Barr Raises the Right Questions, But Has He Already Decided on the Answers

In a speech on Sept. 26, the Federal Reserve's Vice Chair for Supervision Michael Barr spoke on the intersection of discount window policy and liquidity regulation.^[1] He observed that the Fed can promote financial stability, financial market functioning, and efficient monetary policy by encouraging banks to see reserve balances (deposits at a Federal Reserve Bank) and reverse Treasury repos as substitutes and by encouraging ready use of the Fed's standing lending facilities. A few days later, the importance of this issue was illustrated by worse-than-normal quarter-end turmoil in the repo market that drove repo rates well above Fed policy rates for several days. The spike in repo rates evoked only very limited borrowing at the Fed's lending facilities and occurred even though banks have more than $3 trillion in reserve balances that could have been redeployed into the repo market.

This note discusses why Vice Chair Barr's objectives are beneficial but raises concerns that the Fed is again making critical decisions about aspects of regulations without subjecting them to careful analysis informed by public debate. In particular, he stated that the Fed had established several principles that seem designed to deliver specific policy outcomes. The American Heritage Dictionary defines "principles" as "[a] basic truth, law, or assumption" and "[a] fixed or predetermined policy or mode of action."^[2] The issues under consideration are complex and are consequential for financial stability, monetary policy, and economic growth. The banking agencies should not present their answers as predetermined.

Background

Vice Chair Barr's speech laid out the right objectives. If banks and bank examiners see reserve balances and reverse repos as equivalent ways for satisfying liquidity requirements, then banks will be willing to shift from reserves to lending into the repo market when repo rates rise, helping to reduce rate volatility. To satisfy banks' high demand for reserve balances, which are a liability of the Fed, the Fed must hold a correspondingly large portfolio of securities. If banks and bank examiners see reserve balances and reverse repos as close substitutes, then banks will reduce their holdings of reserve balances, allowing the Federal Reserve to operate with a smaller balance sheet, making monetary policy more efficient.

If banks are willing to borrow from the Federal Reserve at the discount window or standing repo facility, the benefits will be similar. After all, a deposit at the Fed and unused capacity to borrow from the Fed are economically nearly identical. If banks see borrowing as a viable option, they will lend into money markets when money market rates rise above the Fed's lending rates. A driver of banks' high demand for reserve balances is that they wish to reduce to near zero the chance that they will have to borrow from the discount window at the end of the day. If banks are comfortable borrowing from the Fed at the end of the day, they will not feel the need to keep so much cash in their Fed accounts.

As quarter-end events in the repo market made clear, the situation today is far from this optimal state. The banking agencies are currently considering making material changes to liquidity regulations. The issues for the design of liquidity requirements that Barr discussed are both foundational and complex. Socially optimal design of the regulations will require careful analysis of costs and benefits and input from academics and banks and other financial institutions. Unfortunately, Barr recast his solutions to several of these foundational issues as "principles," which may suggest that the agencies already considered them closed for further discussion.

The principles

Barr pointed to a recent Fed FAQ on internal liquidity stress tests as one way the central bank is increasing the substitutability of reserves and reverse repos and encouraging banks to use the discount window and the standing repo facility (SRF) (see Nelson and Waxman (2024)).^[3] The FAQ states that banks can now point to the Fed's discount window or standing repo facility as the means by which they would monetize their liquid assets. Barr observed that the FAQ allows banks to shift the composition of their liquid assets away from reserve balances and toward Treasury securities or reverse repos of Treasury securities.

Barr stated that there were three principles underlying the FAQ response.

1. The Fed sees it as "acceptable and beneficial" for firms to incorporate the Fed's lending facilities to meet liquidity stress in "both planning and practice."
2. Banks must "self-insure against their own liquidity risk," meaning the banks must have sufficient "highly liquid assets to meet their potential funding needs."
3. Banks must be ready and able to use private channels to turn the assets into cash (in addition to public channels).

Unfortunately, the second and third principles undercut the first. While a key objective of the FAQ is to reduce the stigma associated with borrowing from the discount window, the second and third principles clearly discourage banks from using the discount window. Moreover, the second and third principles seem designed to generate specific policy outcomes, cutting off public debate about difficult foundational questions for the design of liquidity regulations.

Time to retire the term "self-insure"

Discussions about liquidity regulation and the discount window almost invariably include the statement that banks should "self-insure" against their liquidity risk. Who could object to banks self-insuring? Unfortunately, the term exacerbates the stigma associated with the discount window and encourages simplistic treatment of difficult issues that require thoughtful analysis and public discussion (see Nelson (2024)).

The term "self-insure" in this context usually means that a bank should have sufficient liquid assets and private funding capacity to meet its funding needs in a stress situation without borrowing from the central bank.^[4] For example, former Fed Governor and current Harvard Professor Daniel Tarullo used the term that way in a speech on liquidity regulation: "Consider first a regime in which there is no [lender of last resort] and, thus, financial intermediaries are left to self-insure against liquidity risk."^[5]

If "self-insure" defined this way is an objective for public policy, then borrowing from the central bank should be discouraged. Indeed, former Fed Governor and current Harvard Professor Jeremy Stein observed that liquidity regulations only make sense if it is socially costly for the Fed to lend to banks:

… if one is going to make an argument in favor of adding preventative liquidity regulation such as the LCR on top of capital regulation, a central premise must be that the use of LOLR capacity in a crisis scenario is socially costly, so that it is an explicit objective of policy to economize on its use in such circumstances.^[6]

Note that Stein did not demonstrate that central bank lending was socially costly; instead, he inferred that it must be costly based on his assumption that liquidity regulations are necessary.

Barr's second "principle" changes the meaning of "self-insure." Rather than meaning "the ability to meet projected funding needs under stress without borrowing from the central bank," it now means having highly liquid assets in the amount of projected funding needs even if the need is actually met in whole or in part by borrowing from the central bank. But why is that a principle, and in what way is that equivalent to self-insuring? A dollar from the discount window is still a dollar whether the collateral backing the loan is exclusively HLA or something else. Indeed, later in the speech, Barr described discount window borrowing capacity against "the full range of assets eligible for pledging" as "readily available liquidity."

Probably not coincidentally, having HLA equal to projected funding needs under stress is precisely what current liquidity regulations require. Restating the current requirement as a "principle" is just a way to endorse the status quo and equating it to "self-insuring" (even though the meaning of the term has been changed to fit the circumstance) makes the policy conclusion sound more like a principle.

But doing so stifles discussion of one of the central challenges for any policy that knits together discount window capacity and liquidity regulations. Specifically, the Fed takes nearly all bank assets as collateral at the discount window, and most of that collateral is loans, not securities. Therein lies the rub. If liquidity regulations were to simply require banks to have collateral pre-positioned at the discount window with lendable value equal to projected funding needs under stress, banks would not be required to have any HLA. While that strikes many as intuitively an incorrect outcome, good public policy needs to be built on sound analysis, not intuition, with notice and public comment, not pre-ordained conclusions. Indeed, only recognizing discount window capacity collateralized by HLA as a source of liquidity essentially requires banks to make loans to the government at the expense of loans to businesses and households. Perhaps the best answer lies somewhere in between recognizing all discount window borrowing capacity and only recognizing capacity collateralized by HLA.

Held-to-maturity securities

The third principle - that banks should be ready and able to turn HLA into cash using private channels even though it is "acceptable and beneficial" that they use the discount window to do so - is both mystifying and costly. If the Fed sees it as beneficial for banks to use the discount window to monetize their securities, why should all banks be required also to be able to monetize a "portion" of those assets in private markets? The principle may have been included in the list to drive the conclusion that there should be a cap on the amount of securities that banks classify as held-to-maturity.^[7]

Barr pointed to events in the spring of 2023 to justify putting a cap on held-to-maturity securities. He observed that some banks could not sell their HTM securities because of the capital consequences of embedded losses, and the banks had not established the capacity to repo the securities, so therefore "HTM securities that had been identified by banks as available to serve as a liquidity buffer of assets in stress could not effectively serve that function." But, as Barr had just emphasized, a bank can use the securities to get a loan at the discount window or the standing repo facility if it is prepared to do so. Why is this not the obvious solution? Because, Barr explains, principle 3 dictates that "[banks] must be able to use private markets to monetize these assets." QED.

The principle has real costs, especially for smaller regional banks subject to the ILST requirement that do not normally borrow in the repo market. Stating in the FAQ that banks must demonstrate that they can monetize a "representative portion" of their liquid assets "in private markets" significantly diminishes the FAQ's usefulness. Prior to the FAQ being published, banks were being told different things by their examiners about the ILST monetization requirement. Some banks were told that they could plan to use the discount window and standing repo facility to monetize their HLA; others that they could plan to use neither; and some that they could only plan on using the standing repo facility. A key benefit of the FAQ is that it gives banks something they can point to when talking with their examiners.

For a smaller regional bank that does not normally fund itself in the repo market, it is expensive to establish access to the market. Ideally, the FAQ would have allowed such a bank to plan on monetizing its Treasury securities and agency MBS using the discount window instead, and it would have armed the bank with a means to convince its examiner that the plan was OK. But, as written, an examiner suspicious of the discount window (sadly, probably many examiners) will still insist that the bank establish unnecessary and costly private market access.^[8]

Bank of England as a sterling example

The BoE has grappled with similar issues and has developed clear and consistent rules. The Bank of England has no formal liquidity requirements other than the LCR, but it does assess each bank's ability to monetize its HQLA.^[9] In those assessments, the banks are allowed to plan on using regular BoE lending facilities to monetize their assets.

The Bank of England also created a new repo facility (the "Short-term Repo Facility or "STR") as part of its QT plan, describing it in terms similar to those used in the Fed's recent FAQ:

The Bank intends that the STR should be used freely from the point of introduction, as a way for counterparties to access reserves as necessary. The [Prudential Regulation Authority] would judge use of the STR as routine participation in sterling money markets and intends that it should be seen as such by bank boards and overseas regulators.

In 2019, the BoE also conducted the first part of a one-time liquidity stress test that resembled ILSTs.^[10] In the test, the BoE simulated a system-wide severe liquidity stress event and examined how banks would respond, including their use of BoE credit facilities. The guidelines for the test stated: "Banks may also seek to use the Bank of England's liquidity insurance facilities to generate liquidity, drawing down pre-positioned collateral in some cases."^[11]

The ECB and the central banks of Brazil and Singapore make similar assumptions in their system-wide liquidity stress tests. In particular, they allow banks to anticipate borrowing from the central bank's ordinary lending facilities.^[12]

Conclusion

The Federal Reserve and other banking agencies are currently working on a proposal that would make substantial changes to liquidity regulations. Liquidity regulations set limits on the extent to which banks can engage in liquidity transformation by taking demandable deposits and making loans. As such, they put limits on banks' support for economic activity. As former governors Stein and Tarullo and now Vice Chair Barr have recognized, a defining element of a liquidity regulation is how it treats central bank lending, but it is a complex issue with no easy and obvious solutions. The Fed and other banking agencies need to promote a public discussion of the issue and base any new regulations on clear and sound reasoning, not seek to stifle such a debate by stating that their conclusions are principles.

Addendum: An Incorrect assertion about the SRF

After the speech, Barr was asked if the Fed might allow broker-dealers who were not primary dealers access to the standing repo facility. Barr stated that Fed lending facilities are limited by law to depository institutions. While that is true of the discount window, it is not true of the standing repo facility. The SRF is available to primary dealers in addition to certain commercial banks, and primary dealers are mostly not depository institutions. The SRF is authorized under Section 14 of the Federal Reserve Act, the authority to engage in open market operations, and that authority places no limits on counterparties.^[13] Expanding the set of counterparties to the SRF may make it a more effective backstop to the repo market and therefore a better aid to Treasury market functioning.^[14]

References

Bank of England. (2022) 'DP1/22 - The prudential liquidity framework: Supporting liquid asset usability', 31 March. Available at: https://www.bankofengland.co.uk/prudential-regulation/publication/2022/march/prudential-liquidity-framework-supporting-liquid-asset-usability

Bank of England. (2019) 'Financial Stability Report Issue No. 45', July. Available at: https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2019/july-2019.pdf?la=en&hash=976688AB50462983447A8908BE079743A3E3905F.

Barr, Michael. (2024) Supporting Market Resilience and Financial Stability. 2024 U.S. Treasury Market Conference, New York, NY. 26 September. Available at: https://www.federalreserve.gov/newsevents/speech/files/barr20240926a.pdf.

Baudino, Patricia, de Carvalho, Pablo & Svoronos, Jean-Philippe. (2014) 'Liquidity stress test for banks - range of practices and possible developments', FSI Insights on policy implementation, No 59,October.Available at: https://www.bis.org/fsi/publ/insights59.pdf

Liang, Nellie & Parkinson, Pat. (2020) 'Enhancing liquidity of the U.S. Treasury market under stress', Brookings, 16 December. Available at: https://www.brookings.edu/articles/enhancing-liquidity-of-the-u-s-treasury-market-under-stress/

Nelson, Bill & Waxman, Brett. (2024) 'A Helpful Federal Reserve Board Statement on Bank Liquidity', Bank Policy Institute, 21 August. Available at: https://bpi.com/a-helpful-federal-reserve-board-statement-on-bank-liquidity/#:~:text=The%20Federal%20Reserve%20encourages%20firms,of%20any%20major%20asset%20class.

Nelson, Bill. (2022) 'Against What Liquidity Risks should a Bank Self-insure?', Bank Policy Institute, 1 December. Available at: https://bpi.com/against-what-liquidity-risks-should-a-bank-self-insure/#:~:text=At%20the%20other%20end%20of,insure%20for%20those%20liquidity%20risks.

Stein, Jeremy. (2013) Liquidity Regulation and Central Banking. "Finding the Right Balance" 2013 Credit Markets Symposium sponsored by the Federal Reserve Bank of Richmond, Charlotte, NC, 19 April. Available at: https://www.federalreserve.gov/newsevents/speech/stein20130419a.htm.

Tarullo, Daniel. (2014) Liquidity Regulation. Clearing House 2014 Annual Conference, New York, NY, 20 November. Available at: https://www.federalreserve.gov/newsevents/speech/tarullo20141120a%20.htm.

[1] Barr (2024).

[2] https://www.ahdictionary.com/word/search.html?q=principles

[3] Banks are required to conduct monthly internal liquidity stress tests (ILSTs) for the overnight, 30-day, 90-day, and 1-year horizon under multiple stress scenarios. To pass the tests, banks must 1) have sufficient "highly liquid" assets to cover projected net funding needs under stress and 2) show that they can "monetize" the assets (convert them into cash). "Highly liquid assets" or HLA consist primarily of reserve balances, Treasury securities and agency-guaranteed mortgage-backed securities.

[4] If it is self-evident that a bank should be expected to self-insure against its liquidity risk, then shouldn't it also project its stress-funding needs under the assumption that none of its deposits are insured?

[5] Tarullo (2014).

[6] Stein (2013).

[7] Banks classify their investment account securities as either "available-for-sale" or "held-to-maturity." AFS securities are valued at fair value and for the largest banks, variations in those fair values pass through to regulatory measures of equity. HTM securities are valued at par value, and gains and losses on the securities only affect capital if the securities are sold. Despite being recorded on bank's books at par value, HTM securities are valued at fair (market) when counted toward satisfying liquidity requirements.

[8] Perhaps the FAQ is intended to mean that banks must have a plan to shift to market funding within a few days or so but can point to the discount window as a way to get immediate funding. If so, the Fed should clarify the FAQ.

[9] Liquid assets held to satisfy ILSTs are called "highly liquid assets" (HLA). Liquid assets held to satisfy the LCR are called high-quality liquid assets (HQLA).

[10] Bank of England (2022).

[11] Bank of England (2019).

[12] Baudino and colleagues (2024).

[13] Alternatively, the Fed could create a standing lending facility using Section 13(13), which authorizes the Fed to lend to anyone with essentially no restrictions as long as the loans are collateralized by Treasury or agency securities (the same collateral accepted at the SRF. Note that lending authorized under section 13(13), unlike section 13(3), is not limited to emergencies.

[14] See Liang and Parkinson (2020).

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