Liquidity Emergency?

Over the past few weeks, a great deal of the financial press coverage has been centered around the Federal Reserve (the US Central Bank) “injecting hundreds of billions of dollars of liquidity into the US banking system.” The Fed has not had to do this since the Great Financial Crisis of 2008-2011, and the media has taken this as a sign of returning instability to the financial system, foreshadowing another financial crisis. The prediction may turn out to be correct, but few outside of the banking system really understand the problem the Fed and the national financial system are dealing with, what the Fed is actually doing when it injects liquidity into the banking system, and what the Fed is hoping to achieve in doing so.

To understand the problems in the financial system, we first need a simple understanding of banks and the cash management issue they are dealing with daily. If we consider a bank in the simplest of terms, it does two things related to cash: 1) cash comes in via deposits and goes out via withdrawals, and 2) cash goes out via loans and comes back in via loan repayments. A bank has to continuously and carefully balance the flow of cash coming in with the flow of cash going out as a result of both of these functions occurring continuously every day. Banks have sophisticated quantitative models for dealing with this cash management problem, and for the most part they do an excellent job. Even so, a bank will sometimes find itself either a little short of cash or with a little excess cash. Excess cash isn’t a major problem (except that it isn’t earning interest) but being short on cash can be a major problem for a bank.

Now let’s take a look at the flow of cash within the global banking system. Cash never leaves or enters the banking system as a whole. When a bank lends money out to a firm, for example, the firm deposits that money into their bank. If the firm spends some of that money on purchasing raw materials for production, then the money that is spent flows as a deposit into the bank of the firm providing raw materials. When both of these firms use cash to pay employees, the cash flows into the employees’ banks as deposits. When the employees withdraw cash from their banks and spend it on products, the cash flows as deposits into the banks of the stores at which they purchased those products. And on and on. So, cash never leaves the banking system as a whole — it is simply transferred around the banking system.

Let’s put the conclusions of the last two paragraphs together. As cash flows within the banking system, imbalances can occur at individual banks in the system, leaving them with either a bit of cash surplus or a bit of cash deficit. However, because cash never enters or exits the banking system as a whole, the system as a whole is continuously cash neutral — neither in surplus nor in deficit. So, if we add up the surpluses and deficits of the individual banks across the entire banking system, we’ll end up cash neutral. This provides a simple solution for the problem the individual banks with a cash deficit are facing. The sum of the cash deficits at those banks running deficits must equal the sum of the cash surpluses at those banks running surpluses. So, why not have the banks running cash surpluses lend their total cash surplus out to the banks running cash deficits? Since the total cash surplus equals the total cash deficit, this would completely solve the deficit problem while simultaneously allowing those banks with cash surpluses to earn a bit of interest. Because the velocity of money across the global banking system is so high, the surpluses and deficits only last a very short period of time (a day or two), so the loans from surplus banks to deficit banks would only need to be ultra short-term loans.

This solution is precisely what the global banking system arrived at decades ago. The market where the banks with surplus cash lend to the banks with cash deficits is called the interbank lending market (or the overnight loan market). The interest rate at which overnight loans are made is known simply as the overnight rate, and it forms the basis for interest rates on all loans made by banks in the economy (the interest rates on all bank loans are developed as a spread against the overnight lending rate; for example, the overnight lending rate + 2%). US banks lend between $100 and $200 billion to each other every day in this market.

The difficulties that the financial press has been talking about have been taking place in this interbank lending market. Recently, overnight rates have spiked several times to high single-digit and low double-digit interest rates — typically these rates have hovered around 2% this year (see graph below).

The reason for this is that some banks running cash deficits were finding it difficult to source cash in this market. In desperate need of cash, they bid up the interest rate they were willing to pay for overnight loans. As the overnight rate is so critical to all other interest rates in the economy, these spikes in the overnight rate threatened the entire economy with higher bank loan rates.

The Federal Reserve, as the central bank of the US, is also just a bank that is part of the worldwide banking system (as are other countries’ central banks). What differentiates the Fed from other banks is that the only customers that the Fed has are other banks (and the US government).

When the Fed saw the desperation of those banks that were running cash deficits and could not get an overnight loan, they stepped in to provide the banks with overnight loans. This is the “liquidity injection” that the press was referring to. It was simply the Fed participating in the overnight lending market.

The exact mechanics of how the Fed lent cash to banks is not quite as simple as described. The more precise way includes default risk mitigation. The Fed wants to be protected against the chance of a bank defaulting on the loan. So, the Fed takes collateral from the bank against the loan. Typical collateral is US Treasuries. When the bank pays back the loan, the Fed returns the collateral. This process is known as a repurchase agreement, or a “repo.” The lending rate attached to the loan with this collateral is known as the repo rate.

So, now it’s a bit easier to understand what the Fed was doing. It was trying to stabilize the overnight lending market because there seemed to be no banks with cash surpluses willing to lend to satisfy the demand from those with cash deficits. The Fed was simply bridging this gap.

But the real question, which the press and most outside of the banking system missed, is why were banks with cash surpluses not willing to participate in the overnight loan market? It seems as if some banks are beginning to hoard cash. The question then is why are some banks hoarding cash rather than lending it out? When a bank decides not to supply cash in the overnight loan market, it must think that there’s a higher probability than before of not getting that loan back. This is what happened during the Financial Crisis when many banks were defaulting, and no bank knew which one was next. Therefore, no bank with a surplus of cash was willing to lend to another bank in the overnight market. Something similar seems to be happening again. Some banks must be perceiving a higher likelihood of bank failures, though without knowing which specific banks are the likely failures. So, these banks are refusing to lend into the overnight market entirely until they get a clearer picture of which banks might be in trouble.

And this brings us to the real question at hand. Is there a substantially higher probability of bank failures now, as those banks with cash surpluses are worried about? If that’s true, then there really is a chance of a major financial crisis hitting us, and that has huge implications for the securities markets. If not, what is suddenly causing the cash surplus banks to be reluctant to lend? No one yet knows the answer to these questions, but there is a great effort in the banking community, especially at the central banks, to figure them out. In the meantime, the Fed continues to intervene in the overnight loan market and inject liquidity to fulfill the cash needs of those banks running cash deficits.