# Analysis: U.S. banks face trillion-dollar reverse repo headache
Author:  Pal Sinha, Barnali 
Author URL: https://financedigest.com/author/pal-sinha-barnali
Published: 2022-08-02
Category: NEWS
Category URL: https://financedigest.com/category/news
Meta Title: Fed Balance Sheet Concerns: Bank Reserves Squeezed by
Meta Description: The trillions parked at the Fed are impacting banks' lending ability - Find out how the reverse repo facility is affecting the financial system!
URL: https://financedigest.com/analysis-u-s-banks-face-trillion-dollar-reverse-repo-headachehtml

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By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – The trillions of dollars in overnight cash tucked away daily at the Federal Reserve could turn into a major headache for banks that could squeeze their balance sheets and impair their ability to lend.

The Fed’s reverse repurchase facility (RRP) has attracted a wide array of market participants, helping mop up excess liquidity in the financial system. Led by [money market funds](https://www.financedigest.com/explainer-why-european-money-market-funds-inflows-are-lagging-behind-the-u-s-torrent.html "Explainer-Why European money market funds inflows are lagging behind the U.S. torrent?"), volume at the reverse repo window has topped $2 trillion for 39 straight days.

The Fed is paying a record reverse repo [rate of 2.3% following its 75-basis-point interest rate hike](https://www.financedigest.com/dollar-firms-after-u-s-labor-data-suggests-more-rate-hikes.html "Dollar firms after U.S. labor data suggests more rate hikes") last week. Barclays [expects daily reverse repo levels to hit](https://www.financedigest.com/uks-dominos-expects-tech-investments-to-hit-2023-profit.html "UK’s Domino’s expects tech investments to hit 2023 profit") between $2.8 trillion and $3.0 trillion by the end of the year.

Investors are effectively taking deposits away from [banks and putting them into government money](https://www.financedigest.com/marketmind-banks-are-leaking-money.html "Marketmind: Banks are leaking money") market funds, which invest mainly in Treasuries and repos. These money funds, in turn, funnel the cash to the Fed’s overnight window.

Repo allocations from government money market funds have increased to [nearly 40%](https://www.financedigest.com/demand-for-5-gal-safety-portable-fuel-containers-is-projected-to-record-a-cagr-of-nearly-4-0-through-2028.html "Demand for 5 Gal. Safety Portable Fuel Containers Is Projected to Record a CAGR of Nearly 4.0% through 2028") of their assets currently, from around 30% at the start of the year, Barclays said.

The Fed will [shrink its balance sheet by $95 billion per month](https://www.financedigest.com/russian-services-activity-shrinks-for-third-month-running-in-dec-pmi.html "Russian services activity shrinks for third month running in Dec -PMI") from September, accelerating “quantitative tightening,” which started in June. The concern is that the outflow of deposits from banks into money market funds could reduce [bank reserves at a rapid pace that could hinder lending activities to financial markets and the broader economy](https://www.financedigest.com/bank-of-canada-seen-on-hold-even-as-economy-accelerates.html "Bank of Canada seen on hold even as economy accelerates").

GRAPHIC: [Fed Balance Sheet and Bank](https://www.financedigest.com/asian-shares-gain-as-fears-about-rapid-fed-hikes-bank-crisis-fade.html "Asian shares gain as fears about rapid Fed hikes, bank crisis fade") Reserves (https://fingfx.thomsonreuters.com/gfx/mkt/byprjwzxbpe/Fed%20balance%20and%20bank%20reserves.PNG)

![](https://www.globalbankingandfinance.com/wp-content/uploads/2022/08/378-666x500.jpg)

The decline in [bank reserves could also lead to a spike in the repo and effective fed funds rate similar to what happened in September 2019 when bank reserves dwindled due to heavy withdrawals for tax payments](https://www.financedigest.com/5-ways-banks-can-compete-in-payments.html "5 ways banks can compete in payments") and settlement of Treasury purchases at auctions. That forced the [Fed to provide additional reserves to the banking](https://www.financedigest.com/analysis-china-central-bank-under-pressure-to-ease-is-hemmed-in-by-inflation-fed-jitters.html "Analysis-China central bank, under pressure to ease, is hemmed-in by inflation, Fed jitters") system.

The drift of [reserves into money](https://www.financedigest.com/u-s-money-reserve-reviews-real-talk-about-diversifying-with-precious-metals.html "U.S. Money Reserve Reviews: Real Talk About Diversifying With Precious Metals") market funds and away from banks constitute movement of money away from financial markets,” said Matt Smith, investment director at asset manager Ruffer in London, which has $31 billion in assets under management.

For now, [bank reserves are still considered](https://www.financedigest.com/5-things-to-consider-when-choosing-a-challenger-bank.html "5 Things to Consider When Choosing a Challenger Bank") abundant at $3.3 trillion, but the decline has been rapid, some market participants said. From a peak of [nearly $4.3 trillion in December last year](https://www.financedigest.com/nearly-60-of-people-are-worried-about-their-data-being-used-by-mobile-apps-but-continue-to-download-as-many-as-100-apps-over-the-course-of-a-year.html "Nearly 60% of people are worried about their data being used by mobile apps, but continue to download as many as 100 apps over the course of a year"), bank reserves have declined about 23%. In the Fed’s previous quantitative tightening (QT), $1.3 trillion in [liquidity was withdrawn in five years](https://www.financedigest.com/the-liquid-chromatographymass-spectroscopy-market-is-estimated-to-witness-stupendous-growth-in-the-years-to-come.html "The Liquid Chromatographymass Spectroscopy Market is estimated to witness stupendous growth in the years to come").

To be sure, there are other factors that have contributed to the decline in bank reserves, such as asset re-allocations and loan demand, analysts said.

MONEY [MARKET FUND ASSETS](https://www.financedigest.com/asset-management-it-solution-market-asset-management-grow-crucial-for-various-organizations-to-evaluate-entire-business.html "Asset Management IT Solution Market – Asset Management Grow Crucial for Various Organizations to Evaluate Entire Business")

Government money market [fund assets have been fairly steady as of July](https://www.financedigest.com/in-renewed-push-spain-to-tender-eu-funds-for-evs-batteries-in-july.html "In renewed push, Spain to tender EU funds for EVs, batteries in July") 27, at $4.025 trillion, up about 0.1% from a week earlier, data from the Investment Company Institute showed. The shift of deposits to money [funds has been a slow](https://www.financedigest.com/british-ev-startup-arrival-gets-300-million-funding-aims-to-slow-cash-burn.html "British EV startup Arrival gets 0 million funding, aims to slow cash-burn") process.

The Fed’s QT will shrink its [balance sheet](https://www.financedigest.com/ecb-policymakers-back-jumbo-rate-hike-differ-on-balance-sheet-cut.html "ECB policymakers back jumbo rate hike, differ on balance sheet cut") quickly. But bank reserves are [set](https://www.financedigest.com/bank-of-england-set-to-hike-to-4-as-rate-peak-looms.html "Bank of England set to hike to 4% as rate peak looms") to fall much faster as cash shifts out of bank deposits to government-only money funds. We expect money funds to put this cash in the RRP,” wrote Joseph Abate, [managing director](https://www.financedigest.com/anya-libova-joins-apester-as-uk-managing-director.html "Anya Libova joins Apester as UK Managing Director") at Barclays, in a research note.

Expectations that the U.S. Treasury will [increase bill issuance for fiscal year](https://www.financedigest.com/food-fiber-market-to-exhibit-increased-demand-in-the-coming-years.html "Food Fiber Market to Exhibit Increased Demand in the Coming Years") 2023, which starts in October, could help ease the surfeit of inflows into the reverse repo window, analysts said.

Abate estimated that bank reserves will [fall to $2.3 trillion this year](https://www.financedigest.com/spains-november-retail-sales-fall-0-6-on-year.html "Spain’s November retail sales fall 0.6% on year"), perilously near what he termed banks’ “minimally ample level” of $2 trillion, as the exit of deposits starts to weigh on their balance sheets.

Yet for many [big banks](https://www.financedigest.com/big-banks-can-be-challengers-too.html "Big banks can be challengers too"), those deposits are unwanted anyway.

As the Fed’s balance sheet increased with quantitative easing during the pandemic, so did bank reserves deposited at the [central](https://www.financedigest.com/stock-pickers-reckon-its-time-to-move-on-from-central-banks.html "Stock pickers reckon it’s time to move on from central banks") bank. Once reserves reached a level at which [banks were not willing to absorb the regulatory](https://www.financedigest.com/how-banks-can-avoid-regulatory-reporting-mistakes-with-a-good-dose-of-automation.html "HOW BANKS CAN AVOID REGULATORY REPORTING MISTAKES WITH A GOOD DOSE OF AUTOMATION") costs on their balance sheets, they started turning deposits away.

The Fed in April 2020 temporarily excluded Treasuries and [central bank](https://www.financedigest.com/dollar-skulks-at-eight-month-low-central-bank-meetings-in-focus.html "Dollar skulks at eight-month low, central bank meetings in focus") deposits from the supplementary leverage ratio (SLR), a capital adequacy measure, as an excess of bank deposits and Treasury bonds raised bank capital requirements on what are viewed as safe assets.

But the Fed let that SLR exclusion expire and [big banks](https://www.financedigest.com/big-ecb-hike-adds-fuel-to-the-banking-sector-fire.html "Big ECB hike adds fuel to the banking sector fire") had to resume holding an extra layer of loss-absorbing capital against Treasuries and central bank deposits.

[“Banks are still not keen to increase deposits](https://www.financedigest.com/european-central-bank-to-raise-deposit-rate-to-3-25-by-mid-year-reuters-poll.html "European Central Bank to raise deposit rate to 3.25% by mid-year: Reuters poll") due to regulatory costs in the absence of SLR relief and want to free up their balance sheet,” said Imran Siddiqui, portfolio manager at Mosaic Capital. In a subtle way, they are sending a message to the Fed to [provide some form of permanent SLR relief.”](https://www.financedigest.com/recovery-bus-provides-cool-relief-for-s-koreas-covid-19-testers.html "‘Recovery bus’ provides cool relief for S.Korea’s COVID-19 testers")

Should the [Fed tweak the SLR and give banks breathing](https://www.financedigest.com/dollar-pauses-for-breath-as-fed-swings-into-focus.html "Dollar pauses for breath as Fed swings into focus") room on regulatory costs, that should push these financial institutions to accept more deposits and help stabilize reserves. The Fed earlier this year said it would review this leverage ratio, but has yet to publish a proposal.

(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Leslie Adler)


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