[Economics] The role of the Federal Reserve in the US banking turmoil

[Draeno]

 

Banks are turning to the Federal Reserve's lending programs to access financing as the financial system is in turmoil following the recent failures of several high-profile banks.

The collapse of Silicon Valley Bank on March 10, followed by that of Signature Bank on March 12, caused account holders to withdraw their money from some banks and caused wild fluctuations in the stock prices of several financial companies. The tumult has left some institutions looking for a ready source of cash, either to settle accounts with clients or ensure they have enough cash on hand to ride out a rough patch.

That's where the Federal Reserve comes in. The central bank was founded in 1913, in part, to support the banking system: in a pinch, it can give financial institutions loans secured by its assets, which can help banks raise funds faster than than they could if they had to sell those collateral on the open market.

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But now the Federal Reserve will go further: on March 12, central banks created a program that extends credit to banks and uses their financial assets as collateral, as if they still had their original value. Because? As the Federal Reserve has raised interest rates to contain inflation in the past year, bonds and mortgages paying lower interest rates have lost value.

By making loans collateralized with the assets at their original price instead of their lower market value, the Federal Reserve can protect banks from having to sell those securities at huge losses. That could calm depositors and prevent a bank run.

This week, two key programs together awarded $163.9 billion in loans, according to data the Federal Reserve released Wednesday, up from about $164.8 billion a week earlier. That amount is much higher than normal. The report typically shows banks borrowing less than $10 billion worth of loans in the Federal Reserve's “discount window” program.

This increase in lending underscores a disturbing reality: stress is still present in the banking system. The question is whether the government's response, including a new central bank financing program, will be enough to quiet him.

A little history
Before delving into what these new numbers mean, it's important to understand how the Federal Reserve's funding programs work.

The first, and most traditional, is the discount window, affectionately nicknamed “disco” by financial analysts. It is the original tool of the Federal Reserve: at the time of its founding, the central bank did not buy and sell securities as it does today, but it could lend to banks with collateral.

However, in the modern era, obtaining discount window loans carries a stigma. It is perceived in the financial industry that if a large bank uses the resource, it must be a sign of distress. Borrowers' identities are made public, albeit with a two-year delay. Its most frequent users are community banks, although some regional lenders such as Bancorp used it in 2020 at the start of the pandemic. Over the years, Federal Reserve officials have modified the terms of the program to make it more attractive in times of adversity, but the results have been mixed.

Then came the new option from the Federal Reserve, which is like the discount window to the fifth power. Officially known as the Bank Term Financing Program, it takes advantage of emergency lending powers that the Federal Reserve has had since the Great Depression, and that the central bank can use in "extraordinary and exigent" circumstances with the authorization of the Federal Reserve. Treasury Secretary. With this resource, the Federal Reserve grants loans backed by Treasury bonds and mortgage bonds valued at their original price for a maximum of one year.

Policymakers seem hopeful that the program will help reduce interest rate risk in the banking system—the current problem—while managing to avoid the stigma of borrowing from the discount window.

Banks request more loans than usual
These support mechanisms appear to be working: during the recent crisis, banks turned to both programs.

As of the middle of last week, discount window lending had risen to $110.2bn, down from $152.9bn the week before, when the turbulence began. Those numbers are abnormally high: Discount window loans totaled just $4.6 billion a week before the turmoil began.

The new program also attracted borrowers. Banks took out $53.7 billion in loans, according to Federal Reserve data. Two weeks ago, the figure was $11.9 billion. The names of the specific borrowers will be released in 2025.

Loan application could be an indication of trouble
The next question is perhaps the most critical: Analysts are weighing whether it is a good thing for banks to resort to these programs or whether their increased loan requests are a sign that they are still in deep trouble.

“There are still banks that feel the need to take advantage of these programs,” said Subadra Rajappa, director of US interest rate strategy at Société Générale. “Without a doubt, money is being taken out of the banking sector and going to other investments or to bigger banks.”

While Silicon Valley Bank had some glaring weaknesses that regulatory experts say were not made known to the rest of the banking system, its failure has prompted people to take a closer look at banks, with account holders choosing to withdraw their money to punish those who share similarities with the failed institutions. PacWest Bancorp has been one of the banks beset by trouble. This week, the company said it had taken out a $10.5 billion loan from the Federal Reserve's discount window.

Or the loans could be a good sign
The fact that banks feel comfortable using these tools could give depositors and financial markets peace of mind that money will continue to flow, which could help avoid future problems.

In the past, borrowing from the Federal Reserve carried a stigma, as it was seen as an indication that a bank might be in trouble. Now, the collateral held by banks is not at risk of default, just worth less in the debt market as a result of rapidly rising interest rates.

“In my opinion, this situation is very different from what I have seen in the past,” concluded Greg Peters, Co-Head of Investments at PGIM Fixed Income.

 

https://www.elespectador.com/economia/macroeconomia/el-papel-de-la-reserva-federal-en-la-turbulencia-bancaria-de-ee-uu/