America’s banks are missing hundreds of billions of dollars

U.S. economy

It is simple to comprehend how money is wiped out in a conventional bank run. Think of the “Mary Poppins” men in top hats screaming at the shop employees. The throngs are requesting cash, and bank workers are attempting to give it to them. But as customers leave, staff is unable to serve everyone who arrives before the establishment collapses. The remaining debts are discharged, including deposits for banks.

In the digital era, this is not what takes place. The evacuating depositors from Silicon Valley Bank (SVB) did not demand cash or coins. Their accounts needed to be wired elsewhere. When the bank failed, deposits weren’t either written off. Regulators offered to compensate SVB’s clients instead. Even though the institution’s demise was bad news for the shareholders, the total number of deposits in the banking system shouldn’t have been affected.

Deposits in US banks are really declining, which is strange. Commercial bank assets have dropped by $500 billion in the last year, or about 3%. Because banks must become smaller in order to repay their depositors, this makes the financial system more vulnerable. What happens to the money?

Money-market funds, low-risk investment instruments that hold capital in short-term government and corporate debt, are the starting point for the solution. Due to SVB’s failure, such funds, which only slightly outperform bank accounts in terms of yield, attracted inflows of $121 billion last week. They had $5.3 trillion in assets in March, up from $5.1 trillion in the previous month, according to the Investment Company Institute, an organisation for the sector.

Yet, because they are unable to accept deposits, money does not really flow into these funds. Instead, funds departing a bank for a money-market fund are credited to the fund’s bank account, where they are then utilised to buy the commercial paper or short-term debt the fund wishes to invest in. The money flows into the bank account of the organisation that sells the asset after the fund spends the money in this manner. Hence, deposits should be moved across the banking system rather than being forced out by inflows to money-market funds.

And that is what previously occurred. The Federal Reserve’s reverse-repo facility, which was launched in 2013, is one new method through which money-market funds may syphon deposits from the banking system. The method involved a seemingly harmless modification to the internal workings of the financial system that may, less than ten years later, be seriously destabilising banks.

In a typical repo transaction, a bank deposits collateral in exchange for borrowing money from rival banks or the central bank. Contrarily, a reverse repo operates. In exchange for securities, a shadow bank, such as a money-market fund, directs its custodian bank to deposit reserves with the Fed. The plan’s goal was to help the Fed leave its ultra-low rate policy by capping the cost of borrowing on the interbank market. After all, why would a bank or shadow bank ever lend to its competitors at a rate that is lower than what the Fed is willing to offer?

Nonetheless, usage of the facility has increased recently as a result of significant quantitative easing (QE) in CVID-19 and regulatory changes that left banks with a lot of capital. QE generates deposits because a bank is required to handle the transaction when the Fed purchases bonds from an investment fund. The bank account for the fund grows together with the bank’s reserve balance at the Fed. Commercial bank deposits increased by $4.5 trillion between the beginning of QE in 2020 and its end two years later, virtually equaling the expansion of the Fed’s own balance sheet.

Because the Fed relaxed a regulation known as the “Supplementary Leverage Ratio” (SLR) at the beginning of the credit crunch, the banks were able to handle the influxes for a while. This prevented the expansion of the balance sheets of commercial banks without requiring them to raise additional capital, allowing them to use the influx of deposits to enhance their holdings of Treasury bonds and cash in a secure manner. In due course, banks bought $1.5 trillion worth of Treasury and agency bonds. Then, in March 2021, the Fed allowed the slr exemption to expire. Banks discovered that they were awash in unneeded cash. They decreased their borrowing from money-market funds, which instead parked cash at the Fed, causing them to contract. Compared to a few billion a year earlier, the funds had $1.7 trillion deposited overnight in the Fed’s reverse-repo programme by 2022.

America’s smaller banks worry about deposit losses following SVB’s demise. They are now even more probable due to monetary tightening. According to research by Gara Afonso and colleagues at the Federal Reserve Bank of New York, the use of money market funds increases as rates rise because returns fluctuate more quickly than bank deposits. In fact, the rate on overnight reverse repos has increased by the Federal Reserve from 0.05% in February 2022 to 4.55%, making them significantly more attractive than the standard interest on bank deposits of 0.4%. Money-market funds that were parked at the Fed in the reverse-repo facility—and hence outside the banks—increased by $500 billion during the same time period.

a permit to create money

It is safer to leave money at the repo facility than at a bank for people without a banking licence. There is no need to be concerned about the Fed becoming bankrupt, and the yield is also greater. Money-market funds might inadvertently develop into “narrow banks”—institutions that support consumer deposits with central bank reserves as opposed to riskier but higher-yielding investments. A small bank is unable to issue mortgages or business loans. It cannot fail either.

The Fed has long been wary of these organisations because it fears they will hurt banks. 2019 saw the denial of a licence to TNB USA, a startup looking to establish a niche bank. Opening the Fed’s balance sheet to money-market funds has sparked similar concerns. William Dudley, the president of the New York Fed at the time, expressed concerns about the “disintermediation of the financial system” when the reverse-repo facility was first established. It might make the situation more unstable during a financial crisis by causing money to flow from safer assets and onto the Fed’s balance sheet.

No indication of a significant surge has yet emerged. The banking system is currently experiencing a gradual bleed. Yet, as the system is stressed, deposits are becoming more scarce, and America’s small and mid-sized banks may suffer as a result.

The Economist Newspaper Limited, year 2023. Toutes droits réservés. taken from The Economist and used with permission. You may access the original content at