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Financial Crisis Responsibility Fee May Produce Its Own Crisis
Henry CK Liu
Henry CK Liu
Henry Liu argues that a proposed “responsibility fee” for banks could upset the repo market and raise borrowing costs.
The Obama administration’s proposal to subject some bank liabilities to a financial crisis responsibility (FCR) fee highlights the unintended consequences of regulating an industry that depends on an obscure but crucial funding mechanism, such as the $3.8 trillion repo market, in which top-rated securities are used as collateral for short-term loans at lowest available cost. The repo market will be unsettled by the proposed FCR fee. A fee of 15 basis points would be paid on all bank liabilities not already subject to an insurance premium paid to the Federal Deposit Insurance Corporation.
The FCR will place the repo market — which is used by banks for funding a large amount of their liabilities — in the direct line of fire. The FCR also has implications for bank funding via commercial paper and could affect trading in the overnight rate set by the Federal Reserve.
A 15 basis point tax on bank assets above $50 billion will have a devastating effect on the repo market because typical repo operations at Wall Street primary dealers do not generate a spread of 15 basis points. As a result, this tax can be expected to strongly motivate primary dealers of US securities to reduce financing provided to clients for government securities transactions.
While banks use repo to borrow low-cost cash for short periods, which helps fund their balance sheets, they also provide funding for investors wanting to buy the securities without using their only funds. The difference banks earn between the interest rate they borrow at and the one they lend at is reflected by the narrow 5 basis points bid/offer spread in repo, which would be swamped by a new 15 basis points charge. The dealer to customer market in repo will lose liquidity, particularly at times when the FCR fee is expected to be calculated — at the end of a quarter or year. If higher costs for those borrowing through the repo market should force investors to seek alternatives such as derivatives, returns for lenders, such as money market mutual funds, could become lower, from an already low level.
Such entities, which hold more than $3.2 trillion in assets, are large lenders through repo. The industry, which predominantly holds short-term, liquid investments, is already struggling because low interest rates have pushed yields on funds close to zero. Disrupting the repo market could also affect mooted plans by the Federal Reserve to eventually use large-scale reverse repos to drain excess banking reserves from the monetary system — part of its “exit strategy” to unwind extraordinary intervention policies put in place after the financial crisis.
Also, the Fed funds market, the overnight rate between banks set by the central bank, would be affected by the FCR fee. Once the Fed has reduced some of the excess reserves in the system, the implementation of monetary policy will rely in part on banks buying funds in the market and leaving the cash on deposit at the Fed, whenever the funds rate drops below the target level set by the Fed. Under the FCR fee regime, the risk is that large banks will not do that until Fed funds trade 15 basis points below the rate on excess reserves. As the industry and repo market digest the implications of such a fee, expect an army of lobbyists to descend on Congress to pushback against the current version of the proposal.
Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.
The Obama administration’s proposal to subject some bank liabilities to a financial crisis responsibility (FCR) fee highlights the unintended consequences of regulating an industry that depends on an obscure but crucial funding mechanism, such as the $3.8 trillion repo market, in which top-rated securities are used as collateral for short-term loans at lowest available cost. The repo market will be unsettled by the proposed FCR fee. A fee of 15 basis points would be paid on all bank liabilities not already subject to an insurance premium paid to the Federal Deposit Insurance Corporation.
The FCR will place the repo market — which is used by banks for funding a large amount of their liabilities — in the direct line of fire. The FCR also has implications for bank funding via commercial paper and could affect trading in the overnight rate set by the Federal Reserve.
A 15 basis point tax on bank assets above $50 billion will have a devastating effect on the repo market because typical repo operations at Wall Street primary dealers do not generate a spread of 15 basis points. As a result, this tax can be expected to strongly motivate primary dealers of US securities to reduce financing provided to clients for government securities transactions.
While banks use repo to borrow low-cost cash for short periods, which helps fund their balance sheets, they also provide funding for investors wanting to buy the securities without using their only funds. The difference banks earn between the interest rate they borrow at and the one they lend at is reflected by the narrow 5 basis points bid/offer spread in repo, which would be swamped by a new 15 basis points charge. The dealer to customer market in repo will lose liquidity, particularly at times when the FCR fee is expected to be calculated — at the end of a quarter or year. If higher costs for those borrowing through the repo market should force investors to seek alternatives such as derivatives, returns for lenders, such as money market mutual funds, could become lower, from an already low level.
Such entities, which hold more than $3.2 trillion in assets, are large lenders through repo. The industry, which predominantly holds short-term, liquid investments, is already struggling because low interest rates have pushed yields on funds close to zero. Disrupting the repo market could also affect mooted plans by the Federal Reserve to eventually use large-scale reverse repos to drain excess banking reserves from the monetary system — part of its “exit strategy” to unwind extraordinary intervention policies put in place after the financial crisis.
Also, the Fed funds market, the overnight rate between banks set by the central bank, would be affected by the FCR fee. Once the Fed has reduced some of the excess reserves in the system, the implementation of monetary policy will rely in part on banks buying funds in the market and leaving the cash on deposit at the Fed, whenever the funds rate drops below the target level set by the Fed. Under the FCR fee regime, the risk is that large banks will not do that until Fed funds trade 15 basis points below the rate on excess reserves. As the industry and repo market digest the implications of such a fee, expect an army of lobbyists to descend on Congress to pushback against the current version of the proposal.
Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.
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