Did the FDIC really kill the repo market?
Back in April 2011, Jim Bianco penned a commentary, “Why The Federal Reserve May Have A Hard Time Raising Rates.” He argued that the increase in the FDIC insurance assessment rate for large banks adds to bank funding costs, and thus offsets the impact of Fed ease. Bianco and others infer a roughly 15bp tax or “wedge” on money market assets is created by the FDIC assessment rule. By way of reference, the Fed’s target band for fed funds is 0 to 25bp but has been at low end of this range for months.
David Kotok of Cumberland Advisors subsequently wrote that the FDIC tax is offsetting the 25 bp paid to banks on Fed reserves and is effectively forcing U.S. banks out of the market. (See my paper published by Networks Financial Institute at ISU, “What is a Core Deposit and Why Does It Matter?”, which goes into the changes to the deposit insurance made by the Dodd-Frank legislation.)
Let’s agree with the central contention of the “Bianco-Kotok Hypothesis” (or BKH), namely that the new FDIC assessment is affecting the money markets. But is this change the most compelling explanation for the alarming exodus of banks from the institutional credit markets? Bianco’s research illustrates the collapse of yields in the securities repurchase (or repo) market since April, when the FDIC implemented the new deposit insurance assessment rules. He talks about the task the Fed faces to raise rates given the FDIC assessment:
“If the Federal Reserve attempts to overcome this FDIC fee by raising [interest earned on excess reserves] IOER from 025% to 0.75% or to 1.00%, will the market understand? More than likely such a move would be seen as an extreme tightening.” Indeed, but would we even be talking about the FDIC assessment if Fed funds were trading at 1%?
The new FDIC assessment regime does not raise much more money than the old rule, but the burden is now carried more proportionately by the big banks. This pound of flesh was extracted from Congress by the community bankers to win approval of Dodd-Frank. The other was a future “special assessment” by FDIC on the largest banks to push the insurance fund well above pre-crisis levels. Stay tuned on that count.
The new FDIC premium assessment regime actually reduces the maximum levy for the weakest banks from 75bp to 45bp, roughly reflecting the proportional increase in the size of the insurance assessment base to include tangible bank assets less capital. Low risk core domestic deposits of all banks, large and small, are taxed in single digits and not more than before Dodd-Frank. But the large banks now must also pay insurance premiums on debt liabilities.
Debt, repo assets and foreign deposits are all now part of the FDIC assessment base, so the broad BKH observation that FDIC is a tax on repo transactions is correct. Banks can reduce the assessment by up to 5bp based on the amount of non-deposit funding, but the assessment is a tax on all liabilities less capital. In the case of repo there is clearly an increased tax vs. nothing before the crisis, but the increase in cost for a top-rated bank is less than 15bp, probably high single digits. Or as one banker told me, the leverage ratio is the constraint — not the cost of the funding.
Does the change in the FDIC assessment premium explain the antipathy of U.S. banks for the repo market? One large bank treasurer told me that the FDIC premium increase is not so much a price issue as it forces counterparties to look very hard at risk and reward for the entire balance sheet. So my answer today is that the BKH seems a partial but not sufficient explanation of the “run from money.” Here’s the list of other factors:
First and foremost, the state of the money markets is due to the Fed’s zero interest rate policy. Large U.S. banks are literally forcing deposits out of the system as interest rates fall. In the Fed’s zero rate world, cash has no value. Steven Hanke, Professor of Applied Economics at Johns Hopkins University, argues the Fed should raise interest rates to get the economy moving. Ditto.
Second is the impact of Basel III and other regulatory efforts. The additional friction added to the money markets due to these efforts to “strengthen” the financial system is actually causing the markets to shut down. Regulators are terrorizing banks that use brokered funds or FHLB advances. The BKH thesis that large U.S. banks are disadvantaged vs. foreign institutions seems supported by a broader regulatory issue than merely higher FDIC premiums.
Third is the growing uncertainty in the markets regarding Greece, Ireland and even the U.S. debt ceiling situation. Such is the risk of democracy. With mid-August looking to be the next date for the end-of-the-world-as-we-know-it, bankers are cutting exposure and limiting risk with other banks before fleeing the markets for family vacation — perhaps for the very last time.
Fourth is pricing. Given that repo is taxed in the same bucket as core deposits and has up to 5 bp of mitigation from FDIC, we ought to question whether the effect of this change by the FDIC is all or even mostly felt on the short end of the interest rate curve. The FDIC tax on brokered deposits is far larger, totaling an additional 10bp for brokered deposits above 10% of core deposits. The average bank pays less than 10bp on total liabilities besides brokered funds.
The BKH illustrates some important issues, but is not, in my opinion, sufficient to explain the growing surplus of funding in the markets today. The point made by Bianco and Kotok about behavior in the short end of the markets highlights a more profound structural problem in the financial system, a problem ultimately created by the continued manipulation of the markets by the Fed. Let interest rates rise so that financial assets and risk once again have value and the FDIC “wedge” problem goes away.
The real problem, in my view, is that banks are increasingly shy of doing business with one another, especially across national borders, because of Fed low rate policies and credit concerns. Zero rates by the Fed means no incentive for taking risk, thus repo is moot.What Hanke calls the “zero interest rate trap,” created by the Fed, is the root of the problem, not the insurance levies by the FDIC.