Background – Basel III Framework
One of the less obvious facts about the Basel III regulatory framework is that it limits the amount of deposits banks can hold on their balance sheets. To clarify, deposits are invariably debt from the perspective of banks and a massive increase, though beneficial from a liquidity perspective, increases a bank’s leverage (indebtedness). If we consider the massive amount of stimulus that’s been provided to the US market since the start of the pandemic, it can then be understood that U.S. banks have seen a considerable increase in deposits. So, how do the banks remain within the regulatory requirements set out by Basel III when savings and deposits have increased significantly? The answer is to move these deposits or, as strange as it might seem, discourage depositors from depositing. To the latter point, despite rates being at all-time lows, bank deposits remain heightened, again reflecting just how much cash has entered the economy. In this article, we look at how the Fed has been somewhat indirectly managing the excess liquidity it has created through Quantitative Easing (QE) and consider the next move for banks.
The U.S. Department of Treasury (“The U.S. Treasury”)
To set further context, we must remember that at the heights of the pandemic, the US Treasury borrowed significant sums at super low rates to facilitate the government’s large stimulus packages provided to Americans. Now, the U.S.’ debt ceiling or debt limit will come into effect at the end of July. This debt ceiling is a legislative limit on the amount of national debt that can be incurred by the U.S. Treasury, thus limiting how much money the federal government may borrow. Importantly, despite the significant amounts borrowed for pandemic relief, the Treasury did not spend all this cash. Consequently, with the imminent deadline, the Treasury needs to reduce its massive cash balance (approximately US$ 746 billion as at June 30, 2021) to US$450 billion by July 31, 2021. As a result, more cash will flow into the financial system that is already highly flushed with cash given the QE actions that have been taken by the Federal Reserve. Again, banks receiving these massive deposits have to offload this excess leverage somehow; therein lies the role of the Federal Reserve’s Overnight (O/N) Reverse Repo Program (RRP).
The Rotation into Reverse Repos
Now, given these developments, the Fed raised its O/N RRP rate to 0.05%, making it highly attractive relative to Treasury Bills (T-bills). Specifically, with excess cash in the system, money market rates have been ranging at their lowest levels in recent history. Given this fact, banks and other “Money Market Funds” are earning practically 0% on overnight rates from instruments such as T- Bills. In fact, 6 months T-Bills current yield 0.05%, the same as an O/N RRP, making the Fed’s O/N RRP, as stated before, extremely attractive. This characterizes the increased importance and use of the O/N RRP in the last month. In our view, this has been the Federal Reserve’s way of managing excess liquidity in the market, without explicitly decreasing bond purchasing or ‘tapering’. Further to this point, on June 24, 2021, the Federal Reserve Board indicated that the results of its annual bank stress tests were favorable. Specifically, the Fed noted that “large banks continue to have strong capital levels and could continue lending to households and businesses during a severe recession”. Therefore, banks can restart their share buyback activities and pay larger dividends starting June 30, 2021, once they pass this year’s stress test; which they have already done. This not only increases returns to shareholders but can reduce the size of the banks (from cash reduction), magnifies their “leverage”, and induces even further usage of the RRP.
The Net Effect and Positioning
The net effect of the Fed’s actions, is an attempt to reduce liquidity in the market, taking out as much as US$ 991 billion in a single day via RRP while buying assets of only $120 billion monthly. This has ultimately maintained stability in what could have otherwise been a somewhat chaotic market, as money market rates would potentially go into negative territory. As banks maneuver these circumstances, we believe the next step for most large banks is to use this opportunity to repurchase shares and make larger dividend payments as they now have the regulatory approval and capital to do so. Consequently, from a positioning perspective, large banks have become even more attractive for investors. Therefore, it may be an opportune time for investors to seek further exposure to this asset class, which doesn’t have much correlation to the movements of our local market.
Written by Awah Muirhead, Senior Investment Strategy Analyst
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