The problem starts with the banking system’s commitment to convert deposits into the prevailing money of the day—that could be gold, specie or currency notes issued by the state or central bank. To fulfil this commitment, banks hold reserves of these higher forms of money. The level of these reserves is often set by bank regulators.
"The history of banking traces the innovations—some successful, some not—in reserve management.”
Behind this is what is known as “reserve management” with its own history of innovations—some successful, some not. Early innovation, from the wildcat days of US banking in the 1800s, involved each bank presenting the same lockbox of gold or money reserves to inspectors before racing it on to the next bank to be presented again. Unsurprisingly, bank failures during this time were a common occurrence.
Ultimately, having each bank manage its own gold reserve is inefficient and costly—sharing it is much better. The development of banks that could centralise this activity allowed the efficient sharing of a small stock of gold reserves. The central bank issued money convertible into gold, and would hold gold reserves to ensure that it could meet its convertibility requirement.
Most central bank assets were discounted bills of exchange, with the outstanding stock of central bank money managed by adjusting the discount rate on these bills. A high rate would discourage money creation and protect the gold reserve by limiting the amount of currency potentially convertible into gold, increasing the gold reserve ratio to a more prudent level.
This “discount window” provided the pressure relief valve for the whole system. (The idea that central bank rates could be used to affect economic policy came later.)
The commercial banks could then use this central bank money as the reserve that backed their own money creation. By allowing commercial banks to discount bills with it, a central bank provided both the stability and elastic capacity to handle the variability of trade flows and payments.
For example, a series of global crises in the early 1900s—triggered by the US banking system’s inability to manage its seasonal gold requirements—forced the creation of the US Federal Reserve.
The innovation of the overnight interbank market led to further economising of reserves as commercial banks learnt to lend excess reserves to each other, effectively allowing each “dollar” to go further. Thus the Fed funds market was born. (It doesn’t matter too much that the central banks no longer had to keep reserves of gold). This activity was encouraged by the quirk that interbank and offshore US deposits (known as ‘Eurodollars’) were exempt from official reserve requirements.
The overnight interbank market - and not the discount window - became the source of the banking system’s elasticity. To reflect this change, central banks adjusted their pressure gauge instruments to reference the interbank rate, instead of the discount rate, and gradually official reserve requirements were removed altogether.
When the global bank regulator, the Bank for International Settlements, instituted what is known as the Basel III regulatory regime which stipulated a liquidity cover ratio, reserve requirements were back in a new form.
This has shifted the pressure point of the money market. Bank funding of less than 30 days requires corresponding low-earning liquid reserves of 100 per cent meaning that funding cannot support income-earning assets. The overnight interbank market is now much less relevant.
The Fed funds market has reduced in size from $US250 billion before the global financial crisis to about $US50 billion now and trades between only a few of players always on the same side of the trade. The Federal Home Loan Banks (FHLB) have large reserve balances but cannot earn the interest that the Fed pays (IOER) for regulatory reasons. Instead they lend these funds to mostly foreign banks that arbitrage this arrangement by splitting the difference with them. For all other players, the $US2.5 trillion of existing Fed funds removes the need to borrow and lend them overnight. This has led some to suggest the Fed Funds market has lost its relevance.
Regulatory changes to money market funds, off-shore US tax rules and other developments are forcing the global money system to feel its way towards a new normal. We have seen the US Treasury bill market suffer indigestion from increased issuance – to fund Trump administration spending - and bank funding rates periodically flare up as balance-sheet restrictions imposed by Basel III prevent orderly money flows.
Could it be these regulatory changes herald an adjustment more broadly in the policy focus of central banks? Unsecured overnight cash rates are yesterday’s story; the crucial pressure gauges are US Treasury bills, bank funding rates and the basis on cross-currency swaps.
The constraints which inhibit the smooth and elastic functioning of the global banking system have moved; they are now further out the money market curve. So perhaps the pressure-release valves need to move as well.
Could it be time for the next phase of central bank evolution?
James Culham is Director, Institutional Portfolio Management at ANZ