Here Are The Signs Of Systemic Bank Stress In Money Markets

In the wake of the biggest US bank collapse in over a decade, investors are closely monitoring key segments of the short-term dollar borrowing market.

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There is concern that additional banks might also face funding shortages after Silicon Valley Bank failed. It appears that the broader system, despite some notable moves in funding markets and a record beating for stocks of several supposedly at-risk firms like First Republic Bank and Western Alliance Bancorp, is holding steady.

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Depository institutions are able to lend overnight to one another through the federal funds market, which has seen considerable movement. In order to meet the funding needs of its members, the Federal Home Loan Bank system has curtailed activity in this area. A funding war chest has also been built by the company.

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The tightening of financial conditions has also been reflected in a number of closely watched gauges, although they are still a long way off panic levels. Traders are shifting cash to account for bank and policy risks, which has led to a creep in overnight repurchase agreement rates.

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Below are some indicators of funding market pressure and potential knock-on effects to consider.

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Backstop replacement

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The US government introduced a new backstop for banks over the weekend, which officials said was large enough to protect deposits across the country. Because it will provide funding for the par value of pledged securities, the Bank Term Funding Program offers banks the opportunity to monetize their underwater hold-to-maturity portfolios without creating losses.

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A weekly balance sheet update will reveal borrowing from the emergency bank facility, but individual borrowers will not be revealed for two years. Every Thursday, a report will be published on the Bank Term Funding Program. Watchers of the money market and bank investors will be closely monitoring the take-up in the coming weeks to see how it affects the system as a whole.

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Unlike Federal Home Loan Banks, an additional key source of funding for lenders, the facility will offer one-year term funding at 10 basis points over one-year overnight index swap rates. The demand for FHLB advances may decrease if banks move to the central bank facility. However, despite its relatively advantageous terms, it remains to be seen whether participants regard this new facility as stigmatizing.

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Discounts

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The Federal Reserve's discount window is one facility that carries a stigma. A shorter-term funding program provides dollars for up to 90 days, similar to the new backstop. Cash borrowers have historically received is less than 100% of the collateral they put up, unlike the new facility. As a form of risk management, the Fed imposes this so-called haircut. Additionally, the Fed has eased terms for its window, although the reputational impact is likely to persist.

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It was the highest level since June 2020 by the end of 2022 when Fed discount window balances reached the highest level since June 2020. Furthermore, US banks were borrowing more through other channels, indicating an accelerating deposit loss. All eyes will be on whether usage has rebounded on the back of regional bank strains since that time. Demand declined after that, but there is a chance it has rebounded since then on the back of regional bank strains.

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Facility for standing repo 

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Also, the Fed provides banks with dollars through its standing repo facility, under which approved counterparties can exchange Treasury notes overnight for cash. However, there are only 16 banks eligible to participate in this facility, none of which is a regional bank. It is not surprising that no bids were received on Monday for the Fed facility as pressures were focused on the smaller lenders.

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A previous episode of quantitative tightening resulted in rapid decreases in bank reserves. The Fed's decision to restart overnight operations after the 2008 crisis was prompted by an imbalance in repo markets in late 2019. To prevent short-term rate markets from exploding, these daily interventions evolved into the SRF in July 2021.

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As of last year, SRF, along with the discount window, was rated the second least likely to be used by Wall Street strategists.

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Bank advances on federal home loans

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Commercial banks and other members of the Federal Home Loan Bank System obtain funding from the Federal Home Loan Banks, known as advances. Mortgages or other assets are often used as collateral for these short-term loans. Since banks were flush with cash, they rarely had to resort to this channel, but with higher interest rates, they have become less reliant. There is a potential for this demand to be boosted by the latest turmoil.

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The FHLB got an extra $88.7 billion in funding on Monday, in a move highly unusual for the institution, suggesting members are already seeking funding - or soon will be. Additional term discount notes of $22,87 billion were issued on top of that, and an additional $19 billion of FRNs were issued on Tuesday. Also, the FHLBs borrow a considerable amount of funds overnight; on Monday they borrowed $67.55 billion, and on Tuesday they borrowed $50.2 billion.

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As the Fed sent interest rates spiraling higher and deposit balances came under pressure last year, the total amount of advances to members had already more than doubled. This latest episode may push them higher still than the $819 billion they reached at the end of December, which is above their highs from the 2020 pandemic.

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The Federal Funds Market

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In order to estimate FHLB advances on a more real-time basis, investors have to rely on proxies because there is no official data released quarterly or with a delay. In addition to getting overnight money through the federal funds market, banks can also obtain it via several other avenues.

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Most of the excess cash in the fed funds market is allocated to the Federal Home Loan Banks as opposed to other alternatives, such as repurchase agreements. The institution is therefore corralling cash, which could indicate that its members expect a higher dollar demand in the future.

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It was the highest trading volume in seven years in the fed funds market in January, and it was close to that level again last week as well. On Monday, volumes dropped to around $41 billion excluding quarter-end adjustments, the lowest level in at least seven years, indicating fewer dollars are available.

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Funds held by banks

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Another important indicator is the level of bank reserves. Fed quantitative tightening and interest rate increases have led to a decline in these over the past year.

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In addition to draining deposits, the Fed's reduction in its own securities holdings has led to a substantial reduction in cash in the system. Reverse repurchase agreements are becoming increasingly popular among money funds as a risk-free investment vehicle.

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As a result of recent turmoil surrounding banks, more cash could be invested in money funds, both for their yield and perceived safety, which would further exacerbate bank funding pressures. If the Fed plans to continue raising rates to combat inflation, that might force it to end its QT program earlier than intended.

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Interest rates for short-term loans

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Due to a combination of haven flows and repricing of expectations of monetary policy, the recent turmoil has resulted in large shifts in short-term interest rates. In the past week, for instance, the market pricing of central bank policy has been completely upended, with the largest one-day decline in yields since Paul Volcker was at the Fed.

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Silicon Valley Bank, for instance, could have relieved the pressures if the overall rate structure was lower, but it's how the short-term rates compare among themselves that gives information about funding strains.

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It is possible that deposits could continue to be pressured by rates that remain relatively high compared to bank rates.

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Compared with other gauges, the overnight general collateral repo rate has remained relatively steady, suggesting strains have been contained. Compared to risk-free alternatives, commercial paper rates have actually tightened, showing that investors still have dollars to invest.

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The gap between index-tied and direct floating-rate agreements - often used as a measure of banks' difficulty in obtaining funds - has grown between cross-currency basis swaps.

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Finances in a broader sense

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Added to this is the backdrop of major market turmoil that has caused financial conditions to tighten drastically. The equity prices of banks have plummeted, and the spreads on financial loans have widened. In the early months of the Covid pandemic in 2020, the Bloomberg financial conditions index showed its biggest one-day tightening.

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Repricing of Fed expectations is a major factor due to the increasing tightness in financial markets. Further policy steps may therefore be determined by whether this tightness persists - and whether financial strains continue to persist.