What are the effects of the repo rate

"A volatile repo rate is by no means a sign of an impending crisis"

The US repo rate has seldom received as much attention from financial markets and media as it has recently. The reason for this is the short-term increase in the repo rate to 10 percent on September 17th. Vincent Reinhart von Mellon, a company of BNY Mellon Investment Management, sees no sign of an impending crisis in this increase.

In principle, repo transactions give banks quick access to liquidity. A commercial bank buys securities from another bank with an agreement to buy them back the next day. The rise in the repo rate can therefore be a sign that banks are no longer lending to each other. This in turn fuels speculation about a possible systemic problem in the financial system - as it did during the financial crisis. That begs the question of whether the banks are in trouble.

Banks wanted to hold larger reserves

"We don't think so. Rather, it appears that the increase was due to a series of random events," said Vincent Reinhart, chief economist at Mellon, a company of BNY Mellon Investment Management. After injecting ample liquidity into the banking system for a decade, the central bank gradually reduced its holdings of securities over the past two years, and with it its reserves.

In addition, the US Treasury received billions in tax revenue in mid-September, as did the proceeds from some large securities auctions. As a result, the central bank's balance sheet swelled by $ 200 billion, and roughly the same amount of liquidity was withdrawn from commercial banks. "The banks, on the other hand, wanted to hold larger reserves than the Fed made available, and because these were not available on the money market, the repo rate rose sharply," says Reinhart.

It is unclear how much liquidity the central bank has to provide

Fed President Jerome Powell recently stated that it was unclear to what extent liquidity would have to be made available by the central bank in order to keep the repo rate at a stable level. This is not new news, however, as finding the right balance between supply and demand for the Fed has always included an element of trial and error.

"The current volatility clearly shows, however, that the central bank may have misjudged the situation, although it recognized the problem relatively quickly and temporarily made 75 billion dollars available to the banking system," said Reinhart. The amount has since increased to $ 100 billion.

The ten years since the financial crisis are unique in the financial markets because the US Federal Reserve flooded the banking system with liquidity and thereby significantly narrowed the fluctuation range of the repo rate. Before the financial crisis, the Fed's balance sheet was significantly shorter and the central bank was far more reluctant to provide permanent liquidity. Sudden changes in the repo rate were common at the time, as were short-term measures to ensure liquidity. The central bank provided the repo market with around 200 days of liquidity per year.

Historically, the approach taken by the central bank is not unusual and until the Fed decides to permanently increase reserves, it will continue to provide liquidity to the repo market. "Since there is no guarantee that the Fed will find the right balance straight away, investors should be prepared for the fact that volatility in the repo market will continue to increase," the chief economist points out.

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