Elizabeth Warren fears Wall Street will use the recent mayhem in overnight lending markets to convince Washington to relax regulations aimed at preventing a repeat of the 2008 crisis.
Warren, the Democratic presidential candidate, wrote a letter on Friday to Treasury Secretary Steven Mnuchin saying she is “alarmed” by last month’s spike in overnight lending rates.
The September cash crunch in a critical corner of finance forced the New York Federal Reserve to come to the rescue for the first time in a decade.
The precise cause of the market stress is unclear. However, bankers and some analysts have said that post-crisis rules may be at fault, because they limit the ability of banks to provide cash to short-term borrowers when it’s needed.
Warren, a strong proponent of tough regulation on Wall Street, doesn’t buy that argument.
“Banks are reporting profits at record levels,” Warren wrote in a letter her office released on Tuesday, “and it would be painfully ironic if unexplained chaos in a small corner of the banking market became an excuse to further loosen rules that protect the economy from these types of risks.”
For instance, big banks must comply with the liquidity coverage ratio, or LCR, which requires them to keep a large amount of easily tradeable assets on their balance sheets. The goal is to avoid a repeat of 2008, when banks were sitting on toxic mortgage assets they couldn’t unload when they needed the cash.
Warren urged Mnuchin, who serves as chairman of the Financial Stability Oversight Council, to answer a series of questions by November 1 about the causes of the overnight market turmoil and what regulators are doing to prevent the disruption from impacting the real economy.
Emergency cash injections
The inquiry underscores the lingering mystery over the market stress more than a month after it first emerged. Although borrowing rates have tumbled back to normal levels, there are still signs of strain.
The overnight lending market plays a crucial role in modern finance. This market allows banks, hedge funds and other institutions to quickly and easily borrow money.
On September 17, the rate on overnight repurchase agreements, or repos, soared as high as 10%. That’s well above the target range of about 2% for short-term borrowing set by the Federal Reserve. The episode suggested that the plumbing in the financial system was broken.
The NY Fed stepped in with a series of emergency cash injections aimed at easing the market stress. The rescues successfully drove rates back down.
Initially, the Fed pinned the blame on two one-off factors: The withdrawal of cash by US companies to make quarterly tax payments to the Treasury Department, and the settlement of a large amount of Treasury purchases. But both factors should have been anticipated by investors, and the market pressure continued even after those events subsided.
In fact, there was such strong demand for the NY Fed’s repo operations that it suggested the central bank’s continued support is needed. Banks and other financial institutions were still clamoring for cash.
Earlier this month, the Fed announced a new program aimed at easing the liquidity squeeze. The central bank said it will purchase up to $60 billion of Treasury bills per month. The move will boost the size of the Fed’s balance sheet, reversing recent efforts to shrink it. The reversal suggests the Fed underestimated how much cash is needed to keep the system running smoothly.
The Fed stressed that unlike the aftermath of the 2008 crisis, this round of bond buying is not designed to boost sluggish economic growth. It’s squarely focused on fixing the problem in the overnight lending market.
’We’d have been happy to’
Some analysts and industry officials argued that the overnight lending problems show the unintended consequences of post-crisis rules, such as the liquidity requirements.
Almost immediately, the Bank Policy Institute, a bank lobbying organization, wrote a blog post urging regulators to rethink liquidity requirements.
Even JPMorgan Chase (JPM) CEO Jamie Dimon chimed in. During a conference call last week, Dimon said JPMorgan had the cash required to soothe the overnight lending markets – but its hands were tied by regulations.
“We could not redeploy it into the repo market, which we’d have been happy to do,” Dimon said. “And I think it’s up to the regulators to decide they want to recalibrate the kind of liquidity they expect us to keep.”
Philip Marey, senior US strategist at Rabobank, agrees that regulation is playing a role.”Due to post-crisis regulation, banks are no longer taking the risks necessary to keep the plumbing of the financial system open in times of stress,” he wrote in a note to clients on Tuesday.
Warren expressed concern that regulators “might support” efforts to dial back post-crisis regulations in response to the market turbulence.
“These rules were designed to ensure that banks have enough cash on hand to meet their obligations in the event of another market crash,” she wrote.
$99.9 billion pumped in on Tuesday alone
No matter the cause, there are still clear signs of pressure in the short-term borrowing markets.
The NY Fed pumped in $99.9 billion of cash into the financial system on Tuesday alone. That included $64.9 billion of overnight repurchase agreements as well as a $35 billion operation that doesn’t expire until November 5.
In addition to that short-term liquidity, the Fed injected $7.5 billion into the market through Treasury bill purchases. Banks tried to secure $41.5 billion of funding from the Fed, meaning the operation was five-and-a-half times oversubscribed. In other words, banks are still clamoring for cash.
And US fixed income strategists at JPMorgan are warning that the funding stress is likely to intensify towards the end of the year, when seasonal stress normally emerges.
“This is all likely to get much worse, in our view, before it gets better,” the JPMorgan analysts wrote.