Beneath the still waters of the economy this summer, there is a clog in the financial system’s plumbing. The situation reminds us that all fluids, whether money or water, seek their natural level.
In the case of money, the Federal Reserve has been repressing the level of interest rates to virtually the bottom of the basin for more than six years. Meanwhile, financial regulators have demanded that banks and other financial institutions maintain deep and crystal clear pools of capital to guard against a repetition of the financial system meltdown. But those very rules are reducing the lubrication in the financial system and raising the risk that the engine may ultimately break down.
Money needs to flow freely in order to be put to its best use. To get money where it is most needed, financial institutions routinely borrow from one another and post Treasury securities for collateral. Not just any Treasury security will do; certain securities that are most easily valued and traded are in the highest demand. These “borrow with collateral deals” are called repurchase agreements, or repos.
The problem is that the more-desirable Treasury securities are hard to come by between the Fed’s own bond purchases and, perhaps more pressingly, the deep reserves banks are required to keep on hand. Because regulators have pressured private lenders to sit on their holdings to a much greater extent than they otherwise might, fewer collateral-ready securities are available to borrowers. This state of affairs makes it too difficult, too expensive or both for borrowers to obtain and deliver these securities. When a borrower can’t get its hands on the required collateral, the repo is said to fail. Under the Fed’s rules, the borrower then pays a 3 percent penalty.
Repo failures are spiking. Weekly failures recently averaged as much as three times as high as last year’s levels, when failures were already creating some concern. But repo failures are still far below the levels that occurred at the height of the financial crisis in 2008, when they reached $2.7 trillion at their peak. Bank of America Merrill Lynch analysts noted that “The recent increase in fails is important, but not alarming,” observing that widespread repo failures were more common before the Fed introduced the 3 percent penalty rule. In other words, it could be worse - and it used to be.
Still, the Fed is clearly concerned and closely watching the situation as it plans to wind down its quantitative easing exercise by October and prepares for a likely rise in interest rates as early as next year. The Fed has not issued any comment on the most recent spike in failures this June, yet we can expect some sort of operational or policy adjustment if the repo failure rate continues to rise.
All of this probably sounds like a technical and arcane, if not completely academic, concern. But it has real consequences.
When financial institutions can’t get their hands on capital that they need, the result is fewer loans being made, fewer houses being built, fewer goods and services being purchased and fewer jobs being created. Even amid a dropping unemployment rate, economic growth remains well below historic levels when recovering from a deep downturn. The combination of extremely low interest rates discouraging savers and very high capital requirements encouraging bankers to hoard, rather than lend, their cash is exacting a price - even if that price is not clearly labeled.
Repos serve as a mechanism for getting money to where it can do the most good. While an individual spike of failures may not mean much, as a trend it is indicative of the larger trouble spots in the country’s economic plumbing. Until the clogs are removed, the flow of money will continue to struggle to reach equilibrium.
The sooner we can get back to a normal economic environment, where capital flows at market rates to those who can best use it, and banks are encouraged to take prudent risks and retain reasonable but not excessive reserves, the better our chances of generating the additional wealth that our society craves.
Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book,
The High Achiever’s Guide To Wealth. His contributions include Chapter 1, “Anyone Can Achieve Wealth,” and Chapter 19, “Assisting Aging Parents.” Larry was also among the authors of the firm’s previous book
Looking Ahead: Life, Family, Wealth and Business After 55.
Posted by Larry M. Elkin, CPA, CFP®
photo by Les Chatfield
Beneath the still waters of the economy this summer, there is a clog in the financial system’s plumbing. The situation reminds us that all fluids, whether money or water, seek their natural level.
In the case of money, the Federal Reserve has been repressing the level of interest rates to virtually the bottom of the basin for more than six years. Meanwhile, financial regulators have demanded that banks and other financial institutions maintain deep and crystal clear pools of capital to guard against a repetition of the financial system meltdown. But those very rules are reducing the lubrication in the financial system and raising the risk that the engine may ultimately break down.
Money needs to flow freely in order to be put to its best use. To get money where it is most needed, financial institutions routinely borrow from one another and post Treasury securities for collateral. Not just any Treasury security will do; certain securities that are most easily valued and traded are in the highest demand. These “borrow with collateral deals” are called repurchase agreements, or repos.
The problem is that the more-desirable Treasury securities are hard to come by between the Fed’s own bond purchases and, perhaps more pressingly, the deep reserves banks are required to keep on hand. Because regulators have pressured private lenders to sit on their holdings to a much greater extent than they otherwise might, fewer collateral-ready securities are available to borrowers. This state of affairs makes it too difficult, too expensive or both for borrowers to obtain and deliver these securities. When a borrower can’t get its hands on the required collateral, the repo is said to fail. Under the Fed’s rules, the borrower then pays a 3 percent penalty.
Repo failures are spiking. Weekly failures recently averaged as much as three times as high as last year’s levels, when failures were already creating some concern. But repo failures are still far below the levels that occurred at the height of the financial crisis in 2008, when they reached $2.7 trillion at their peak. Bank of America Merrill Lynch analysts noted that “The recent increase in fails is important, but not alarming,” observing that widespread repo failures were more common before the Fed introduced the 3 percent penalty rule. In other words, it could be worse - and it used to be.
Still, the Fed is clearly concerned and closely watching the situation as it plans to wind down its quantitative easing exercise by October and prepares for a likely rise in interest rates as early as next year. The Fed has not issued any comment on the most recent spike in failures this June, yet we can expect some sort of operational or policy adjustment if the repo failure rate continues to rise.
All of this probably sounds like a technical and arcane, if not completely academic, concern. But it has real consequences.
When financial institutions can’t get their hands on capital that they need, the result is fewer loans being made, fewer houses being built, fewer goods and services being purchased and fewer jobs being created. Even amid a dropping unemployment rate, economic growth remains well below historic levels when recovering from a deep downturn. The combination of extremely low interest rates discouraging savers and very high capital requirements encouraging bankers to hoard, rather than lend, their cash is exacting a price - even if that price is not clearly labeled.
Repos serve as a mechanism for getting money to where it can do the most good. While an individual spike of failures may not mean much, as a trend it is indicative of the larger trouble spots in the country’s economic plumbing. Until the clogs are removed, the flow of money will continue to struggle to reach equilibrium.
The sooner we can get back to a normal economic environment, where capital flows at market rates to those who can best use it, and banks are encouraged to take prudent risks and retain reasonable but not excessive reserves, the better our chances of generating the additional wealth that our society craves.
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