The U.S. Treasury's Office of Financial Research recently released its "2023 Annual Report to Congress," which for once spends more time on banking and other risks rather than on money market funds. The press release, "OFR Finds Elevated Threats to U.S. Financial Stability Due to Inflation, Ongoing Geopolitical Risks, and Global Conflicts explains, "The OFR published its 2023 Annual Report to Congress ..., which concluded that financial stability risks to the U.S. financial landscape have increased since last year and remain elevated in 2023. The report examined these risks to financial stability between Oct. 1, 2022 – Sept. 30, 2023.... The monetary tightening policies begun in 2022 by the Federal Reserve may have created stressors for the banking, funding, and real estate markets in 2023. Many banks' fixed-income securities portfolios showed large unrealized losses due to rising rates, which contributed to the demise of some of those banks. Following the regional banking crisis in the first half of 2023, banks' balance sheets shrunk and lending to small, medium, and (to a lesser extent) large corporations declined." (Note: For those of you attending our Money Fund University Monday and Tuesday, welcome to Jersey City! Attendees and Crane Data subscribers may access the materials via our "Money Fund University 2023 Download Center.")
Discussing "Short-term Funding," the report says, "The Federal Reserve is maintaining a monetary-tightening stance to combat inflation. From March 2022 to September 2023, the central bank increased the EFFR target range by 525 basis points. The rapid pace and magnitude of the rate increases created challenges for banks and nonbank financial institutions that rely on short-term funding markets. The Federal Reserve primarily controls the policy rate in the interbank market by adjusting the supply of reserves in the banking system through changes to the IORB (the ceiling on rates) and by engaging in repurchase agreements through its ON RRP to reinforce the floor on policy rates. The system transacts its ON RRP operations at a specified rate with eligible nonbank counterparties such as MMFs and GSEs."
It explains, "As the central bank continued to hike policy rates through 2022 and early 2023, commercial bank deposit rates increased slower than comparable market rates. For instance, the cost of interest-bearing deposits was about 0.26% at the end of 2020, compared to 0.75% at the end of 2022. Consequently, the gap between deposit rates and money-like assets widened. Some depositors began to move their cash balances away from banks to higher-yielding investments. The exodus of deposits accelerated in the second half of 2022. As a result, banks increased their reliance on other borrowings and used cash balances to meet liquidity needs. Some banks had to sell securities to fund deposit outflows. After the banking stress that began in March 2023, consumers moved deposits from banks to a combination of alternative financial products such as MMFs and Treasury bills."
The Report continues, "As deposits left several banks at a record pace, federal government agencies took action to restore confidence and minimize contagion risk to other regional and smaller banks. A number of banks tapped the Federal Reserve's emergency lending facilities to improve liquidity and or make up for funding shortfalls. The FDIC also protected uninsured deposits at certain failed banks. These actions appear to have eased depositor concerns."
It states, "Deposits are the largest source of funding for banks and a source of liquidity for individuals and corporations. Historically, banks have been slow to adjust deposit rates when the Federal Reserve is hiking interest rates, and there is typically a lag of several months between the first interest rate hike and when yield-sensitive cash investors begin to shift out of bank deposits and into alternative financial products, such as Treasury securities and MMFs. The size and speed of recent interest rate hikes were unprecedented and accelerated the shift. Total bank deposits at U.S. commercial banks peaked at over $18.1 trillion in April 2022 before declining to $17.3 trillion in September 2023."
The OFR writes, "As the risk of uninsured deposit flight from regional banks further accelerated following the failure of SVB and SB, some banks sold assets or replaced their deposit funding with relatively more expensive borrowings, such as FHLB advances. The bank deposits and borrowings series in Figure 30 includes deposits plus other borrowing sources. As the level of deposits fell, other borrowings rose. FHLB borrowing -- an indirect measure of the degree to which banks and other members turn to wholesale funding to meet liquidity needs -- rose over the past year by nearly $200 billion, or 19%. Secured borrowing from the FHLBs provides a lower-cost and more stable alternative to unsecured bank borrowing, such as the issuance of commercial paper. However, FHLB advances are indirectly funded by MMFs. Potentially, this creates stress on the FHLBs because MMF shares are redeemable on demand."
They explain, "With over $6 trillion in net assets as of September 30, 2023, MMFs are important lenders in short-term markets. OFR analysis indicates that money market mutual funds benefited from the continued differential between MMF yields and general deposit rates. MMFs compete for deposits with other cash management instruments and have historically experienced growth in periods of rising market rates because of their ability to quickly pass market rate increases on to fund investors."
The report tells us, "The first MMF was launched in 1971, but MMFs did not experience their first period of rapid growth until 1974 and early 1975. That was because of Regulation Q's strict ceiling on the interest rates that insured depository institutions were permitted to pay to depositors. In the high-interest-rate environment that existed during this period, money market rates of return rose well above this ceiling -- so to benefit from these higher rates, many customers withdrew their assets from deposit accounts and placed their funds into MMFs."
It states, "Explosive growth in MMFs occurred again in the late 1970s and early 1980s when very high money market rates produced large differences between the rates of return being paid by MMFs and depository institutions. This trend has persisted over most rate-hiking cycles. However, the increasing awareness of alternative money market rates through numerous internet sources and the utilization of mobile banking and information-sharing applications can accelerate bank customer deposit withdrawals because (1) these communication platforms can quickly coordinate customer sentiment and set off chain reactions and (2) the mobile banking platforms enable withdrawals at faster speeds."
The OFR report comments, "In the first nine months of 2023, MMF assets rose about $864 billion, or 17%, to a record $6.16 trillion. This was largely because MMF yields are six to eight times more than deposit rates. A portion of the increase in MMF assets circulated back into the banking system through the purchase of FHLB discount notes and lending through the tri-party and cleared bilateral repurchase agreement markets. However, some funds left the banking system as MMFs invested cash in the Federal Reserve's ON RRP, Treasury bills, and other short-term U.S. government obligations offering higher yields."
It adds, "MMFs are key participants in the repo markets, accounting for over 47% of the lending in this funding segment. MMFs are primarily active in three different repo markets: (1) the noncentrally cleared tri-party repo market, (2) the FICC-sponsored repo market, and (3) direct dealings with the Federal Reserve via the ON RRP. While volumes at the ON RRP facility are still large, they are not very elevated relative to Q4 2022. Instead, much of the extra funds were invested in other repo markets. The tri-party market saw a roughly $200 billion increase in daily transaction volume since the beginning of the year, while activity in the FICC-sponsored repo markets increased by approximately $400 billion over the past year."
The OFR also writes, "These other repo markets withstood the recent volatility in the banking sector relatively well. Rates in the interdealer markets briefly increased after the failure of SVB but quickly reverted to their previous levels. However, MMF repo lending to primary dealers may still pose a financial stability risk as dealers pass these dollars on to riskier institutions, such as hedge funds. Because it is difficult to see what kinds of risks are building up in these low-visibility markets, it is important for regulators to use market data to see what types of institutions dealers are lending cash to so that the regulators can properly assess sources of potential short-term funding disruptions."
They state, "The counterparties receiving these inflows from MMFs are very large dealers that are subsidiaries of commercial banks. These dealers are subject to interest rate and liquidity concerns similar to those of their commercial bank affiliates. Dealers typically take cash inflows from MMFs and lend them to clients in the FICC-sponsored and NCCBR markets. Cash borrowers in the NCCBR market are usually leveraged institutions such as hedge funds. Market volatility can prompt such borrowers to deleverage, which in turn can amplify price volatility in key asset markets, such as those for Treasuries."
Finally, the report says, "In summary, the repo markets have functioned effectively YTD, avoiding the volatility seen in bank deposit funding. However, it is important to highlight that while we have not seen any financial risks take shape in these markets, there may be unseen financial stability risks building up in the economy that are not easy to anticipate and that are invisible to policymakers and regulators. The OFR will continue to use its resources to track these potential risks and communicate them to other government agencies as they arise."
