Fed says bank funding vulnerabilities in line with historical norms

Fed says bank funding vulnerabilities in line with historical norms

The Federal Reserve Bank of Cleveland President, Beth Hammack, recently expressed her views on the current state of bank funding vulnerabilities, suggesting they are aligned with historical norms. In a speech delivered to the Money Marketeers of New York University, Hammack discussed the implications of the Federal Reserve's balance sheet reduction and its potential impact on overnight reverse repurchase agreement (repo) market volatility.

Hammack noted that while some volatility in the overnight repo market could be beneficial in the long run, there are open questions about the acceptable levels of such volatility. She emphasized that a moderate amount of volatility could help inform market dynamics and provide additional discipline, giving firms practice and incentive to prepare for occasional large movements. Hammack also highlighted the importance of striking a balance between maintaining an ample reserves regime and avoiding an overly abundant one, which could promote risk-taking in financial markets.

The Federal Reserve has been gradually reducing its balance sheet since June 2022, with a current reduction of $2.2 trillion. Hammack suggested that the Fed could have continued to allow $25 billion of Treasuries to roll off its books this month, rather than reducing the runoff cap to $5 billion. This change was voted on by the Federal Open Market Committee (FOMC) with a 11-1 decision, with Fed Governor Christopher Waller dissenting. Hammack acknowledged the necessity of this decision as a step towards approaching the 'just-above-ample' point carefully but expressed her preference for continuing the prior pace of runoff.

As the Fed continues its balance sheet reduction, it must also shrink its liabilities by a commensurate amount. Hammack indicated that the overnight repo borrowing program is nearing zero, and quantitative tightening (QT) will soon begin depleting the amount of reserves at the Fed. The goal is to lower the amount of reserves from the current level, deemed "abundant," to one that is merely "ample," or sufficient to cover bank liquidity requirements and enable the financial system to function normally.

Hammack also addressed the potential risks of having a larger balance sheet than necessary, noting that it could dampen money market volatility but also promote risk-taking in financial markets. She suggested that the Fed should consider steps like mandatory testing of firms' abilities to use the Standing Repo Facility and central clearing of SRF transactions to ensure sufficient liquidity in the financial system during times of stress.

Overall, Hammack is comfortable with slightly more frequent Fed interventions into the financial space if it can be done without expanding its balance sheet. She believes that an ample-reserves regime that requires occasional intervention strikes the right balance.

References:
[1] https://www.americanbanker.com/news/fed-official-some-repo-volatility-is-good-for-the-market
[2] https://www.federalreserve.gov/econres/notes/feds-notes/costs-of-rising-uncertainty-20250424.html