... this week, banks in aggregate abruptly needed cash buffers that are much bigger than they needed last week. ... But this week, the parties who had cash were not willing to earn a risk-free profit.
Wait. The market offers a risk-free profit, and no one is taking it? Where have we discussed this before? Oh, yeah. It is when gold backwardation becomes permanent!
The equivalent of gold backwardation has occurred in the repo market. ...
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We can think of two reasons why banks needed to swap Treasurys for cash. Last week, there was a greater amount of Treasury bond issuance. Unlike in a transaction between banks, when a bank pays cash to the US Treasury to buy a bond, the cash goes out of the banking system until Treasury spends it with a lag. So when net Treasury bond issuance is rising, there is a net drain of liquidity from the banking system.
Also, of course the Treasury obviously cannot accept its old paper as payment for purchase of new paper! To do that would risk shining too much light on the shabby little secret of the monetary system. The Treasury bond is payable only in Federal Reserve Notes, which are backed only by Treasury paper, which is payable only…
The second reason is macroprudential regulation. Under most bank regulation, there is no difference between holding Federal Reserve liabilities and Treasury liabilities. If a bank has reserves on deposit at the Fed, or if it has short-term Treasury bills, its capital ratios are the same.
But as part of the sweeping regulations that were enacted in the wake of the 2008 crisis, there is one area where the two are not equivalent. Banks deemed too big to fail are required to have a plan of how they could be wound down in a crisis. For purposes of this wind-down process, they need to have cash—Federal Reserve liabilities only. Treasurys will not do, because the assumption is that in a crisis there may not be an orderly market or a buyer. And the bank is required by regulation to be able to fund its needs for 30 days until it can be wound down or the Federal Kraken can slap another tentacle on whatever leaking hole is causing that particular crisis symptom.
The proximate cause of the crisis this week is that settling purchases of Treasurys drained cash. Banks assumed they could raise the cash in the repo market as they always had. But this measure of so-called resolution liquidity forces the banks who have cash not to lend it. Not even when a Treasury is offered in repo.
So the Fed jumped in, offering tens of billions of dollars in repo. We have read that there was more demand than the Fed expected—more bank stress.
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