Mar 14, 2022

Bill Nelson on the Fed’s Operating System, Standing Repo Facility Stigma, and the Future of the Central Bank’s Balance Sheet

In order for the Fed’s standing repo facility to be utilized frequently and effectively, regulators and other officials must help remove the stigma associated with its use.
David Beckworth Senior Research Fellow , Bill Nelson

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Bill Nelson is a chief economist and an executive vice president at the Bank Policy Institute. Bill was previously a deputy director of the Division of Monetary Affairs at the Federal Reserve Board, where his responsibilities included monetary policy analysis, discount window policy analysis, and the analysis and financial institution supervision. He also worked closely with the BIS working groups on the design of liquidity regulations. Bill is also a previous guest of the podcast, are rejoins Macro Musings to talk about the outlook for US monetary policy, the future of the Fed’s balance sheet, and its implications for the Fed’s operating system and bank regulations. David and Bill also discuss the Fed’s response to current macroeconomic events, the stigma surround the standing repo facility, and how to think about exogenous risks to the US banking system.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Bill, welcome back to the show.

Bill Nelson: Thanks Dave. It's great to be here.

Beckworth: Well, it's great to have you back on the show, Bill, and today is March 10. We're recording this show and this will come out on Monday before the next FOMC meeting. We're looking forward to that, but this is quite a moment for the Federal Reserve. Today big inflation numbers came out, 7.9% CPI. We are also right now in the midst of the Russia-Ukraine war. Oil prices are soaring and they got as high as $135 a barrel. I know they're back down now, but that portends higher inflation coming through, at least the supply side shock of higher oil prices down the road.

Beckworth: So life is getting trickier and trickier for the Fed and this talk of a safe landing seems harder and harder if not impossible at this point. So I would love to hear your take on it, just more generally, but also as a former senior Fed staffer who worked at the Board. Imagine you're going into the Eccles Building this week preparing for the meetings. What's going through the minds of Fed officials? Are they stressed? Are they on top of this? How are they approaching such a complicated situation?

How is the Fed Handling the Current Macroeconomic Environment?

Nelson: So I agree with you, David. It's an extraordinary, consequential moment for monetary policy. It's sort of like nothing we've seen for 40 years almost. And you have this combination of not just elevated inflation, but monetary policy as stimulative as it possibly could be. There's talking about removing stimulus, but rates and the balance sheet keep getting more stimulative every day. Real rates of falling. The balance sheet's still getting bigger. They're at the peak of stimulus at this moment. Usually the decision is made before the meeting takes place. There's a lot of discussion that takes place and the and views about the future will be discussed. But the actual policy action itself, and certainly the language to that action is pretty much baked in the cake by the time the meeting comes along.

It's an extraordinary, consequential moment for monetary policy. It's sort of like nothing we've seen for 40 years almost. And you have this combination of not just elevated inflation, but monetary policy as stimulative as it possibly could be.

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Nelson: So the committee will have received three different statements that they could release. There's A, B, and C, where B is sort of the preferred approach that's being presented. A and C are meant to span the range of views on the committee, but it's rare that they do anything other than B. They might change some words. If there is some genuine decision to be made, there'll be a B, B prime, B double prime, even. But what's interesting about this meeting is that because of Powell's statement last week at the two Humphrey-Hawkins testimonies that he was going to propose and support a 25-basis-point hike, that any real debate about what they will do with respect to the target for the funds rate is done. And so there had been a lot of discussion in the market about whether they were going to do 25 or 50, and they may well have wanted to shut that down.

Nelson: He also seemed to signal that decision to do 25 was probably a compromise struck across the committee because some of the participants also seemed to support a more aggressive move. And as is often done, the compromise seemed to be struck with respect to the language about the future. So he also made it very clear in his statement that every meeting was a live meeting, that 25 basis points was by no means a speed limit, that 50 was on the table if inflation didn't come back in to the way that they expected. So that appears to be the structure of the statement and the post-meeting communications that we're likely to see. But they have a lot to discuss about the balance sheet, about what to do further down the road. So it'll be a full and lively meeting despite that having taken place.

Beckworth: Now, do you think they had an inner meeting before this one that maybe justified or gave reason for Powell to make that statement about 25 basis points?

Nelson: It's definitely seems possible to me because given that there were participants who were indicating some preference potentially for going 50, or at least wanting to discuss it as a possibility, I don't think that Powell would've made this statement, which would've effectively sort of front run them if he hadn't already reached agreement across the committee in some way or another, either through a lot of bilateral conversations or conceivably at an intermeeting meeting. They had a lot to discuss. They already are making a lot of decisions about how they're going to wind down the balance sheet. It's a very long intermeeting period. Just it happens to be one of those periods… It's almost two months long. And there was a tremendous amount of market volatility, and there was the Ukraine war, so lots of reasons to have the meeting. So it seems like that's a real possible... We'll find out.

Beckworth: You wouldn't be surprised if it happened?

Nelson: No, I wouldn't.

Beckworth: There was a lot of speculation about it a few weeks ago, and then it kind of died down. But interestingly, you think it may have happened and we don't know about it now because of why? What's the rules governing the release of the news if they had this meeting?

Nelson: So I'm not completely sure. Certainly the minutes of the subsequent meeting discuss any intermeeting meetings. But I actually think that they may have to... Generally you have to announce that there was a meeting. But under emergency circumstances, I think that they can say, "Well, this was an emergency. And if we had announced the meeting, it would be very unsettling for markets." And I think that they may have to announce that there had been a meeting next Wednesday when they meet again. But again, we'll see what happens.

They have a lot to discuss about the balance sheet, about what to do further down the road. So it'll be a full and lively meeting despite that having taken place.

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Beckworth: Okay. I want to move on to the Fed's balance sheet, but before we do, one other point about this meeting, the rest of the year for the Fed, and its monetary policy. Again, this is a very difficult time. I mean, looking back, it does seem like there was too much stimulus in 2021. Maybe the Fed should have tightened sooner, but I mean, it caught me off guard. I didn't see it coming, the inflation particularly. And nominal GDP, one of my favorite metrics, is above trend too. So on many levels, it seems like the economy is hotter than it should be. And so we both agree it was important that the Fed tighten policy this year and engineer this soft landing. The Fed needs to bring demand back to a sustainable level while also maintaining long-run inflation expectations.

Beckworth: And now on top of that, we have this added inflationary pressure. Which in normal circumstances, all else equal, you would say, "See through it." It's a supply shock. "See through it." But it might put the Fed in a place where it's not forced to, but it's a very highly-charged political environment. It feels the pressure, feels the heat to do something. And I'm reminded of a paper that speaks to this. It's a paper by Ben Bernanke, Mark Gertler, and Mark Watson, *Systematic Monetary Policy and the Effects of Oil Price Shocks.* It’s a 1997 Brookings paper. And what they found is, and their analysis is that whenever oil shocks happen and you see it's in the data, at least correlation, there tends to be a recession afterwards. So a big oil shock, but what they found was it wasn't the oil shock that caused the recession. It was the Fed's response to the oil shock. And what makes it so tricky now is the Fed does need to be doing something, but how much is too much and how much is too little?

Nelson: I mean, that's why they're in such a difficult spot. I mean, I'm sure that they would love to make the decision six months from now after the… there's also, of course, the fading of COVID stimulus. There was a large fiscal stimulus that's turned into a fiscal drag as that ends, combined with the impact of an oil shock. They have very elevated inflation of which some is transitory, for sure, because it reflects these bottlenecks. And not only would inflation decline when those clear, but at least for those prices, it will be negative. So you could see quite a reduction of inflation, but that will be transitory too. And then you kind of need to know where it's going to settle out. It matters a lot if it's going to settle out at four or go back to two. How strong will the recovery continue to be? I think that's one of the reasons why I think it was so wise of them not to allow themselves to be hemmed into a 25 basis point meeting or every other meeting kind of a path is because the outlook is just so uncertain. So they're in a very tough spot. I forget what your actual question was at this point.

Beckworth: Well, just going with the fact that it's difficult to make this soft landing that they wanted to do. And there's the possibility they can make a mistake, that the Bernanke paper… they often will make mistakes. Now this is looking back at the '70s, I think, more than a recent period. But yeah, it just seems like they're in a very tight position right now, so they will have their work cut out for them.

Beckworth: Okay. Let's move on to the Fed's balance sheet and where it's headed and what it means for the operating system. And we'll provide a link to a paper that you have written recently on this that was really great. In fact, this is what motivated this interview. I read this. I said, "I got to have Bill back on the show to discuss this note he wrote." And the title is, *The Fed is Stuck on the Floor: Here's How It Can Get Up.* So I love the title. And for those who are really in the weeds in monetary policy immediately what he means when he says the Fed is stuck on the floor, the floor operating system. And it needs to get up. Get up into a corridor operating system is the rest of the story.

Beckworth: So let's talk about just some facts about the Fed's balance sheet. So I believe this week it ended its purchases. So as it stands right now, the Fed's balance sheet is 8.9 trillion up from about a little over 4 trillion before the pandemic started. Of that, Treasury holdings is a little over five and a half trillion, up from 2.4 pre-pandemic. Mortgage-backed securities, 2.7 trillion up from 1.38. So the asset side has grown dramatically. I think it's also consequential to look at the liability side, and I know we're going to talk about this later, but 3.8 trillion. It was around 4 trillion in reserves. Just under 2 trillion in overnight reverse repo balances. So these are both liabilities, close to 6 trillion. And I know we'll get into this later, but just to throw this out there, I can imagine in a world where interest rates start going up and these interest payments to banks, and money market funds, and maybe GSEs, and they start to look bad and create bad optics. There's another reason why they should be thinking long and hard about shrinking the balance sheet.

Beckworth: But we'll come back to that in a bit. But that's the contours of the Fed's balance sheet. And it's been talking about shrinking the balance sheet, and maybe the Russia-Ukraine war will put that on hold for a bit. But let's talk about the Fed’s operating system and how it's tied into the size of the Fed's balance sheet. So maybe give us a brief history of how we got to what we call the floor operating system and tell us what it is. I know our listeners have heard this before, but give us a good review of what it is and how we got here.

The Basics and Implications of a Floor Operating System

Nelson: Sure. So if you go back before the global financial crisis, for the 20 years before that, the way the Fed was operating, conducting monetary policy was that it didn't pay any interest on reserve balances. Reserve balances are deposits of banks at their reserve bank. It's a source of liquidity that they hold. They hold them to meet reserve requirements, which were positive then, and to meet payment needs. But since they didn't pay interest, they economized on those to the greatest extent possible. Every day, the Fed would adjust its balance sheet. The Fed can control the level of reserve balances perfectly. So the Fed would either increase or decrease the size of its balance sheet to increase or decrease the reserve balances to meet the demand for reserves. And by meeting that demand and setting the discount rate and announcing where rates were going to be, they were able to move money market rates to the federal funds rate in particular, which is the unsecured overnight rate that banks borrow and lend to each other. They had very good control over that.

Nelson: And they were able to control the macro economy by moving it around, basically just by providing that small amount of reserves that were demanded. Our reserve balances were $30 billion, say. And by manipulating that quantity with small open-market operations, they set the federal funds rate, or they controlled the federal funds rate. That was well-transmitted into the macro economy. What they observed when doing that, what we observed, is that if they provided extra money on any given day, that rates would quickly fall down to zero. And that was because nobody wants to hold these extra reserves because they don't earn any interest and so it was easy. The elasticity of demand around that amount that banks wanted to hold was quite high, or rather it was inelastic. The demand was very inelastic. So rates would fall rapidly.

Nelson: So in the global financial crisis, the Fed had to grow rapidly, first because of its emergency lending, and then because of its asset purchases and that oversupplied the quantity of reserve balances. At that time, it also got the authority to pay interest on reserve balances. And so it effectively changed operating systems after Lehman failed by oversupplying reserves and pushing rates down to the interest that it pays on reserves. And that's kind of a different way of thinking about it. By providing a lot of reserves, there was abundant liquidity. Nobody really needed to go out and borrow it. Those who had it, they wouldn't lend it for less than the interest that the Fed was paying, because why do so? Just leave it at the Fed. So that effectively pushed money market rates down to the floor that was established by the interest rate that they're paying.

Nelson: Now in, I think it was in January 2018, the Fed made the final decision that that's the way that they were going to conduct policy going forward, that they were going to keep oversupplying reserves and keep conducting policy using this floor system. Interestingly, what they found though, was that the quantity of reserves that they seemed to need in order to achieve that interest rates at the floor kept growing. And by the time they actually made the decision to operate with a floor system, they by that time concluded that they needed about $1.8 trillion. Well, about $1.5 trillion is probably what they thought about that time. Well, actually I stand corrected. It kept moving. At that time they probably thought it was about a trillion dollars that they needed to provide just to be at the floor.

Nelson: So not long after they made that decision in September 2019, there was a severe disruption in repo markets that happened partly because reserve balances declined rapidly because it was a tax day and that moves reserve balances around. And at that point, the Fed then concluded, "We need to keep at least about 1.65 trillion out there…” Sorry, 1.45,”…and we need a buffer over that of 300 billion or so." So they seem to be saying, "We now think we need about 1.8 trillion in order to meet that demand, that structural demand, and to have a buffer over it that's so large that we don't need to go in and manage the level of reserve balances." So, what I wrote about in the most... I've written quite a bit on the fact that…

Beckworth: Right, that's why I like having you on the show.

Nelson: I'm not a fan of this approach, because I think it's really increased the involvement of the Fed in the financial system. They went from having a very light touch and good control to now having these vast quantities of reserves. And they not only interact with banks, but they also interact with money market mutual funds because they're so big, they're providing such a quantity of reserves that they have to expand the set of counterparties that are soaking them up. My point in this paper was that that model that was used to think about the floor system and how inelastic demand was and how it drops down to the floor relatively quickly. That model was really based on what we learned about the intraday behavior of reserve balances in a world when interest rates on reserve balances were zero. And it doesn't actually work very well to describe the situation that we're currently in, but it's still how the Fed is thinking about it. They're saying, "Look, okay, the structural demand used to be $30 billion, now it's $1.8 trillion." But it's still the case that once you get beyond that level, reserves can move around a lot, and you're not going to see much movement in interest rates.

I'm not a fan of this approach, because I think it's really increased the involvement of the Fed in the financial system. They went from having a very light touch and good control to now having these vast quantities of reserves.

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Nelson: But that's not how it works. And one of the things that's been enjoyable about my new position is I've gotten to talk a lot to a lot of bankers and market participants and get a more practical perspective on how things work. When the Fed provides $2 trillion in reserve balances, I mean, markets, they don't have any choice in the matter, that money is created, prices have to adjust so that the banks voluntarily hold that money, but it's going to find a way to be held by the banking system. But they'll make use of it, and they will adjust their procedures in a manner that makes use of that $2 trillion. Once that happens, if you drop below $2 trillion, rates will go up. So there's always this upward move movement. If you supply it, you can't then take it back. There isn't this long, flat…

Beckworth: Not easily, at least.

Nelson: Not easily. A banker, a chief investment officer at one of the largest banks gave me an example that I like to use to explain how this works. You can be in compliance with all of the regulations by holding three days worth of cash for your emergency situation. But when reserve balances were cheap, meaning market rates were below the rate that the Fed was paying on reserves, they decided they would hold five days worth of cash rather than holding alternative types of liquid assets.

Nelson: But then when the Fed started to shrink its balance sheet back in 2018 and market rates moved up above the Fed's rate that it was paying, sooner than they expected, as an illustration of what I'm talking about, they thought, "Well, we'll reexamine this. It might not be cheaper. Let's hold three days of cash and then hold a couple days of money in reverse repos, because that's earning a little bit more." And they looked at it and they thought about it and they decided, "Well, but then we'd have to explain this to our examiner and they would want to know why they were doing it." And it just wasn't worth the hassle to make the change. They'd gotten into a certain habit of doing something in a certain way and there's resistance to changing that. Now it's not resistance that can't be overcome, but it is resistance that means that this idea that the floor system allows the Fed to operate monetary policy in some kind of a set it and forget it way, is just not right. And since that's the main reason why-

Beckworth: They created it in the first place.

Nelson: ... they created it, it really just calls into question the whole plan.

Beckworth: Let me go back and look closer at the pre-2008 system and compare it to what we have today, Bill. And you did a nice job summarizing it, but that system before, the stance of policy was tied to the size of the Fed's balance sheet. So if you change the reserves or the assets, you change the interest rate. But now, one of the arguments for doing this is you can set the rate and forget about it. It'll stay there and you can go tinker with the Fed's balance sheet for whatever liquidity purposes, for large scale asset purposes, so you have this extra tool. That was one of the arguments given, right? You've got better interest rate control, and it's independent from the size of the Fed's balance sheet.

I'm not a fan of this approach, because I think it's really increased the involvement of the Fed in the financial system. They went from having a very light touch and good control to now having these vast quantities of reserves.

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Beckworth: And what you're saying is, "Not so fast, that didn't turn out quite that way." And the model you were describing is a supply and demand model where the demand curve, it curves down, then it becomes flat, and the idea is you increase reserves till you're on that flat part of the demand curve. And so even if there's a demand shock, that demand curve shifts, the supply of reserves is so far out there, that it won't matter. You will still have the same interest rate. And what you're arguing is, "Well, actually we need a dynamic version of that model because that demand curve must be growing, and there's a sense of complacency that's created by holding to this view." So this gets to something we talked about, I think in the last show, there's a difference between a short-run demand for reserves and a long-run demand for reserves, and for the Fed to change what it's doing, it has to first run up against the short-run demand for reserves. Is that right?

Nelson: That's right. And just to make one more observation about the note and what we were just talking about, the Fed's current policy is, "We want to hold a buffer over and above what the banks need, their need for liquidity to meet their own purposes, to meet regulatory purposes. And we want to hold a buffer that's so far above that, that shocks to the supply of reserve balances that happen because of tax payments and other things, we won't need to respond to them because-"

Beckworth: The buffer's built in.

Nelson: "... the curve is flat, and that movement will not change interest rates." The problem with that plan, given what I was just describing is that, let's suppose the structural demand as 1.4 trillion, in theory, and they're holding a buffer of 400 billion, so they're holding 1.8 trillion. Well, what you're going to find is that that structural demand will move up to meet the supply that's created. So now, in effect, now you have to hold a buffer over that 1.8 trillion. So it's a explosive plan-

Beckworth: It keeps growing.

Nelson: It keeps growing.

Beckworth: Yeah, right.

Nelson: And what's worse is that once it gets big enough, you exceed the capacity of your counterparties to absorb all of that liquidity. So we saw this certainly play out last year when we saw the overnight RRP facility grow from nearly nothing to almost $2 trillion because of the fact that the Fed was pushing reserve balances into the banking system and they exceeded the capacity of the banking system to really absorb those reserve balances. So that market rates were moving down below where the Fed wanted them to be, and then that was picked up by the money funds. And that's sort of a... You could see that just continuing to grow.

Beckworth: Keep going. Right, so it's not just an academic argument, it's a practical concern that the Fed's going to have to deal with one way or the other. It could be political pressures come down. And I mentioned at the beginning of the show, these liabilities that the Fed holds to banks, to money market funds, to GSEs, as rates go up, I can imagine the Elizabeth Warrens of the world hammering down on the Fed, "Why are you paying these high-interest payments to the financial firms that we bailed out back in 2008?" So this balance sheet's going to get politicized really quickly if the Fed's not careful, so it behooves them to get on top of this. But just to reiterate your point, you give the banking system a buffer, but then that buffer becomes a part of the structural demand and you got to keep adding and it keeps growing. And so it's not an easy, set the system up and wash your hands and you're done with it.

Beckworth: So the other thing that you mentioned, and I want to come back to is this idea that you outgrow your counterparty's capacity to fund the Fed’s activities. And so I want to maybe flesh that out a little bit more. So there's two ways you can think about the Fed's asset purchases. So one way is the bank reserves demand will take up the new reserves created from these purchases. But the other way I think you're getting at is that the Fed's purchases have to be funded by somebody, right?

Beckworth: So it's not just a matter of what the reserve schedule the banks have, it's who's ultimately going to fund the Fed’s activities. And you're saying, "Okay, we used up all the ability of the banks to fund the Fed’s activities, now we go to money market funds. And if we continue to allow the balance sheet to grow, we'd have to go somewhere else." And so, you didn't explore this in your article, but if we take that process and keep growing, it's pretty troubling the implications, right? At some point the Fed becomes the financial market and the limit, right?

Nelson: Right, right. Well-

Beckworth: Big footprint and private sector loses all the earnings it could make because the Fed's getting it then.

Nelson: Right, a third of money market mutual fund assets now are investments, loans to the Fed in the form of reverse repos with the Fed. And of course, I don't know the figure off the top of my head, but a large percentage of bank balance sheet is now loans to the Fed in terms of deposit to the Fed. And this idea of looking at the Fed's balance sheet from how are you funding versus we're acquiring these assets and the reserves are created, both approaches are valid and both approaches can be helpful to illuminate… I usually don't talk about the funding side of it, but I think under these circumstances, it could be illuminating, right?

A large percentage of bank balance sheet is now loans to the Fed in terms of deposit to the Fed. And this idea of looking at the Fed's balance sheet from how are you funding versus we're acquiring these assets and the reserves are created, both approaches are valid and both approaches can be helpful to illuminate.

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Nelson: I mean, originally the Fed was almost entirely funded by the public in the form of currency, basically assets were roughly equal to currency. And then in the global financial crisis, they pushed way beyond that so that they were funded by banks. What really was the trigger was that during the crisis… So banks are subject to two types of capital requirements, as you know, there's risk-based requirements and there's leverage requirements. Risk-based requirements depend upon the riskiness of the assets, leverage requirements don't, they just depend upon the total amount of assets. So if you hold a lot of very low-risk assets you end up having trouble with your leverage requirements, but not your risk-based requirements. And the Fed had tried to set things up so that risk-based requirements were binding and the leverage requirements were a backstop, but reserve balances have zero weight in risk-based requirements, because they're perfectly safe, but a hundred percent weight in leverage requirements.

Nelson: So as you get more and more reserve balances being held by the banking system, you have this rotation out of risk-based requirements being binding and leverage requirement are more binding. And so basically the Fed was pushing all these reserve balances to the banking system and forcing them to hold capital for the privilege of loaning the Fed this money, right? And ultimately, that became so expensive that for banks to be willing to do that market rates fell too low from the Fed's perspective, given their range, they were even moving negative. And so they start order to move over into the money market mutual fund industry.

Nelson: But ultimately you reached a point where the money market mutual fund industry... Of course, the way they moved into the money market mutual fund industry is that the Fed has a standing facility to borrow from money market mutual funds in the form of reverse repos, and it was paying zero on those transactions. Ultimately, the money market industry can't have assets paying zero that are too much of their balance sheet because they have to earn a fee. They can’t pass on any negative rates to their customers. So they were reaching the capacity of the money fund industry to hold all of those things, and they had to raise rates. They raised rates that they paid banks and they raised rates that they paid the money fund industry. What's the next step? I don't actually know what's the…

Beckworth: Well, let me play the devil's advocate here. So there's some folks who would say, "Yes, that's exactly what happened. Let's have more of it. We want to have a super safe financial system. We want anyone to have access to the Fed's balance sheet." So you could also view this as, not only are banks now able to park funds at the Fed, but so can money market funds, maybe in the future you and I will have Fed accounts where we can park-

Nelson: Right.

Beckworth: And that's the path this was going on. And some would argue, this is good for safety. But the flip side of this is, again, you're crowding out private financial intermediation, right? And there's a lot of good that comes with that. I mean, private financial firms, banks, fintechs, they provide innovation, they provide services that we don't necessarily want to see the Fed attempt to do. And this leads us into a whole other discussion about Fed coins, digital currencies, maybe we'll hold off on that for now.

Beckworth: Let's step back then and talk about the Fed's balance sheet. There's good reasons to want to bring it down in size. I mean, again, often we talk about it from the asset side, when we think, "Oh, what's the effect of the asset purchases? Can the Fed stop doing them? Can it dial back? Will it cause disruptions?" But again, I think it's important to look at the liability side because there's a financial argument there too, but the political, I think, implications are huge on the liability side of the Fed's balance sheet for what we've talked about already. So how do we get it down? How far should it shrink, do you think? And how do we get there?

The Process of Shrinking the Fed’s Balance Sheet

Nelson: The Fed was, I think, following the right course of action, when you look back in 2018, and they started to reduce the size of their balance sheet by letting it roll off. It looks like they're going to be doing that soon in May, or June, July, probably more quickly than before. The proof is going to be in the pudding in terms of what I'm saying about structural demand. If I'm wrong and that flat part of the curve is the right way to look at it, the Fed will be able to shrink its balance sheet quite a long way before it sees any response in rates. But if I'm right, then what will happen is that as it starts to shrink much sooner than it would anticipate, you'll see rates moving up. And in that paper, there's kind of an exhibit of how the responsiveness of rates is much different when the balance sheet is shrinking than when it's increasing.

Nelson: However, they'll start reducing the size of the balance sheet, market rates will move up a bit above the interest rate that they pay on reserve balances, that will create an incentive for banks to reduce their holdings, find alternative ways to meet their liquidity needs. Bank supervisors, examiners will start getting used to the idea that not every problem will be solved by the banks holding more reserve balances. The Fed needs to encourage that process by educating examiners that they shouldn't be building in this preference for reserve balances.

Bank supervisors, examiners will start getting used to the idea that not every problem will be solved by the banks holding more reserve balances. The Fed needs to encourage that process by educating examiners that they shouldn't be building in this preference for reserve balances.

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Nelson: And then there's a number of ways that the Fed can facilitate a shift out of holding reserve balances. One of them is the Standing Repo Facility that they just put in place, so if that worked exactly as they've hoped... And as you know, and I think you've probably discussed with several of your guests, but a couple months ago the Fed created a new lending facility called the Standing Repo Facility where they lend to primary dealers and large banks against treasuries, agency debt, and agency mortgage-backed securities. If banks believe that they can go to that facility and get the liquidity that they need, then they'll be that much more comfortable switching from holding reserve balances to holding those securities, that's going to support the production in the Fed’s shrinking of its balance sheet. But once it gets to the point, which could happen relatively soon, where there's some tightness in the market and money market rates begin to move up to or above the interest rate on reserve balances, what the Fed didn't do in 2019 that it needs to do is it needs to, once again, start managing shocks to reserve balances.

Nelson: [The Fed] needs to start engaging in open market operations or taking other steps to offset those shocks because there's scarcity beginning to show up. But as long as it does that and as long as it continues to apply some gradual downward pressure, it will find that the banking system has a lot of room to move down and to hold a much lower level of reserve balances. It's really difficult and almost impossible to know how low the level of reserve balances could get because we're in such a different world now than we were before the global financial crisis. Banks hold much more liquidity than they used to and reserve balances are a good source of liquidity but it could be a lot lower than 1.8 trillion dollars. That's for sure.

Beckworth: Very fascinating, Bill. When you touched on the fact that the staff may need to forecast reserve demand, that takes them right back into pre-2008 corridor system territory. That's what they were doing and as you mentioned in the note, they did it very successfully. It wasn't an impossible task even though some claim that is very difficult to do that. And you also mentioned that the number of folks in the money affairs offices at the board and at the New York Fed… They're actually larger than they were pre-2008. So, it hasn't gotten simpler. It actually had more staff members.

Nelson: That's actually an important misconception. I think when people are describing the value of the floor system and they describe the way the Fed used to do it, it's characterized as this really difficult process where you had to get the reserves just right. And it wasn't difficult. They just got up and they called the banks each day and they provided what was needed and as you mentioned, it was averaged out. It wasn't difficult at all and it took a relatively small staff. So, it's a propaganda presented by those who support the floor system.

[The Fed] needs to start engaging in open market operations or taking other steps to offset those shocks because there's scarcity beginning to show up. But as long as it does that and as long as it continues to apply some gradual downward pressure, it will find that the banking system has a lot of room to move down and to hold a much lower level of reserve balances.

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Beckworth: And they haven't done better. The whole point was easier industry control and as you've noted, it didn't turn out that way. So, it's interesting to see you make the case. Let's go back and let's ease off. You mentioned September 2019, a repo crisis. There's a moment where we did accidentally fall back into a corridor system even with a large amount of reserves and it just required the Fed to be more actively engaged in trying to forecast reserve demand. Let's move on to the specific steps that can be taken to shrink the Fed's balance sheet. And you mentioned a key part of that journey is the standing repo facility. So, you have several other papers out. You have a paper called, *More Taxis Sitting Idle.* You also have a writeup of a symposium where you invited a number of bankers and policy makers and experts. I was fortunate enough to be able to sit in and listen to these thoughtful people.

Nelson: And participate.

Beckworth: And participate, yes. And so, I was very excited to be there. A lot of big names were there but one of the things that really struck me about your conference, Bill, was that the standing repo facility really is not off to a good start.

Nelson: Right.

Beckworth: A slow start, even I could say that much. There was a regional bank that was very cautious about it and a big bank also. Neither were excited about it. I know primary dealers are automatically signed up to be a part of it and they're going to add on banks over time but there hasn't been much participation.

I think when people are describing the value of the floor system and they describe the way the Fed used to do it, it's characterized as this really difficult process where you had to get the reserves just right. And it wasn't difficult. They just got up and they called the banks each day and they provided what was needed and as you mentioned, it was averaged out. It wasn't difficult at all and it took a relatively small staff. So, it's a propaganda presented by those who support the floor system.

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Nelson: Three banks have signed up.

Beckworth: Three banks. So, what's going on with the standing repo facility and what needs to be done to encourage more participation in normal periods so that they'll be able to use it in a crisis period?

The Stigma Surrounding the Standing Repo Facility

Nelson: Right, great question and I was a bit surprised by that too. So, the Fed of course has a lending facility. They have the discount window. The discount window serves the same purpose. The banks provide collateral and the Fed provides them funds for that collateral. The standing repo facility doesn't serve a different function, although it has. The idea behind it mostly was that it was meant to look and feel differently from the discount window. The problem with the discount window of course, is that there's a tremendous stigma associated with borrowing from it. And this has been true since the beginning of the Federal Reserve System and that's because it's always been a tool that the Fed has both used as a means to provide liquidity but also as a backup source of funding.

Nelson: And so, when you use your backup source of funding, that means something has gone wrong. There's been this very complicated love/hate relationship, both within the Fed about lending to banks. And that's resulted in this perpetual problem with the stigma, which just got much worse during the global financial crisis when the banks that did borrow, as they were meant to do, were in many cases labeled as having taken a bailout and was heavily criticized for having done so. And banks are extraordinarily unwilling to use the discount window. So, the standing repo facility uses a different authority. It uses repos rather than loans. Even though it's another collateralized loan from the Fed, the idea was it would look and feel differently. Plus, primary dealers can use it because of this different legal authority.

Nelson: And the hope was that it would be effectively a stigma free discount window and accomplish the objectives that the discount window was supposed to accomplish. It's supposed to put a cap on market rates because people can turn to it and borrow if rates get too high. It's supposed to provide people confidence that they can use it as a funding source so you don't have another September 2019 because people would be willing to lend into that repo market knowing that if they needed it, they could borrow from the standing repo facility if they needed funds. And as we talked about earlier, it's supposed to help the Fed get smaller because banks would say, "Well, I can hold treasuries," and broker dealers could say, "I can hold treasuries. I can hold agencies. I don't need to hold reserves because I can always go to the standing repo facility."

Nelson: But none of that works if people aren't willing to use the standing repo facility just like they're not willing to use the discount window. And what we were hearing in the conference was that they've launched this new thing but the take up isn't there. It appears to be very inconvenient for anybody who isn't a giant bank to use it because the operations take place on the tri-party repo platform, which is really something that only the largest banks that generally maintain access to. The bankers expressed concern that if they borrow from it that they will be told, "Yes, you should use it. We want you to use it." But then after the fact, once again, they'll be told, "Well, the fact that you had to use it suggested that you did something wrong," and they'll get beat up again for having used it.

Beckworth: By the regulators and examiners.

Nelson: By the examiners and by the public and by Congress. All of those things are...

Beckworth: So, it's important that you use it beforehand then. It's important to use it on a regular basis so it appears as a normal course of business.

Nelson: Anybody who says that they've got a solution to stigma, they haven't looked at the problem long enough because it's a very intractable problem. There are certainly some things that seem to be crucial, which is that... And this is something that bankers have told me repeatedly and they talked about it at the symposium, which was that it needs to be seen as a normal course of business. Using it needs to be seen as a normal transaction just like engaging in a Fed repo now is seen as unremarkable. There's no stigma in engaging with the Fed in a repo and an open market transaction.

Nelson: And so, the use of the standing repo facility needs to feel the same. And for that to happen, it needs to be something that happens regularly. And there's another aspect to it, which is important to me because I've spent a lot of time worrying about liquidity requirements and stigma as you know. If the Fed views this as a normal course of business thing to do, then they shouldn't have any real qualms about banks using it and particularly using it when they're under stress and when they need to use it, which is sort of the point. But at this point, the Fed has not indicated to banks that they can fold it into their liquidity plans and in their stress liquidity projections that they can say, "Yeah. My plan at that point in the process is to use the standing repo facility." And so, that's why I'm holding these agency MBS instead of reserves because I know I can do that.

Anybody who says that they've got a solution to stigma, they haven't looked at the problem long enough because it's a very intractable problem. There are certainly some things that seem to be crucial, which is that... And this is something that bankers have told me repeatedly and they talked about it at the symposium, which was that it needs to be seen as a normal course of business. Using it needs to be seen as a normal transaction just like engaging in a Fed repo now is seen as unremarkable. There's no stigma in engaging with the Fed in a repo and an open market transaction. And so, the use of the standing repo facility needs to feel the same.

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Nelson: Not making it very clear and publicly clear that use of this facility is appropriate and encouraged sends a message that, "This is something that you're going to be criticized for using." So, I think that they need to encourage frequent use, they need to communicate, they need to educate the public and Congress and investors that use of it is something that should be viewed as normal. They need to embed that into their rules about liquidity stress projections that embed use of the facility as being an appropriate thing to do.

Beckworth: Is that the job of the vice chair of supervision at the Fed to get that message out or should the Fed overall be on top of that?

Nelson: It's a job that has to be done from the top to the bottom. And it's a very difficult message because it's not clear that the Fed wants to stand up and say, "It's appropriate for banks to borrow from us because of this association between lending to banks and a bailout." But lending to banks is what the central bank does. Providing liquidity ultimately is one of the core purposes of having a central bank and if people aren't willing to borrow from it then it can't execute one of its primary functions in terms of providing liquidity into the financial system when that liquidity is in demand.

Nelson: So, I think that with the board and examinerst, there just needs to be an education and a public communication process that takes place in order to change people's views about these things. If they want the standing repo facility that they just introduced in order to accomplish this to work, they need to do that now. Beginnings are important times for how people view things. And this is really all just a matter of how you view it. And so, that's something that needs to take place. They can't wait until people see it not being used over a long period of time.

Beckworth: So, to all the Fed officials out there listening, please get on top of this already. One last question on the standing repo facility. I think I know the answer but I want to hear it from you because you actually worked on facilities like this. You are a part of the BIS working on all types of challenges surrounding this topic. But some have said, "Well, why do we need the standing repo facility," because the Fed does these temporary repos anyways such as September 2019 and March 2020. What's the advantage of having a standing repo facility over the ad hoc ones that they turn on in midst of a crisis? How would you reply to that?

There just needs to be an education and a public communication process that takes place in order to change people's views about these things. If they want the standing repo facility that they just introduced in order to accomplish this to work, they need to do that now.

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Advantages of the SRF and the Status of the Supplemental Leverage Ratio

Nelson: So, the advantage of a standing facility is that, at least in theory, if people view it as something that they're willing to use is that it can provide a lot of comfort to market participants about their liquidity situation. Ultimately, what you don't want to have happen is you don't want liquidity strains to be magnified by the actions of financial market participants. When people start to get worried about the liquidity situation, they hoard liquidity. They stop lending at term to each other. Maybe they sell assets at fire sale prices in order to raise more liquidity and that's because they're more concerned about being repaid and of course, appearing illiquid under those circumstances is tremendously costly if you lose the confidence of your counterparties.

Nelson: So, the way to short circuit that downward spiral is for the central bank to say, "Don't worry. We're here. We are a reliable source of liquidity that you can always turn to." And that only works with the standing repo facility. It needs to be there at the end of the day so that you can turn to it. It doesn't work if you have to hope that the Fed conducts an operation and then bid on that operation. That's actually one of the reasons why the term auction facility, which was introduced in the global financial crisis as a way to get rid of stigma at the discount window where they auctioned discount window loans isn't really a solution for this problem because it accomplished a number of things and it did reduce stigma for those loans. It helped replace term funding but it doesn't provide that backup and that confidence that you need to provide to get people to keep lending to each other that only a standing facility can provide.

Beckworth: So, it provides the confidence that could nip a crisis in the bud before it emerges because counterparties know there's this entity back stopping any kind of potential liquidity crisis.

Nelson: Each banker should be more confident in their own liquidity situation and armed with the knowledge that they're able to turn to that.

Beckworth: …That there's a standing facility. Two more topics, Bill, that I want to cover with you before we get to the end of the show today. The next one is the supplemental leverage ratio, SLR, and my understanding is the Fed had that out for comment. They're going to work on changing it. There's a temporary change during the crisis and it expired. We know a lot of the activity went to the overnight repo facility. Where does it stand now and what are your views on it?

Nelson: As we discussed earlier, the supplementary leverage ratio requirement is another leverage ratio requirement that was added on banks and bank holding companies as part of the post global financial crisis regulations. And the ESLR was an additional buffer that was an additional add on to that, that the largest banks have to maintain. So, they face an even larger leverage ratio requirement. And as I noted, when that was calibrated, it was done so at a time when reserve balances were expected to fall to zero. And generally, it's really largely not controversial among banking economists that when you design a capital regime, you want your leverage requirements to be a backstop. And that's because if it's binding, it actually creates an incentive on banks to get themselves more risky. If you have to hold the capital anyway, then a risk insensitive capital requirement is going to say, "Well, I might as well just increase the risk of my portfolio, since that's not going to increase the amount of capital that I have, but I can earn a higher return." So you want it to be a back stop to your risk sensitive capital requirements.

Nelson: What has happened is because of the growth of the Fed's balance sheet and all of these reserve balances that are now held by the banking system is about ... Weighted by assets, about half of the large bank assets are at institutions for which the closest binding capital requirement is a leverage ratio requirement. That's been pointed to by a number of private studies. There were some big studies commissioned to look at what happened that caused the Treasury market meltdown in March and April, 2020. Ultimately the answer's ... there was the Brookings-Booth study and the G30 study, which I only learned because a colleague of mine at the Bank Policy Institute, Pat Parkinson, was the project manager for the G30 study. That was the first time I learned that that doesn't refer to 30 countries. It's 30 individuals.

Beckworth: Oh, really? I didn't know that either.

Nelson: Anyway, it's a lot of former, very senior officials.

Beckworth: Well thank you for clarifying that for me, too.

Nelson: Both of those studies concluded that the capacity of the Treasury market to handle peak flows was completely inadequate and that's because the Treasury debt outstanding has grown tremendously over the last decade or so, it's tripled, I think, but the broker dealer capacity has remained largely unchanged. Part of that problem is that intermediating in the Treasury market means you have to hold treasuries. You have to do Treasury repos. All of these are very low risk activities that, if you're bound by a leverage ratio requirement, become unprofitable. One of the fixes for the problems in the Treasury market that has been called for by these studies, and that the Fed seems to recognize, is to recalibrate the leverage ratio requirement so that it moves back into a backstop. They've indicated when the temporary measure ended, that was put in place, they excluded reserve balances, which fixed the problem for a while during the crisis, and treasuries.

Nelson: When that ended on April 1st, 2021, you again saw this big shift. This is when we saw the big shift of reserve balances out of the banking system, but at the time the Fed indicated they recognized that this was the problem and they were going to try to fix it soon. But they haven't fixed it yet. Just for good capital… design of the capital system, for improved Treasury market functioning, this is the problem that needs to be fixed. Everyone seems to agree that it needs to be fixed. There's some disagreement over exactly how to fix it, but it seems like a problem that if everybody sort of were to, in good faith, get together, that it could be done.

For improved Treasury market functioning, this is the problem that needs to be fixed. Everyone seems to agree that it needs to be fixed. There's some disagreement over exactly how to fix it, but it seems like a problem that if everybody sort of were to, in good faith, get together, that it could be done.

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Beckworth: Well, that's good to hear. I thought there were some who were holding out to keep the original ratio in its form, but you're saying most people understand the challenges with it and are on board?

Nelson: Well, it seems that way to me. I mean, there's two ways that you can fix the problem, right? You can reduce the requirement, and there was a lot of concern when it was first put in place that it was very high, much higher than the Basel standard, what's required internationally, at least for the largest banks in the US. Indeed, Basel has proposed that the requirement be adjusted so that the increment for the largest institutions is smaller than the increment that's used in the United States. That would help quite a bit.

Beckworth: Interesting.

Nelson: That's been proposed by Basel. Another way to do it is what the Fed temporarily did, the banking agencies temporarily did, which is to exclude reserve balances. The Bank of England has done that. You just don't treat those as an asset, and that both makes it less binding, but it also prevents this really unfortunate pro-cyclicality of the requirement becomes more binding when the central bank responds to a crisis.

Beckworth: That’s the very moment you want banks to be stepping in, opening up their balance sheets, and providing liquidity to the market, but this ratio actually makes them go the other direction.

Nelson: So, that's right. And there's problems with each approach and benefits for each approach. I think one concern is that if you exclude reserve balances, then you have to decide what else do you not exclude? And then there gets into some international problems with establishing an international standard. But nevertheless, with agreement that this is a problem that should be fixed. With a lot of concern already, Treasury markets are showing signs of liquidity with the Fed stepping out, I think there's a lot of potential for volatility in markets becoming extreme, partly because the Fed has stepped out, but also, as we discussed, or at least we agree, I think, there's a lot of room for sharp upward movements and where people think rates are going. There's the war in Ukraine, so there's a lot of risk of volatility. Making treasury markets perform well is something that we all can agree on, I think.

Beckworth: Yeah. And just to recap the history of this rule. It came out in 2014, 2015, is that right?

Nelson: Yes.

Beckworth: Back when you were at the Fed.

Nelson: Yes.

I think there's a lot of potential for volatility in markets becoming extreme, partly because the Fed has stepped out, but also, as we discussed, or at least we agree, I think, there's a lot of room for sharp upward movements and where people think rates are going. There's the war in Ukraine, so there's a lot of risk of volatility. Making treasury markets perform well is something that we all can agree on, I think.

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Beckworth: And you guys were projecting maybe a hundred billion dollar balance sheet. Was that the number? Is that right?

Nelson: No. So, actually, everybody can watch the open board meeting where this was ... it's an open board meeting. You can read the transcript or you can watch the video. I was in the background there. You could see me there. If you look at the material that was provided to the FOMC just a few weeks before, you can see the staff's forecast for the Fed's balance sheet and for reserve balances that they were writing down. And what they were writing down was that reserve balances would decline basically down to, I think it was 30 billion dollars.

Beckworth: Oh, less than a hundred. Okay.

Nelson: That's for reserve balances. So basically zero. So in some sense, excluding reserve balances isn't that far from what was anticipated since they were basically expected to be zero anyway.

Beckworth: So they weren't expecting reserve balances to grow as they did over the next years following the release of this rule. So, the original motivation, the original intent, the original spirit of the rule was this was not to be a binding constraint, not to be the first rule out the gate that impairs the bank's ability to provide balance sheet capacity to the economy.

Nelson: Right. I mean, almost every governor and the chair around the table said that. They said, "We're approving this relatively high calibration of this with an anticipation of the fact that it won't be binding." First of all, because additional increases in risk based requirements are in the pipeline. And those did happen. And because we think reserve balances are going to decline, and that didn't happen. It didn't work out that way.

Beckworth: Alright, Bill. That was number one. Number two, I mentioned, in terms of my last questions I have for you, and that is there's a lesson I see from the Ukraine-Russian war. And that is how we think about risk to the banking system. I had Matt Klein on the show last week and he looked at the exposure of US banks to Russia. It's not real big, but nonetheless potential risk to the US banking system, depending on exposure. There's also indirect exposure and such. For me, it really put it in perspective, how should we think about risk to the banking system? There's lots of risks. There could be an asteroid that hits earth. There could be a war with China, a nuclear war. And one of the things that I have found puzzling, and maybe a misuse of resources and energy of the Fed, is all this focus on climate change and how it affects banks' balance sheets.

Beckworth: Climate change is a real problem. I think Congress and other agencies are better suited to deal with it. But when we focus just on one risk, when there's a plethora of risk out there that can affect bank balance sheets, again, lots of wars could emerge, lots of natural disasters. We have slow moving crises, like our demographic decline in the US. Productivity growth is trending down. There's a lot of things we could point to that could affect asset values on bank balance sheets, so why focus on just one? For me, this war has really crystallized this thought. What are your thoughts on that? Should we have a broader view? I mean, what's the proper way to think about risks to the banking system and what do you see as the lesson from this?

How to Think About Exogenous Risks to the US Banking System

Nelson: I agree with the way you set this up. There are lots of potential risks to the banking system. When you look at climate change, it's a tremendously serious problem and banks recognize that there can be financial risks associated with them, and have put a lot of resources into measuring those risks and monitoring those risks, but it isn't at all clear that climate change itself poses the kind of risks that would require banks to, say, hold additional capital to meet now. A lot of the more severe loss scenarios that one can think of are not losses that result from a change in the climate, but rather from a sharp change in government policy. It is kind of strange then to have examiners or having the banking agencies or the Federal Reserve saying, "Well, we think you're at risk because we think that the government may change its policy very quickly and rapidly in the future."

Nelson: You could see that as being a hypothesis that was presented for a number of different scenarios, and it's kind of uncomfortably close to the ... I mean we saw in the Operation Choke Point that you can say that there are risks from all kinds of things and it puts the banking agencies, I think, into difficult territory about making what's going to happen with future government policy. One thing that I did to look into this was to ask the question, what's past experience been with losses to the banking system caused by rapid change in the fortunes of an industry?

There are lots of potential risks to the banking system. When you look at climate change, it's a tremendously serious problem and banks recognize that there can be financial risks associated with them, and have put a lot of resources into measuring those risks and monitoring those risks.

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Nelson: And I looked back at the rise of the internet, the rise of Amazon, and the decline of malls and big box stores, the change in different technologies over the last 40 years, and then traced out what happened to firms that had been big, but then fell out of favor: Kodak, K-Mart, these firms that declined. What you see, not surprisingly, is that when an industry fault declines, firms get smaller. The credit needs get smaller. Ultimately they drop out, they disappear, or they get acquired. Some fail, but by the time they fail, mostly banks have gotten out of the lending relationship and other types of lenders step in, or they've taken collateral.

Nelson: I was not able to find any instance where there was material bank losses made in response to a declining industry, so it's very hard to sort of come up with a scenario where you get serious losses to banks, or a financial crisis that's the result of a change in the climate, despite the fact that it's profoundly dangerous and costly, it's just not the kind of development that seems likely to lead to severe problems in the banking system. Really, when you look at it, if you're thinking about changes to policy that can take place rapidly, if Congress turns over, and if the administration turns over, you could see a lot of changes in climate policy, but they would go in the other direction, so once you take this to its logical extreme, you're going to want banks to be protecting themselves against green firms and brown firms. That just seems to be bad territory for an independent agency to be in.

Beckworth: Right. We want to avoid the politicization of the Fed. I worry this is taking us down that path. In general, the solution, as I see it, for these risks, climate change and others, wars, trade wars, whatever it may be, is just have banks fund with more capital overall. Provide that cushion there. That's what you need. Of course, I would add in stable monetary policy, as well, to keep incomes flowing, to meet financial obligations. I think there's-

Nelson: I don't know about more capital. They fund themselves with a tremendous amount of capital now.

Beckworth: I know, I understand. I understand

Nelson: But I agree with your math, that all of these problems are reasons why you want banks to have capital to insulate them against loss.

Beckworth: Rely on capital as the cushion, not on a stress test on a specific industry. Okay. With that, our time is up. Our guest today has been Bill Nelson. Bill, thank you for coming back on the show.

Nelson: Thank you. It's been a real pleasure.

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