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U.S. banks are struggling with a trillion-dollar reverse repo

The massive amounts of overnight cash stored at the Federal Reserve each day might cause banks a lot of trouble by straining their accounting records and limiting their ability to lend.

A wide range of market participants has flocked to the Fed’s reverse repurchase facility (RRP), which has helped clean up excess flexibility in the financial system. Activity at the reverse repurchase window has exceeded $2 trillion for 39 days in a row, driven by money market funds.

After raising interest rates by 75-basis points last week, the Fed is now offering a record-low reversed repo rate of 2.3 percent. By the end of the year, Barclays anticipates that daily reverse repo levels will be between $2.8 trillion & $3 trillion.

Investors are transferring deposits from banks to state money-market funds, which primarily invest in Treasuries and REOs, to avoid paying bank fees. The cash is then directed through these money funds to the Fed’s midnight window.

Government money market funds’ allocations to repo have climbed from roughly 30% at the beginning of the year to almost 40% as of today, according to Barclays.

Beginning in September, the Fed will start to reduce its financial statement by $95 billion a month, speeding up the quantitative tightening process that began in June. It is feared that the movement of bank deposits into money-market funds might quickly erode bank reserves, which could impede lending to capital markets and the larger economy.

The drop in bank reserves may also increase the repo and efficient fed funds rate, as was the case in September 2019 when excess reserves plummeted as a result of significant outflows for tax bills and the payment of Treasury auction purchases. That compelled the Fed to offer the banking system more reserves.

As per the statement of the Investment Director at wealth manager—Ruffer’s Matt Smith, whose company has $31 billion in investments under management, the drift of reserves into money market funds and away from banks constitutes a transfer of money away from financial markets.

At $3.3 trillion, capital reserves are still regarded as being plentiful for the time being, although several market participants noted that the fall has been quick. Bank reserve levels have dropped by almost 23% since December of last year when they reached a height of around $4.3 trillion. In the previous round of quantitative tightening (QT) by the Fed, $1.3 trillion in flexibility was removed over a five-year period.

Analysts noted that there are undoubtedly additional factors, such as asset reallocations and loan demand, that have attributed to the drop in bank reserves.

Reading the data from the Investment Firm Institute, the value of government money market funds as of July 27 was $4.025 trillion, up roughly 0.1 percent from the previous week. It took a while for deposits to transition to cash funds.

The Fed’s QT will result in its financial balance records rapidly declining. But when cash moves from bank’s cash deposits to authorities-only money pools, bank reserves are expected to decline considerably more quickly. By the words of the Managing Director at Barclays, Joseph Abate, money funds are predicted to pour cash into the RRP.

Analysts predicted that the U.S. Treasury will distribute more bills during the upcoming fiscal year 2023, which begins in October. This might assist reduce the excessive inputs into the reverse repurchase window.

Abate predicted that as the outflow of funds starts to strain on banks’ balance sheets, bank reserves will drop to $2.3 trillion in 2022, dangerously close to what he called banks’ “modestly adequate level” of $2 trillion.

Nonetheless, If the Fed modifies the SLR and gives banks some breathing room about regulatory expenses, it ought to encourage these banking firms to accept additional deposits and support the stabilisation of reserves. Although the Fed promised earlier this year to evaluate this leverage ratio, no proposal has yet been made public.

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