A Shift in Approach Could Help Keep Short‑Term Markets Liquid

We think there are policy tools in the Fed arsenal that wouldn’t materially alter the soundness of the banking system but could allow cash to move more freely.

Since overnight lending rates in the U.S. spiked as high as 10% during trading on 17 September, steps taken by the New York Federal Reserve and the Federal Open Market Committee (FOMC) to inject excess cash into the financial system have succeeded in calming funding markets. However, the episode is a stark reminder of an unintended consequence of post-crisis regulations.

Large banks in the U.S. now operate with greater levels of capital and liquidity, which makes the system sounder, but regulations have also reduced the efficient flow of cash through the financial system and constrained the Fed’s ability to further normalize the size of its balance sheet.

While this may not matter most of the time, these frictions can create periods of elevated funding levels and episodes of stress in liquidity markets around scheduled settlement dates for U.S. Treasury issuance and important regulatory filing dates. But more importantly, a still-large balance sheet could make FOMC members warier about expanding the balance sheet during a future downturn. Instead, members might favor policies that extend the weighted average maturity of assets held, or rely more heavily on forward guidance to control the yield curve.

Still, we think there are policy tools in the Fed arsenal that wouldn’t materially alter the soundness of the banking system but could allow cash to move more freely, potentially contributing to fewer dislocations and lower systemwide liquidity needs.

Funding market stress revealed banks’ need for liquidity

Over the past several years, the U.S. Federal Reserve has been slowly normalizing the size of its balance sheet, including reducing banks’ excess reserves, as U.S. economic fundamentals improved. Until recently, that process had occurred with relatively little disruption. However, in mid-September short-term lending rates unexpectedly ratcheted higher as banks struggled to maintain adequate liquidity in the face of large corporate tax payments and other factors, which abruptly drained $100 billion–$150 billion in cash from the banking system.

In response, the Fed injected $75 billion through its temporary overnight open market operations (OMO) and subsequently announced a program to buy U.S. Treasury bills, which will inject $60 billion per month through March of 2020. Overall, we estimate these operations will increase banks’ aggregate cash reserves by roughly $300 billion–$1.5 trillion and lift the Fed’s total balance sheet to $4 trillion.

These cash infusions have succeeded in calming short-term funding markets. However, there is no guarantee the extra liquidity will always be efficiently allocated around the banking system. As a result, we expect funding market pressures to reemerge as we approach important bank reporting dates, including year-end. 

Why aren’t reserves allocated efficiently?

Although the eight largest U.S. banks hold more than $1 trillion in excess reserves (see Figure 1), a variety of regulations and supervisory expectations limit their ability to invest them into short-term funding markets, which help efficiently allocate funds across the system.

For example, to comply with the Comprehensive Liquidity Analysis and Review (CLAR) and resolution and recovery stress-testing requirements, banks are expected to hold adequate cash liquidity to meet funding needs during stressed market conditions. Although the exact level of cash required varies by bank and is not disclosed publicly, we estimate that the largest banks needed roughly all of their reserves to comply with these regulations, constraining their ability to lend cash in funding markets during the September episode.

We expect other bank regulations to further constrain banks’ willingness to lend over year-end. The largest banks are subject to a global systemically important bank (G-SIB) capital surcharge that is based on the size and complexity of their balance sheets on the last day of the year. In recent years banks have actively reduced short-term lending over the year-end period to minimize this surcharge, and we expect this year to be no different.

A Shift in Approach Could Help Keep Short-Term Markets Liquid

Regulatory policy conflicts with monetary policy

More importantly, the recent episode reminds us that a sounder financial system has not come without some costs. Post-crisis liquidity regulations have increased banks’ need for highly liquid assets, including cash, which has constrained the Fed’s ability to fully normalize its balance sheet – and could complicate its ability to employ extraordinary measures in a future downturn.

Alternatively, the Fed could take steps to address these unintended consequences in ways that would not materially alter the soundness of banks. We believe excess reserves could be more efficiently allocated around the financial system if regulators allowed the largest banks to count U.S. Treasury bills toward their intraday liquidity requirements. Separately, the Fed could potentially launch an unlimited standing repo facility that could serve as a further source of liquidity in the event that unexpected market stress pushes funding rates significantly above the upper bound of the fed funds rate.

Taken together, these changes, which are currently under discussion, could enable the Fed to maintain lower reserves while also giving banks flexibility to provide funding during periods of market stress – a potential win for monetary and regulatory policy.

Jerome Schneider is a managing director and PIMCO’s head of short-term portfolio management, Tiffany Wilding is a PIMCO economist focusing on the U.S., and Del Anderson is a PIMCO corporate credit analyst. All are contributors to the PIMCO Blog.

The Author

Jerome M. Schneider

Head of Short-Term Portfolio Management

Tiffany Wilding

North American Economist

Del Anderson

Credit Analyst



PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the Securities Institutions Act (WplG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH- . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

Reassessing Short-Term Strategies Amid Market Recalibration: Liquidity, Libor and the Fed
XDismiss Next Article