The Fed decision markets need to pay more attention to

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is managing partner of Federal Financial Analytics

One big market event for early 2024 will come when the US Federal Reserve makes a decision on whether to close its latest emergency liquidity facility on March 11 as a senior Fed official recently signalled it was likely to do so. 

Called the Bank Term Funding Program, the facility’s name conveys the usual blandness with which the Fed likes to brand the trillions it throws into the financial system. But the BTFP is anything but dull. Without it, all but the biggest US banks could find it even tougher to raise profitability this year; with it, they’ll find it still harder to lend into what the Fed, President Joe Biden, and pretty much everyone else hope will be a robust recovery.

The BTFP is just the latest of the many rescue facilities the Fed brought forth after recent crises, marshalling the new programme as Silicon Valley Bank and Signature bank failed and dozens of other regional banks experienced sudden deposit outflows for which many were woefully unprepared. 

Facing systemic-scale runs, the Fed, Treasury and FDIC backed uninsured deposits at the failed banks and, by inference, any to follow. This systemic-risk designation backing uninsured deposits was designed to comfort depositors, but even a bit of a run might still have been fatal for any bank with large unrealised losses in its securities portfolio. 

The BTFP thus provides funds on very generous terms to any bank that needs to liquidate its securities but doesn’t dare do so because it would be suddenly undercapitalised. To prevent this double-whammy, plentiful BTFP funding comes cheap, with a bank’s borrowing capacity based on par — not mark-to-market — valuations of pledged government securities. 

This facility poses many policy challenges, not least understanding why the Fed and other banking agencies allowed so many banks to be so fragile under such a thoroughly predictable stress scenario. 

This will be debated for months, if not years, but a critical market question needs to be answered now: what happens to banks facing significant profit squeezes if the central bank shutters the BTFP as it seems set to do? And, what then befalls the recovery?

Although it was created under the Fed’s “exigent and urgent” circumstances required for new support windows such as the BTFP, the funding programme is no longer a systemic-risk lifeline. Instead, it’s an arbitrage opportunity that gives banks the chance to sidestep the discount window, the lender-of-last-resort funding the Fed was created to provide when it was chartered in 1913. The Fed has recently pressed banks to ready themselves for discount-window use under stress regardless of whatever stigma it may still convey. But it is unlikely banks would broach this sensitive topic as long as the BTFP is open.

That’s because the BTFP charges banks less for funding — 4.89 per cent as of January 10 — compared with the discount window’s 5.5 per cent. Banks that borrow from the BTFP and place funds right back at the Fed as reserves each earn a 0.51 percentage point spread on the round trip, a welcome source of risk-free margin at a time when depositors are demanding more, lots more. It’s no wonder that, as of January 3, the BTFP’s outstanding loans stood at a record $141.2bn, but all this bank money parked at the Fed is bank money out of the US economy. 

Will the Fed continue to indulge the banks after March 11? Michael Barr, the Fed’s vice-chair for banking supervision, has indicated it is unlikely, saying this week it “really was established as an emergency programme”. An extension would also require approval from the US Treasury.

What then? The easy arbitrage profits will be cut, reducing capacity to lend. Many banks will still be sitting on unrealised losses on investment portfolios, a point of vulnerability in any renewed crisis.

The Fed didn’t want to throw regional banks a profit lifeline — as Barr suggests, it meant the BTFP only as a short-term, systemic backstop to prevent a regional bank crisis with systemic and macroeconomic consequences.

But if the Fed has to subsidise the profitability of banks, that seems both unnecessary and undesirable. As with so much of what the Fed has done in recent years, the BTFP had profound unintended consequences for market functioning. The Fed is right to want to close the window, but fingers will be slammed when it does.