Fed's Balance-Sheet Unwind Could Expose Global Funding Strains

  • Liabilities include $2.2 trillion of reserves held by banks
  • Uncertainty as to how banks choose to replace cash at the Fed

Fed's Yellen Plays It Safe in Cleveland

While market participants were watching the myriad of Federal Reserve speakers this week to gauge the likelihood of a rate hike in December, the more interesting discussion was taking place in Europe on the risks surrounding the unwind of the central bank’s $4.5 trillion balance sheet.

In a panel titled “Exit From Non-Standard Monetary Policy,” held at the Second ECB Annual Research Conference on Sept. 25, former Fed Governor Jeremy Stein focused on the uncertainty on the liability side of the balance sheet. The implementation of post-financial crisis capital rules designed to keep the financial system safe, particularly the liquidity coverage ratio, have incentivized commercial banks to park more excess reserves at the Fed (currently at $2.2 trillion) and slowed demand for safe assets.

By massively increasing reserves, the Fed “was creating at least a certain kind of safe asset that was actually really helpful,” Stein said. “My point is, now as we start to unwind, one ball you want to keep your eye on is what’s happening there and whether we will see some of the strains that were papered over finally starting to emerge.”

Demand for high-quality liquid assets from the eight systemically important banks in the U.S. is about $2.7 trillion, of which roughly $1 trillion is held in the form of reserves, according to Stein. The uncertainty about the reserves depends on how banks decide to replace them.

As the Fed starts unwinding its balance sheet in October, banks could opt to hold Treasuries of any maturity or prefer to hold Treasury bills, creating further competition for short-term paper already in high demand from money-market funds.

Should banks choose the latter, Treasury can decide to alter its supply, issuing less long-term bonds in favor of short-term paper.

“Treasury historically has sort of stopped out at four- or five-hundred billion,” Stein said. “The idea that they’re going to add a trillion to the very short end is probably not likely.”

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