The Fed Tries Tackling a Self-Created Stigma

Most Fed watching these days seemingly surrounds the neverending and unknowable—future monetary moves. But there is another area we took note of last week—actions centering on its founding role: serving as lender of last resort in a crisis. Policymakers generated headlines by announcing the Bank Term Funding Program (BTFP), created to help regional banks after Silicon Valley Bank (SVB) and Signature Bank went bust last March, will wind down as scheduled in a few weeks. No one was terribly surprised or alarmed, which makes a lot of sense to us. Banks’ use of the facility lately illustrates there is little need for it. But there are also some interesting developments that may change the Fed’s playbook next time trouble hits. They aren’t immediately relevant to markets, but we think they are worth investors’ being aware of in advance.

Once upon a time, the Fed was a simple place where banks could get easy financing in a pinch as long as their books were solvent. Nothing available in open markets to meet liquidity requirements? No prob, just visit the Fed’s discount window, pay the required interest rate, do business as normal. It worked well. But then one day, the Fed decided banks were using it too willy nilly, so it started asking more questions and encouraging banks not to come unless they really, really needed it. Soon a stigma was born, making banks scared to tap the discount window, lest other banks and investors think they had a big bad problem—potentially guaranteeing funding would freeze, turning a liquidity pinch into bankruptcy. It got so bad that banks wouldn’t even use the discount window during a crisis, leading the Fed to create special new lending programs whenever trouble struck—an alphabet soup of liquidity acronyms. Because life is funny, banks had no problem using these emergency programs. They didn’t think it might be a bad look to use them. Everyone else was doing it, so it was ok! But now it seems the Fed and regulators are tired of this, tired of having to create bespoke lending facilities—sometimes multiple programs at once—every time something ripples through financial markets. And banks’ creative use of the BTFP seems to be what made the lightbulb go off.

Through the BTFP, regional banks could use US Treasury bonds as collateral to get Fed financing at whatever rate the open market was charging for overnight financing. At the time, SVB had just imploded because uninsured depositors were freaked out about its abundance of Treasurys and the unrealized losses on those securities. Customers worried the bank would be unable to redeem deposits, and a run ensued. Worried about contagion, the Fed concocted what it hoped would be an elegant solution: allowing other regional banks to convert Treasurys to cash without selling them, in the form of one-year loans, giving depositors no reason to flee. We think it is a stretch to credit this with ending the crisis, as the data showed banks outside the West Coast and New York area had little need of it, but it seemed to shore up confidence, and markets moved on.

But in recent weeks, BTFP use spiked. Not because banks suddenly needed emergency funding, though. It was because the interest rate on these loans dropped below the rate the Fed pays on reserve balances. So regional banks could borrow from the BTFP at 4.88% and deposit the proceeds at the Fed as reserves, where they earn a cool 5.4%.^[i] The Economist called it a “free money machine,” which seems apt.^[ii] Now, the profits off this pale in comparison to the fees banks had to pay to replenish the FDIC’s coffers, so it isn’t as though banks are getting off scot-free here. But still, the headlines created an uproar. Last week, there was enough backlash that the Fed finally cracked down, matching BTFP’s rate to the interest rate on reserves, killing the arbitrage math and confirming the facility will close in March as planned.

And in what we suspect is a related move, the Fed stepped up talk of its plans to remove the discount window’s stigma so that banks start using it again, potentially negating the need for more alphabet soup. One proposal in the works would force banks to use the discount window at least once a year for normal liquidity needs. Some lawmakers are jawboning about legislation to curb banks’ more creative lifelines, including Federal Home Loan Banks.

At a philosophical level, we get it, and BTFP arbitrage shows how weird things became. Banks won’t use the discount window even when they need it because it has such reputational—and therefore financial—risk. But they are happy as clams to use “emergency” programs when there is no emergency and they can make free money from it, rendering the “emergency” label a joke. If we lived in Logiclandia, a program like BTFP would have 10 times the stigma a century-plus old, traditional borrowing facility carries. But we live in Realityland, where things get wacky and the Fed ends up essentially paying banks to use its emergency facility when there is no emergency.

But, and there is always a but, we are skeptical that the currently proposed solutions will work as intended. Consider: If banks are required to use the discount window once a year, then wouldn’t a second visit raise the same questions as an initial visit does now? In a Bloomberg interview, acting currency comptroller Michael Hsu implied the proposed rule is more about ensuring banks have the infrastructure to use the discount window, which was an issue with some regional banks last March.^[iii] That makes sense to us, but again, stigma unaddressed.

Overall, we think this is a beneficial aim. The alphabet soup approach has some side effects. One, it adds complexity. Two, it teaches people to presume banking tremors will become monstrous quakes until and unless the Fed makes a bespoke lending program for whatever is happening. Three, when the Fed does create said program, it risks creating the perception that the Fed indeed sees massive problems worth panicking over, which can worsen the stock market’s reaction. Letting the discount window do the heavy lifting would solve a lot of this, and it would let the Fed resume using one of the oldest items in its toolkit: dropping the discount rate below the fed-funds rate so that healthy banks can boost liquidity by borrowing from the Fed and lending to their peers at a slightly higher rate. That worked quite well in the early to mid 20^th century, and we suspect it would be equally helpful in the future, if needed.

So we see some potential positives emerging here in the long run. We also see the potential for some unintended consequences if the rules aren’t written optimally. Therefore, we will watch this one with interest and keep you updated on how things shake out—and what you might expect in a crisis as a result.