In a detective-like fashion, BIS economists Robert McCauley and Patrick McGuire follow the flow of money across borders and conclude that non-U.S. banks’ branches used funds from the rest of the world to take up $958 billion of the Fed’s $2.249 trillion in reserves that were created to fund its purchase of Treasury and mortgage bonds as part of its extraordinary monetary stimulus.
The reason that non-U.S. banks have ended up with such a disproportionate share of Fed reserves is due to legislation following the global financial crises aimed at forcing banks to pay for an increase in the size of the Federal Deposit Insurance Corp. (FDIC) fund.
An FDIC charge was levied on short-term wholesale bank funding, one of the factors that had contributed to systemic instability during the financial crises. But despite concern that such a charge could result in regulatory arbitrage if it wasn’t internationally coordinated, the charge was only applied to U.S. banks that operate with FDIC insurance.
This put U.S. banks at a competitive disadvantage in raising wholesale funding in comparison to non-U.S. banks that don't have FDIC insurance. The new FDIC charge added to the approximate 10 basis points cost of wholesale funding so it was not profitable enough to park the funds at the Fed at 25 basis points.
From a monetary policy perspective, it might not matter which banks hold the Fed's liabilities.
But it matters from a regulatory perspective in a world where regulations vary between jurisdictions because it has induced massive changes in major banks’ international funding patterns and balance sheets.
“Counter to the popular metaphor that the Fed’s bond buying represented an injection of liquidity that could flow out of the United States, non-US banks’ branches brought dollar funds into the United States,” wrote McCauley and McGuire.
Which banks hold reserves at the Fed may also matter when the Fed at some points starts to tighten its policy and reduces its bond portfolio, which now exceeds $4.1 trillion.
The Fed has been experimenting with reverse repurchases as a new operational tool that could reduce bank’s $2.5 trillion claim on it even as it maintains its portfolio of bonds. In a reverse repo, the Fed borrows overnight from cash-rich counter parties, like mutual funds, against its own portfolio of bonds.
This policy instrument will help drain banks’ holdings of excess reserves at the Fed and for non-U.S. banks it would reduce the profit they have been making on a very low-risk trade that involved parking wholesale funds at the Fed.
McCauley and McGuire pose the question of whether this would trigger a reversal of the recent flow of funds into the U.S. Since the global financial crises, foreign banks have more than doubled their exposure to the U.S. official sector to $1.75 trillion.
"Just as the uptake of claims on the Fed by branches of banks headquartered outside the United States led to large changes in the global dollar flow of funds, so too could the Fed’s draining of its excess reserves,” they said.
McCauley is senior adviser in the BIS Monetary and Economic Department, having worked as chief BIS representative for Asia and the Pacific in BIS' Hong Kong office. Prior to joining the BIS, McCauley worked at the New York Fed for 13 years, for the Joint Economic Committee of U.S. Congress and taught international finance at the University of Chicago.
McGuire is head of the BIS-hosted International Data Hub, which oversees the collection and analysis of global banking data for supervisory authorities. He joined BIS in 2002 and worked in the monetary and economic department's financial institutions and financial markets section.
Click to read the March 2014 issue of the BIS Quarterly Review.
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