Basel II didn’t really take liquidity that seriously, or at the very least, it missed major parts of what is now kind of consensus. There’s a consensus that there should be a lot higher liquidity requirements, especially on the major banks. And so Basel III stepped into this space with what’s called LCR, liquidity coverage ratio, which .
. . there’s a lot of complicated details in it, but you can basically reduce it down to rather than a requirement that you have to hold X amount of liquid assets relative to all your liabilities, it’s an agreement that you have to hold a certain amount of liquid assets relative to what’s our estimate of how much payment outflows you’ll have over a given 30 day period.
So let’s say there’s a stressful situation. And we think that there’s gonna be a big quote, unquote “rush to the exits” where people are in the most extreme case, pulling money into cash, but more likely that they’re buying other liquid assets or their redepositing money in other banks or whatever it is, how much of what are called high quality liquid assets do you need to have so that you wouldn’t need to borrow from the central bank over that 30 day period?
And the idea is essentially that, like, if you have more liquid assets on hand, and we have at least this 30 day period to respond to, that it gives central banks breathing room to decide how they’re going to respond to a crisis. In short, it’s trying to make sure that banks can always make payment over a short period of time so that central banks can respond rather than trying to ensure that they have like enough assets in the abstract that they can always make payments over any given period of time, which is kind of more the logic that goes into traditional reserve requirements.
And then there’s a second bit that’s important here, which is called resolution liquidity. And there’s debates over the technicalities of what exactly is causing this. There’s some people who say it’s less to do with Basel III and more to do with Dodd-Frank, which was the specifically US financial reform [inaudible] 2010, but that isn’t really important.
What’s important is with the liquidity coverage ratio, you wouldn’t necessarily have the problem that we’re having now because both treasury securities an central bank settlement balances are considered high quality liquid assets; but with resolution liquidity, for reasons which aren’t precisely clear, how much of it is the formula itself versus how much of it is pressure from individual bank examiners, bank regulators, banks have basically been directed either way to think of central bank settlement balances as a lot more liquid than treasury securities; and thus basically to make sure that they have enough settlement balances on hand to make payments over a given 30 day period.
And so this is where really the issue comes in is you have the normal reserve requirements, which, you know, in the simplest terms are usually, you know, 10% of what are called reservable liabilities. Basically, you know, you can simplify and just say bank deposits, but these reserve requirements are potentially much larger.
And in actual practice has led to the banking system, especially the big, too big to fail banks, as it were holding a lot more settlement balances. And this is where the shortage comes in is that there’s still a lot of excess settlement balances relative to traditional reserve requirements. But these new Basel III dash resolution liquidity requirements are much, much higher.
And this is the point that I think most commentators in this area don’t understand is besides, you know, some friends of mine at Bloomberg journalists and economists, including even some mainstream monetary economists who were very complimentary on things I had commented in this area is that there is this shortage that is relative to all the liquidity requirements that the banking system has.
And people are used to thinking of liquidity requirements as only the traditional one that we’ve had for almost a century, these reserve requirements. And it’s confusing because if you look at the official data, there are settlement balances that are referred to as excess settlement balances and there’s interest on excess reserves, I O R, but that excess is only relative to reserve requirements.
You know, I think it would simplify a lot if those names were changed, then we got an understanding that the banking system is short or has just enough reserves relative to these Basel dash resolution liquidity requirements. And that’s the essence of it because of these new big liquidity requirements, we’re back to 2008.
And I would say this interpretation has come from a few different places, but it has been most prominently pushed by this economist, Zoltan Pozsar who’s very well known, was an expert on this stuff in the treasury, I mean, like 2008 to 2011. And is now like, I think chief economist at Credit Suisse, I think that’s his position so that, you know, this isn’t necessarily something controversial, something that MMT people have talked about.
It’s something that there are a number of monetary economics experts have converged on, but what’s unique an kind of interesting about this, you know, in terms of an MMT point of view is MMT is the only one that has really promoted a detailed understanding of monetary operations, such that people outside of a small group of central banking, treasury, and a few economists experts, but actually like there’s a general population who knows the basics of monetary operations.
And I think the essential point here isn’t that far off above the basics of monetary operations that MMT regularly promotes.
Steve Grumbine (34:35):
Which brings me to basically, an explainer. Can you explain to us what the point of reserves are in general? What are reserves? Some of these terms get thrown around and, you know, when we see, especially some of the experts typing in shorthand, you see, like you said, IOR, interest on reserves and, and there’s all these overnight window type short three letter acronyms, basically to describe all these operations that I think make the average person’s eyes roll back into their heads so far they can see their brain.
Some of these terms while they seem very, very easy, once someone like yourself explains them, it becomes a word salad, or even worse than acronym salad and Twitter shorthand as we try to make heads or tails of this stuff, we can be a better citizen then we can understand the world around us better. Can you describe what reserves are in the hierarchy of money and just sort of explain what they do within the banking system?
Nathan Tankus (35:44):
Yeah, sure. I mean, first of all, I would say, so I’ve been using the term settlement balances regularly through this podcast, and that’s generally the term I use. And I use that term to try to be clear because the monetary economics has not done anyone favors because it uses the term reserves twice.
It uses the term bank reserves when it wants to talk about the IOUs of central banks, you know, money in an account at the central bank. And it also uses the term reserves when it’s talking about capital requirements. So people will talk about equity reserves. People will talk about the money in reserve when they essentially, they mean like how much losses that a bank can take.
So, you know, to distinguish them, there are capital requirements, and then there is the owner’s equity, the equity in a particular bank, basically their net worth, their assets minus their liabilities and the ratio between that net worth that assets minus liabilities and their total assets. And then there is this other concept, which is money in an account at the central bank, basically, a checking account for banks with the central bank.
And that is often referred to as bank reserves as well. But I use the term settlement balances and I use the term settlement balances partially to distinguish it from, you know, all this confusion about what the hell reserves are. But second, because settlement balances can explain what they are directly.
Settlement balances are about settling payments. Settlement is all about you’ve entered in some transactions. There are payment outflows and inflows, you know, or like, let’s say, you know, in the most simplest case, you know, you and I have written a contract where it says, once I fulfilled the duties of the contract, you have to pay me a thousand dollars.
You paying me a thousand dollars is you settling your payment. It’s you’re settling your obligations with me. And that’s what settlement balances are for — they’re to settle your obligations to either the government or other banks. That’s it. You even need to make a payments to other banks or to the government.
And then there’s the second thing that you can settle with the government, which is your obligation to hold a certain amount of balances in your account for basically historical leftover reasons, we have these what are called reserve requirements that are really settlement balance requirements, where you have to hold a certain amount of settlement balances in ratio to all your deposits if you’re a bank.
So you have to hold a certain amount of balances because of how many liabilities you have outstanding. An this, you know, settlement balance requirement, often termed a reserve requirement, is one type of a liquidity requirement that you can impose. And these Basel requirements, the liquidity coverage ratio and these resolution liquidity requirements, what are technically referred to in the US called RLAP, resolution liquidity assistance planning, I think that’s the acronym, and they are different types of liquidity priority.
They’re different types of requiring you to hold a certain amount of liquid assets relative to your liabilities, or some estimate of how many payment outflows you’ll have over a given 30 day period. And what’s important about liquidity requirements is when liquidity requirements require you to hold whatever liquid asset you have to hold, you can’t then necessarily, or it might be costly to you in terms of violating liquidity requirement to then go use those assets in payment.
So, you know, the essential thing is that like, and this is sort of like what the contradiction of liquidity requirements are, is by requiring you to hold a liquid asset, they’re immobilizing that liquid asset and making it less likely that you’re going to use it to make payments because you then need to make payments on top of this immobilized amount of liquid assets that you can no longer use because you’re required to hold them.
And that’s essentially what’s driving the process now is there’s a whole bunch of liquidity requirements, especially the resolution liquidity requirements, which are immobilizing settlement balances in the banking system, and generating a demand for settlement balances above and beyond them, such that there needs to be something like 4 trillion or 5 trillion.
I haven’t looked at the recent estimates. I don’t know the numbers offhand of settlement balances in the system of central bank I O U’s outstanding held by commercial banks in order to clear payments and satisfy these liquidity requirements. So, I mean, that’s the essential element. The big takeaway is we have these new requirements, which are mobilized liquid assets of the banking system and for the Federal Reserve to meet that demand for settlement balances, that demand for liquidity, they have to buy up a whole bunch of government bonds, either on a temporary basis, which is basically what they’re doing with repos or a permanent basis.
And they need to keep a quote, unquote “big batch” now is that there was a lot of talk that the Federal Reserve was going to shrink its balance sheet, was going to move away, basically reverse quantitative easing, quantitative tightening, sell off bonds. And what has been made clear now and what certain experts were warning about, but basically wasn’t clear, or wasn’t publicly talked about until now is that these new liquidity requirements require the Federal Reserve to keep a big balance sheet in order to meet those liquidity requirements.
Steve Grumbine (42:36):
Does this have anything to do with the term liquidity trap? I mean, we hear this a lot and it’s thrown around so much and you know, I oftentimes think I get it. And then I come back and say, “No, no, I don’t think I get it.” What is a liquidity trap and how does it play into this? Or does it?
Nathan Tankus (42:55):
It would be great if we had that term reserved for this issue, but unfortunately not. The liquidity trap, I’m just going to talk about how the Orthodox economists do, and I’m not going to get into Keynes on the general theory, but the conception basically, as most famously Krugman uses it, is that if interest rates go to zero or the zero lower bounds, then you can’t lower interest rates anymore.
And thus buying government bonds doesn’t necessarily do anything because there’s quote, unquote, “no difference between bonds and settlement balances.” There’s a number of different objections you can have to this kind of point of view. One is that interest rates don’t really stabilize the economy, but the more technical response that I think Scott Fullwiler has written the most about is in this concept for interest rate purposes, there isn’t much difference between bonds and settlement balances is true as soon as the central bank is paying interest on reserves.
So that, back to the idea of setting interest rate targets used to be, as I said before, it used to be set through the federal funds market, basically, you know, lending overnight between banks. Now it’s set just by the interest rate that the Federal Reserve charges or pays on settlement balances. So, it’s the interest on reserve rate IOR and what Scott’s point has always been that once you’re paying this interest rate to hit your interest rate target on settlement balances, then since it’s not affecting the interest rate paid on government liabilities or not affecting it much for this interest rate purpose, there isn’t much difference between them.
So the short form of this is that the liquidity trap concept is not really related, but a good understanding of monetary operations and MMT’s argument is that for many reasons, but especially for this interest on settlement balances reason, the liquidity trap as usually talked about is irrelevant. Where this is most important is in emphasizing that MMT isn’t about printing money.
This essential difference why? Because when you’re paying interest on reserves, there isn’t much difference between bonds and settlement balances for interest rate target reasons means that MMT in the narrow economic sense doesn’t really care whether you’re selling bonds or issuing settlement balances.
So of course the big strawman is that MMT is about printing money. You print money, you flood the system with liquidity, and then we’re going to get hyperinflation and Weimer and all this stuff. So it is important for emphasizing that MMT doesn’t really care about printing money. It’s about understanding how the monetary system works.
And once you understand how the monetary system works, you can A, deficit spend based on demand constraints rather than financial constraints. And second, we can reorganize both financial regulation and how the central bank and the treasury interact to make our monetary operations make more sense, to simplify them, and to make them more understandable by making this whole process a lot simpler.
Steve Grumbine (46:47):
Okay. So I guess the big question to tie a bow on this is we have QE, which was seen as printing money and flooding the market with money and QE in Mosler’s terms would be QE is a tax. So it would say that that’s not the case. And then you have the quantitative tightening that you’re talking about, which is going on.
And then you’ve got this concept of repo and every step along the way, no matter which way you go, the cry in the streets is that we’re bailing out Wall Street yet again. This repo thing, is it, or is it not bailing out Wall Street?
Nathan Tankus (47:31):
It’s not bailing out Wall Street. What I would say is from a bigger picture, the relationship between the banking system and the central bank, where the central bank has to guarantee that there’s enough settlement balances in the system to meet liquidity requirements and for the banking system to make payments, to clear payments, shows the essential franchise nature of banks.
I think this is the bigger picture . . . is that these liquidity requirements, and then there’s also capital requirements, all these attempts to regulate the banking system are trying to convince people that because we have these regulations that are going to prevent financial crises, and since we have these regulations, there’s no social costs to the banking system, to you.
There was a big social cost, and we’re very sorry about it when we had to bail out the banks in 2008, and yeah, there was this big foreclosure crisis and, “Oh, it wasn’t that bad,” but now we’ve regulated the banking system. And now we’ve, in the language of economists, internalized the costs that they’re putting on everyone else and thus, stop worrying about it.
Everything’s fine. Whereas from the MMT point of view, the fact that we’re always have to provide this liquidity, the fact that we’ve essentially franchised the ability to create money to the banking system, and we’ve expanded the amount of activities that they’re able to undertake, whether or not those activities necessarily serve a public purpose that we need to rethink whether the banking system is really serving public purposes and whether we need to shrink it.
And we need to shrink it, not because repurchase agreements are bailing out the banking system or whatever, but because they illustrate that there’s always a partnership between the government and the private sector involved with the granting of bank charters and the granting of privileges to the banking system.
And because of that, we need to shrink the banking system and we need to get a handle on its activities and reduce the amount, the types of activities it’s allowed to engage in. And this regulatory regime is trying to convince us that we don’t need to do these things because we’re making sure that the banks are bearing the costs of their activities.
And there’s still always a big social cost to how the banking system operates. So, my short form is it’s not a bailout, but it illustrates that the banking system is a creature of the public and should be shamed by the public.
Ending Credits (50:33):
Macro N Cheese is produced by Andy Kennedy, descriptive writing by Virginia Cotts and promotional artwork by Mindy Donham. Macro N Cheese is publicly funded by our Real Progressive Patreon account. If you would like to donate to Macro N Cheese, please visit Patreon.com/realprogressives
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If you follow the financial press you’ve probably noticed some recent hysteria about the “repo market.” Since this involves the dealings of the Federal Reserve, it falls under our purview here at Macro ‘n Cheese. Because unraveling the strands of this dense subject requires someone more knowledgeable than we are, we called upon friend-of-the-podcast Nathan Tankus to help us out. Nathan is Research Director at Modern Money Network and can often be found on Twitter, educating the world about MMT.
“Repo” simply refers to the repurchase of bonds. Banks and bond traders sell Treasury bonds back to the Federal Reserve with the understanding that they (the banks) will buy them back the following day. As Nathan points out, this is always spoken of from the point of view of the central bank as buyer; it could just as well be called the resale market.
Why does this matter? Why do the banks sell back their Treasurys for such a brief period of time? When banks buy them back the price is higher due to the interest charged. So why do it at all? It turns out to be the mechanism by which banks ensure that they have enough balance reserves to ensure that their payments clear. To do this they need to deal with liquid assets, which can quickly be bought and sold and converted to “money” (or at least change the balance in their account). Nothing is more liquid than a Treasury bond.
See? Perhaps the banking industry isn’t just lawlessness and anarchy after all? Well, they certainly want us to believe the system is self-regulating so we won’t demand that the lawmakers rein them in and protect the public.
As Nathan explains it, concern about the repo market is much ado about nothing. The central bank has been doing these repurchase agreements since 1917 and during some periods they are a normal part of the Fed’s toolbox. But the 2008 financial crisis put a halt to the practice for a while. In response to the liquidity crisis (ie, the lack of liquid assets), the Fed created trillions of dollars of what most of us think of as bail-out money, which was distributed to all the banks. At that point, banks didn’t need to sell bonds to meet their reserve balances because they all had plenty. Thus, no need for repo.
When repo agreements started up again, some in the media thought that, since it hadn’t been done since 2008, it must be a sign that there’s a new crisis at hand. It doesn’t help that the FDIC, headed by Trump appointee Jelena McWilliams, is investigating the central bank, insisting that the repo market is actually another bank bailout by the Fed. Somehow, people have forgotten that these have historically been normal activities.
In this interview we learn the meaning of the liquidity trap — and liquidity itself. We learn about settlement balances, quantitative easing, and overnight interest rates. We learn of regulations like Dodd-Frank and international banking agreements like Basel III. We learn how these things are connected to such far-flung historical events as Bretton Woods, the Yom Kippur War, and German postwar reparations. We learn why MMT economists have promoted a detailed understanding of monetary operations and argue that the banking system does not serve the public purpose. The next time you get spooked by a headline in the financial press, tune into this episode again. It all makes so much sense when explained by someone who knows what he’s talking about.
Nathan Tankus is Research Director at Modern Money Network. modernmoneynetwork.org
@NathanTankus on Twitter
Macro N Cheese – Episode 42
Repo Mania: Has The Fed Bailed Out Wall Street Again? with Nathan Tankus
November 16, 2019
Nathan Tankus [intro/music] (00:04):
When we say that there is sufficient liquidity in the banking system, what we’re saying is that banks have sufficient access to what they need to make payments. And for the banking system, the ultimate thing is balances in an account at the Federal Reserve. MMT in the narrow economic sense, doesn’t really care whether you’re selling bonds or issuing settlement balances.
Geoff Ginter [intro/music] (00:31):
And now let’s see if we can avoid the apocalypse altogether. Here’s another episode of Macro N Cheese with your host, Steve Grumbine.
Steve Grumbine (01:34):
This is part one of a three part interview with Nathan Tankus, research director of the Modern Money Network. In this episode, we discuss in great detail, the idea of what repos are and what they mean to us as regular citizens. This is deep, it’s extensive, and it’s enjoyable. I hope you enjoy part one of this episode of Macro N Cheese.
Yes. And this is Steve Grumbine with Macro N Cheese and Real Progressives. And today I have my good friend, Nathan Tankus, who is the research director of the Modern Money Network. And Nathan’s going to be talking to us today about something pretty, pretty dicey, and I’m hoping we can make it palatable and easy to understand for everyone.
And that is the essence of the repo market and understanding the role of the Federal Reserve when it comes to the repo market and what all the latest news about repo rates, et cetera, mean to Joe Q public and the economy at large. So without further ado, let me bring on my guest, Nathan Tankus. Welcome to the show, sir.
Nathan Tankus (02:51):
Hi! Thank you for having me, Steve.
Steve Grumbine (02:53):
So first things first. It was great seeing you at the Modern Money Conference here in New York, really nice to see you and really was impressed with the overall production, all the work you guys put out. I just want to tip my hat to you and say, well done,
Nathan Tankus (03:10):
Thank you very much. As you know, like those conferences are a lot of work, but they’re definitely more than worth it.
Steve Grumbine (03:17):
I enjoyed the heck out of it. And in particular, I thought that it was interesting, the breadth of topics that were covered as it expanded into social structures and other dynamics that are frequently left out of the economic conversation. And I just applaud you guys for attacking this from such a 360 perspective.
All right. So let’s get to the meat of this man. I profess right up front. I knew very little about repo markets and I know even less about why this matters to people. Can you start us off, I guess, with, you know, how repo markets even came to be and what they are and what the role of the Fed is in this?
Nathan Tankus (04:01):
Yeah, I can do that. I think the thing to start with isn’t so much repo itself, but the basics of what the Federal Reserve does. The Federal Reserve is about, at a fundamental level, setting interest rates and making sure payments clear. So we all have accounts in different banks and we don’t really think about it; but there’s a lot of work that goes in behind the scenes to make sure that a dollar in one bank is worth a dollar in another bank.
And both of those dollars in turn are worth a dollar of the US dollar, the currency that the federal government issues. So there’s a lot of work that goes behind the scenes. And the essence of what the Federal Reserve does is it makes sure that there’s always access to what are sometimes called bank reserves.
But it’s easier to think about it as settlement balances, you know, balances that are used to settle payments and they make sure that they’re available. And the way that they make sure they are available is essentially for the most part buying government bonds. They buy government bonds from the private sector, including the banking system.
And when they make those purchases, they increase the amount of settlement balances that are circulating in the system and the settlement balances ensure that banks are able to clear payments with each other and the government. And so that’s the essential part of the basics. When now when you get to repos, you know, before I explain what repos is, the basic way you can think about a repurchase agreement is, the alternative the Fed has to repo agreements, is outright purchase and sales.
They can outright buy a bond and outright sell a bond. But given that for many, many decades, the amounts of reserves that the system needed changed on a daily basis, even, you know, potentially on an hourly basis, but especially on a daily basis, it’s kind of cumbersome to constantly be making outright purchases and sales.
So what comes as an alternative is the repurchase agreement. In a basic repurchase agreement, what happens is that a dealer sells bonds to the government and the government provides settlement balances to a bank in the case of a bank, or the dealer’s a bank or provides a settlement balances to a dealer’s bank.
And what they agree in turn is to buy back those government bonds at the end of the end of day. So that’s the basic repo agreement or repurchase agreement is when someone in the private sector agrees to sell the bond to the government and they agree buy it back a day later. So using this terminology, a reverse repurchase agreement is when they buy a government bond from the government or the Federal Reserve, and then they agree to sell it back a day later.
So there’s repurchase agreements and reverse repurchase agreements and what they’re actually doing, you know, any agreement to repurchase something isn’t so complicated, but it can be very complicated to keep it straight in your head, which type is supposed to be the repurchase agreement and which type is supposed to be the reverse repurchase agreement.
Steve Grumbine (07:26):
So let me interrupt you real quick. Why does this matter to the average person? Why would this be making its way on the Jimmy Dore? Why would this be making its way to Dylan Ratigan and all these other folks? They’re predicting the end of days because of repos. So just curious as to understand what the impact is of, just in general, a repo agreement.
Nathan Tankus (07:54):
I think generally the reason it’s gotten to everyone’s headlines is people aren’t used to repurchase agreements, or like when the Federal Reserve is conducting a repurchase agreements. But historically this has been what the Fed has been doing since the beginning, since 1917, the Fed is involved in repo agreements.
It did some in the twenties and thirties. It started really drawing in the 1950s on, but it was a regular part of the Federal Reserves’ toolbox. What changed was 2008, because what happened in 2008 was you had a liquidity crisis, a crisis because you know, the normal system where they inject just enough settlement balances to make sure that payments clear and banks can settle their reserve requirements.
That system broke down because it relies on banks lending settlement balances to each other. It relies on the ones that have too many, to lend to the ones that have too few, but the federal funds market, the market that used to dominate how this all works, that market relied on unsecured lending, lending that wasn’t secured by collateral, and at the very least didn’t involve a government guarantee.
So when every bank looked dicey, each one looked like they were going to get shut down. That market froze up and then the Federal Reserve had to respond; but in the process of the Federal Reserve responding, lending to almost every bank and even some non-banks, they created trillions of dollars of settlement balances.
And thus the banking system had a lot of “excess settlement balances,” quote unquote. So no one needed to really lend anymore because in the normal system the people who had too many need to lend to the ones who have too few; but if everyone has too many, then no one needs to lend anymore. And so basically the market — quote, unquote, “shut down.”
And then after that process happened, what it was followed up with after the banking system stabilized, was quantitative easing, which was just the Federal Reserve outright purchasing lots of government bonds. And they basically just outright purchased so many government bonds that, you know, we basically haven’t been concerned with it for many, many years.
So, you know, a lot of financial reporting people don’t have a deep understanding of this infrastructure, but if you know that repo agreements are things that happen and things that happen regularly, fine. But now this turning point is, well, they haven’t been doing repo agreements since the crisis.
So they had to do it even more. They start to have to do it again. Everyone’s assuming that this is about a crisis that’s about to happen because they don’t understand the kind of intricate workings of the financial system. And also because they’re very complicated.
Steve Grumbine (11:02):
Okay. Fair enough. That makes sense. So ultimately, before I diverted you there, you were in the process of breaking down the repo market itself in general. Let’s see if we can get back to what that process is and how that process is playing out on the stage today.
Nathan Tankus (11:24):
Okay. So, so to fill in a little bit more about how things historically worked. The New York Federal Reserve bank would basically get up each day. They would produce an estimate of the demand for settlement balances coming from the banking system. They would, you know, survey banks, they would ask questions.
They would estimate what was going on with the Treasury’s Federal Reserve account, whether there was a big inflow or a big outflow; they would estimate how much orders for physical cash and coins that were happening from commercial banks. They would put all these estimates together and based on that, they would enter in enough repurchase agreements.
They would buy enough government bonds with the private dealers agreeing to buy them back the next day, to make sure that there was just enough settlement balances in the system that payments would clear, that reserve requirements would be satisfied, and the interest rate would be at the level that the Federal Reserve wanted, because if there was too little settlement balances in the system, then the banks that were short settlement balances would keep on demanding settlement balances.
And they would keep on offering higher and higher interest rates to try to satisfy their demand. And that would interfere with the Federal Reserve interest rate target policy. And there’s been a lot of complications added since the 2008 prices, but it basically works the same way today, except because the system has had so much settlement balances in it, has so much excess settlement balances relative to reserve requirements, they stopped doing that survey process of estimating the demand for settlement balances.
And a couple of years ago, they started what was called quantitative tightening, which is basically just not purchasing more bonds after the bonds that they purchased before matured. You know, they got final repayment and the combination of this factor, which another thing that we’ll talk about, which is the liquidity requirements that came from what is called Basil III, came together such that in the middle of September, suddenly the banking system didn’t have enough settlement balances to satisfy these other liquidity requirements, plus satisfy their payment needs.
And thus, you know, we got back to what is usually considered the normal situation, which is the Federal Reserve needs to conduct repurchase agreements to satisfy the demand for settlement balances.
Steve Grumbine (14:20):
What is liquidity in the macro term here when we’re talking about monetary policy? What exactly does liquidity mean when we say that?
Nathan Tankus (14:30):
It’s a very good question. What I would put as the essence of liquidity is the need to be able to sell an asset or use an asset to make monetary payments very soon. So when we say that there is sufficient liquidity in the banking system, what we’re saying is that banks have sufficient access to what they need to make payments.
And for the banking system, the ultimate thing you use to make payments is balances in an account at the Federal Reserve at the central bank, because you can use that payment to make a payment to any bank or the government and any customer of a bank, which is basically almost everyone.
Steve Grumbine (15:31):
Okay. So basically what it means is in order to clear these payments, there’s gotta be money flowing as opposed to tie it up in an asset. Am I close to that? Is that . . .
Nathan Tankus (15:39):
Yeah. I mean an asset, whether it’s a financial asset or a nonfinancial asset, can have a high degree of liquidity, if you’re able to essentially sell it quickly for money. I mean, so you can think about a house, a house, famously, is not very liquid because if you want to sell it and you want to sell it at close to it’s currently estimated price, you have to put it on the market and you probably have to like, have people visit the house.
And you wait nine months to a year, maybe even longer before you’re able to sell the house at anywhere near what it’s estimated value is. So that is something that has a low degree of liquidity. Whereas, a government bond you can sell very rapidly and get a quote, unquote “cash” or get balances in a bank account or balances at the central bank, if you’re a licensed bank.
So liquidity is like monetary sovereignty in the sense that there’s this hierarchy. And there’s basically almost a series of in this case assets and the other case countries or entities, that fall somewhere along that spectrum. And the interesting thing about the central bank and about markets for settlement balances is since it’s like the ultimate liquid asset in terms of the asset that you can make payments with, there are other assets that seem very liquid, which if the Federal Reserve isn’t standing behind them, isn’t necessarily as liquid.
So, you know, in this case, what was actually happening with the repo markets is that there’s an overnight trade you charge in a repurchase agreement. So when you sell a bond to the government and agree to buy it back a day later, you’re agreeing to buy it back at a higher price. And that the difference between the price you sold it at, and the price you paid, is essentially the interest rate that you’re paying.
And what happened in the repo markets was there was this demand for settlement balances, the need to make payments or satisfy liquidity requirements, which we’ll get to in a bit, and entities with government bonds, try to borrow against them in order to get the settlement balances they needed to make payments.
And there wasn’t anyone out on the other side of those transactions. So they, you know, in the same way that when the banking system is short settlement balances, banks used to offer higher and higher interest rates to try to entice someone to lend to them. The same thing happens with the government security repo markets is this that they started offering higher and higher interest rates to try to attract someone to lend to them.
And because the Federal Reserve has an interest rate target and the overnight collateralized lending, which is essentially what repo lending is, it started to interfere with the overnight interest rate, the federal funds rate, and more generally the Federal Reserves’ interest rate target. So they had to intervene in order to stabilize repo markets and make the interest rate prevailing in repo markets consistent with their overnight interest rate target.
Steve Grumbine (19:22):
You got Jelena McWilliams, who is a Trump appointee, currently serves as the chairwoman of the federal deposit insurance corporation, FDIC, the federal agency responsible for ensuring deposits of commercial banks and savings associations comes out and they’re like trying to investigate why the Fed is bailing out Wall Street again.
So this is the framing that we’re seeing in not only left wing circles, but just the mainstream media. And then of course the alternative media picks these things up and there’s never a way that they can’t spin it that’s not a little bit more conspiratorial, more, you know, shady, now that’s not to say it’s not shady.
It’s just the point of saying that they always add a little extra flavor to it. Can you explain to me why the FDIC would even be bothering investigating this if this is normal monetary operations, or are we suggesting that they genuinely don’t understand their job either? Or is there something that we’re not understanding about this that would push them to investigate?
Nathan Tankus (20:32):
I mean, I think there’s two different elements. I think one is, there’s an obvious political element for . . . there’s people who are always looking for like what the bailout is. And if you don’t really understand the financial system, anything involving banks could potentially look like what quote, unquote, “the bailout is.”
I think the second element with people like the Trump appointed head of the FDIC, Trump is tweeting about Powell, like when he’s not distracted by other crisis or impeachment, he’s tweeting about Powell pretty regularly. I mean, he tweeted about Powell like during Powell’s speech at Jackson Hole, which is pretty unprecedented in terms of president/Federal Reserve interactions.
So it’s not surprising to me that an appointee who probably doesn’t understand the financial system very well, you know, and is much more subject to Trump’s opinions than Chairman Powell is, would get into the act of this is a bailout. I think the other element is what I said before is that repo agreements are old news at this point.
And so when the Fed starts doing repo agreements again on a significant scale, it seems like something’s wrong to people. And third, I think the central element is what was, well, I guess I’ll get to now, is I think people don’t understand the effects that the Basil III Agreements have had on the financial system, so . . .
Steve Grumbine (21:57):
Before you go into that, can you break down what the Basil III Agreements are at all, I mean, just get framework for what that even means.
Nathan Tankus (22:07):
Yeah. That’s definitely the place I was going to start because it’s definitely well outside of how people are generally think about things. So to give you the kind of like broad strokes background. The Bretton Woods System, the system where we talk about all the time of the Nixon closed the gold window and thus moved the US to a floating exchange rate system and moved a lot of other countries to floating exchange rate systems at once happened in the early seventies.
And as a consequence of that, you suddenly went from a system where cross-border financial transactions were very heavily regulated and controlled, and there were fixed exchange rates to a system where those controls had broken down and their floating exchange rates. So there were a whole series of new concerns about how the international financial system worked that were unresolved.
And these were set off, especially with the Yom Kippur War in 1973, a war that Israel was involved with that led to changes in behavior among Middle Eastern countries, which had global financial system affects; and what the Basil Committee started with, first of all, the Bank of International Settlements is what the Basil Committee was based around.
And that’s in the international what’s often referred to as a bank of central banks that was set up in 1930s to deal with the international financial system implications of German reparations to the allies. And so what’s important about that is it’s just, it’s this historical entity to deal with international financial system issues, which became more important in the 1970s.
And basically just a meeting of a bunch of technically sophisticated, mid-levels central bankers, not the chairman or even the vice chairman, but lower level to that got together to talk about international financial system issues and trying to coordinate each other’s behavior. And over time, this expanded into a kind of more official group, which came up in the late 1980s with Basil I, which is as with all these agreements are related to capital requirements, the requirements that you’re going to for how much, how high a bank’s net worth needs to be relative to its assets and liquidity requirements, which is how much does a bank need to be holding certain defined liquid assets relative to their liability.
And Basel has never had a sort of official relationship. It’s not like it’s part of the UN or it’s the product of a treaty between dozens of countries. It’s basically been just a standard meeting place for central bankers to coordinate on financial regulation that’s been taken more and more seriously and kind of treated more and more officially as time has gone on.
And so, whenever there’s a crisis basically, or whenever there’s evolutions that lead to consensus opinion changing for how the financial system is regulated, the Basel Committee gets together to come up with new regulations. So there was Basel I in 1988, there was Basel II, which started to be implemented in 2004.
And then there’s been Basel III, which is basically started to be implemented since 2015. And it’s going to have more implementation up until like 2021. And it’s a meeting of major countries. So what’s ended up de facto happening, even though it wasn’t necessarily the original intention is that you get a bunch of countries together who are the major powers and they come up with these consensus rules, these best practices between them.
And then there’s a lot of pressure on developing countries to follow the financial relation framework that they have set up.
Intermission (26:21):
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Steve Grumbine (27:24):
Okay. So thank you very much. I appreciate that. So we’re going back to the framing of the Basel Agreements in terms of the repo. Let’s get back to how that impacts the other.
Nathan Tankus (27:38):
So the important key piece here is that Basel II didn’t really take liquidity that seriously, or at the very least, it missed major parts of what is now kind of consensus. There’s a consensus that there should be a lot higher liquidity requirements, especially on the major banks. And so Basel III stepped into this space with what’s called LCR, liquidity coverage ratio, which .
. . there’s a lot of complicated details in it, but you can basically reduce it down to rather than a requirement that you have to hold X amount of liquid assets relative to all your liabilities, it’s an agreement that you have to hold a certain amount of liquid assets relative to what’s our estimate of how much payment outflows you’ll have over a given 30 day period.
So let’s say there’s a stressful situation. And we think that there’s gonna be a big quote, unquote “rush to the exits” where people are in the most extreme case, pulling money into cash, but more likely that they’re buying other liquid assets or their redepositing money in other banks or whatever it is, how much of what are called high quality liquid assets do you need to have so that you wouldn’t need to borrow from the central bank over that 30 day period?
And the idea is essentially that, like, if you have more liquid assets on hand, and we have at least this 30 day period to respond to, that it gives central banks breathing room to decide how they’re going to respond to a crisis. In short, it’s trying to make sure that banks can always make payment over a short period of time so that central banks can respond rather than trying to ensure that they have like enough assets in the abstract that they can always make payments over any given period of time, which is kind of more the logic that goes into traditional reserve requirements.
And then there’s a second bit that’s important here, which is called resolution liquidity. And there’s debates over the technicalities of what exactly is causing this. There’s some people who say it’s less to do with Basel III and more to do with Dodd-Frank, which was the specifically US financial reform [inaudible] 2010, but that isn’t really important.
What’s important is with the liquidity coverage ratio, you wouldn’t necessarily have the problem that we’re having now because both treasury securities an central bank settlement balances are considered high quality liquid assets; but with resolution liquidity, for reasons which aren’t precisely clear, how much of it is the formula itself versus how much of it is pressure from individual bank examiners, bank regulators, banks have basically been directed either way to think of central bank settlement balances as a lot more liquid than treasury securities; and thus basically to make sure that they have enough settlement balances on hand to make payments over a given 30 day period.
And so this is where really the issue comes in is you have the normal reserve requirements, which, you know, in the simplest terms are usually, you know, 10% of what are called reservable liabilities. Basically, you know, you can simplify and just say bank deposits, but these reserve requirements are potentially much larger.
And in actual practice has led to the banking system, especially the big, too big to fail banks, as it were holding a lot more settlement balances. And this is where the shortage comes in is that there’s still a lot of excess settlement balances relative to traditional reserve requirements. But these new Basel III dash resolution liquidity requirements are much, much higher.
And this is the point that I think most commentators in this area don’t understand is besides, you know, some friends of mine at Bloomberg journalists and economists, including even some mainstream monetary economists who were very complimentary on things I had commented in this area is that there is this shortage that is relative to all the liquidity requirements that the banking system has.
And people are used to thinking of liquidity requirements as only the traditional one that we’ve had for almost a century, these reserve requirements. And it’s confusing because if you look at the official data, there are settlement balances that are referred to as excess settlement balances and there’s interest on excess reserves, I O R, but that excess is only relative to reserve requirements.
You know, I think it would simplify a lot if those names were changed, then we got an understanding that the banking system is short or has just enough reserves relative to these Basel dash resolution liquidity requirements. And that’s the essence of it because of these new big liquidity requirements, we’re back to 2008.
And I would say this interpretation has come from a few different places, but it has been most prominently pushed by this economist, Zoltan Pozsar who’s very well known, was an expert on this stuff in the treasury, I mean, like 2008 to 2011. And is now like, I think chief economist at Credit Suisse, I think that’s his position so that, you know, this isn’t necessarily something controversial, something that MMT people have talked about.
It’s something that there are a number of monetary economics experts have converged on, but what’s unique an kind of interesting about this, you know, in terms of an MMT point of view is MMT is the only one that has really promoted a detailed understanding of monetary operations, such that people outside of a small group of central banking, treasury, and a few economists experts, but actually like there’s a general population who knows the basics of monetary operations.
And I think the essential point here isn’t that far off above the basics of monetary operations that MMT regularly promotes.
Steve Grumbine (34:35):
Which brings me to basically, an explainer. Can you explain to us what the point of reserves are in general? What are reserves? Some of these terms get thrown around and, you know, when we see, especially some of the experts typing in shorthand, you see, like you said, IOR, interest on reserves and, and there’s all these overnight window type short three letter acronyms, basically to describe all these operations that I think make the average person’s eyes roll back into their heads so far they can see their brain.
Some of these terms while they seem very, very easy, once someone like yourself explains them, it becomes a word salad, or even worse than acronym salad and Twitter shorthand as we try to make heads or tails of this stuff, we can be a better citizen then we can understand the world around us better. Can you describe what reserves are in the hierarchy of money and just sort of explain what they do within the banking system?
Nathan Tankus (35:44):
Yeah, sure. I mean, first of all, I would say, so I’ve been using the term settlement balances regularly through this podcast, and that’s generally the term I use. And I use that term to try to be clear because the monetary economics has not done anyone favors because it uses the term reserves twice.
It uses the term bank reserves when it wants to talk about the IOUs of central banks, you know, money in an account at the central bank. And it also uses the term reserves when it’s talking about capital requirements. So people will talk about equity reserves. People will talk about the money in reserve when they essentially, they mean like how much losses that a bank can take.
So, you know, to distinguish them, there are capital requirements, and then there is the owner’s equity, the equity in a particular bank, basically their net worth, their assets minus their liabilities and the ratio between that net worth that assets minus liabilities and their total assets. And then there is this other concept, which is money in an account at the central bank, basically, a checking account for banks with the central bank.
And that is often referred to as bank reserves as well. But I use the term settlement balances and I use the term settlement balances partially to distinguish it from, you know, all this confusion about what the hell reserves are. But second, because settlement balances can explain what they are directly.
Settlement balances are about settling payments. Settlement is all about you’ve entered in some transactions. There are payment outflows and inflows, you know, or like, let’s say, you know, in the most simplest case, you know, you and I have written a contract where it says, once I fulfilled the duties of the contract, you have to pay me a thousand dollars.
You paying me a thousand dollars is you settling your payment. It’s you’re settling your obligations with me. And that’s what settlement balances are for — they’re to settle your obligations to either the government or other banks. That’s it. You even need to make a payments to other banks or to the government.
And then there’s the second thing that you can settle with the government, which is your obligation to hold a certain amount of balances in your account for basically historical leftover reasons, we have these what are called reserve requirements that are really settlement balance requirements, where you have to hold a certain amount of settlement balances in ratio to all your deposits if you’re a bank.
So you have to hold a certain amount of balances because of how many liabilities you have outstanding. An this, you know, settlement balance requirement, often termed a reserve requirement, is one type of a liquidity requirement that you can impose. And these Basel requirements, the liquidity coverage ratio and these resolution liquidity requirements, what are technically referred to in the US called RLAP, resolution liquidity assistance planning, I think that’s the acronym, and they are different types of liquidity priority.
They’re different types of requiring you to hold a certain amount of liquid assets relative to your liabilities, or some estimate of how many payment outflows you’ll have over a given 30 day period. And what’s important about liquidity requirements is when liquidity requirements require you to hold whatever liquid asset you have to hold, you can’t then necessarily, or it might be costly to you in terms of violating liquidity requirement to then go use those assets in payment.
So, you know, the essential thing is that like, and this is sort of like what the contradiction of liquidity requirements are, is by requiring you to hold a liquid asset, they’re immobilizing that liquid asset and making it less likely that you’re going to use it to make payments because you then need to make payments on top of this immobilized amount of liquid assets that you can no longer use because you’re required to hold them.
And that’s essentially what’s driving the process now is there’s a whole bunch of liquidity requirements, especially the resolution liquidity requirements, which are immobilizing settlement balances in the banking system, and generating a demand for settlement balances above and beyond them, such that there needs to be something like 4 trillion or 5 trillion.
I haven’t looked at the recent estimates. I don’t know the numbers offhand of settlement balances in the system of central bank I O U’s outstanding held by commercial banks in order to clear payments and satisfy these liquidity requirements. So, I mean, that’s the essential element. The big takeaway is we have these new requirements, which are mobilized liquid assets of the banking system and for the Federal Reserve to meet that demand for settlement balances, that demand for liquidity, they have to buy up a whole bunch of government bonds, either on a temporary basis, which is basically what they’re doing with repos or a permanent basis.
And they need to keep a quote, unquote “big batch” now is that there was a lot of talk that the Federal Reserve was going to shrink its balance sheet, was going to move away, basically reverse quantitative easing, quantitative tightening, sell off bonds. And what has been made clear now and what certain experts were warning about, but basically wasn’t clear, or wasn’t publicly talked about until now is that these new liquidity requirements require the Federal Reserve to keep a big balance sheet in order to meet those liquidity requirements.
Steve Grumbine (42:36):
Does this have anything to do with the term liquidity trap? I mean, we hear this a lot and it’s thrown around so much and you know, I oftentimes think I get it. And then I come back and say, “No, no, I don’t think I get it.” What is a liquidity trap and how does it play into this? Or does it?
Nathan Tankus (42:55):
It would be great if we had that term reserved for this issue, but unfortunately not. The liquidity trap, I’m just going to talk about how the Orthodox economists do, and I’m not going to get into Keynes on the general theory, but the conception basically, as most famously Krugman uses it, is that if interest rates go to zero or the zero lower bounds, then you can’t lower interest rates anymore.
And thus buying government bonds doesn’t necessarily do anything because there’s quote, unquote, “no difference between bonds and settlement balances.” There’s a number of different objections you can have to this kind of point of view. One is that interest rates don’t really stabilize the economy, but the more technical response that I think Scott Fullwiler has written the most about is in this concept for interest rate purposes, there isn’t much difference between bonds and settlement balances is true as soon as the central bank is paying interest on reserves.
So that, back to the idea of setting interest rate targets used to be, as I said before, it used to be set through the federal funds market, basically, you know, lending overnight between banks. Now it’s set just by the interest rate that the Federal Reserve charges or pays on settlement balances. So, it’s the interest on reserve rate IOR and what Scott’s point has always been that once you’re paying this interest rate to hit your interest rate target on settlement balances, then since it’s not affecting the interest rate paid on government liabilities or not affecting it much for this interest rate purpose, there isn’t much difference between them.
So the short form of this is that the liquidity trap concept is not really related, but a good understanding of monetary operations and MMT’s argument is that for many reasons, but especially for this interest on settlement balances reason, the liquidity trap as usually talked about is irrelevant. Where this is most important is in emphasizing that MMT isn’t about printing money.
This essential difference why? Because when you’re paying interest on reserves, there isn’t much difference between bonds and settlement balances for interest rate target reasons means that MMT in the narrow economic sense doesn’t really care whether you’re selling bonds or issuing settlement balances.
So of course the big strawman is that MMT is about printing money. You print money, you flood the system with liquidity, and then we’re going to get hyperinflation and Weimer and all this stuff. So it is important for emphasizing that MMT doesn’t really care about printing money. It’s about understanding how the monetary system works.
And once you understand how the monetary system works, you can A, deficit spend based on demand constraints rather than financial constraints. And second, we can reorganize both financial regulation and how the central bank and the treasury interact to make our monetary operations make more sense, to simplify them, and to make them more understandable by making this whole process a lot simpler.
Steve Grumbine (46:47):
Okay. So I guess the big question to tie a bow on this is we have QE, which was seen as printing money and flooding the market with money and QE in Mosler’s terms would be QE is a tax. So it would say that that’s not the case. And then you have the quantitative tightening that you’re talking about, which is going on.
And then you’ve got this concept of repo and every step along the way, no matter which way you go, the cry in the streets is that we’re bailing out Wall Street yet again. This repo thing, is it, or is it not bailing out Wall Street?
Nathan Tankus (47:31):
It’s not bailing out Wall Street. What I would say is from a bigger picture, the relationship between the banking system and the central bank, where the central bank has to guarantee that there’s enough settlement balances in the system to meet liquidity requirements and for the banking system to make payments, to clear payments, shows the essential franchise nature of banks.
I think this is the bigger picture . . . is that these liquidity requirements, and then there’s also capital requirements, all these attempts to regulate the banking system are trying to convince people that because we have these regulations that are going to prevent financial crises, and since we have these regulations, there’s no social costs to the banking system, to you.
There was a big social cost, and we’re very sorry about it when we had to bail out the banks in 2008, and yeah, there was this big foreclosure crisis and, “Oh, it wasn’t that bad,” but now we’ve regulated the banking system. And now we’ve, in the language of economists, internalized the costs that they’re putting on everyone else and thus, stop worrying about it.
Everything’s fine. Whereas from the MMT point of view, the fact that we’re always have to provide this liquidity, the fact that we’ve essentially franchised the ability to create money to the banking system, and we’ve expanded the amount of activities that they’re able to undertake, whether or not those activities necessarily serve a public purpose that we need to rethink whether the banking system is really serving public purposes and whether we need to shrink it.
And we need to shrink it, not because repurchase agreements are bailing out the banking system or whatever, but because they illustrate that there’s always a partnership between the government and the private sector involved with the granting of bank charters and the granting of privileges to the banking system.
And because of that, we need to shrink the banking system and we need to get a handle on its activities and reduce the amount, the types of activities it’s allowed to engage in. And this regulatory regime is trying to convince us that we don’t need to do these things because we’re making sure that the banks are bearing the costs of their activities.
And there’s still always a big social cost to how the banking system operates. So, my short form is it’s not a bailout, but it illustrates that the banking system is a creature of the public and should be shamed by the public.
Ending Credits (50:33):
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