A Banking Transformation Not Fully Appreciated by Economists
In September 1928 the Federal Reserve Board ruled that any federal funds transactions initiated as a two-step method of exchanging checks would be classified "nonreservable money borrowed." This was a significant designation as it reduced the costs of money intermediation in a system that was just becoming more used to the Federal Reserve System. As early as the summer of 1921, according to the Richmond Fed, the federal funds market began when some unknown bank exchanged a check on its reserve account with some other unknown bank that delivered an equal check only drawn on its clearing account. The difference was in the setup delivered by membership in the Federal Reserve System itself, which was not at all universal even by the late 1920's.
The check drawn on the reserve account cleared immediately at presentation, crediting the "borrowing" bank with funds right away. The reciprocal check drawn on the borrower's clearinghouse account took an additional day for presentation, meaning that the terms of the loan were overnight and, importantly, self-extinguishing. The use of this federal funds market, as it came to be known since only Federal Reserve member banks could access these features, grew somewhat cautiously, not more than $20 million a day as reported by the New York Herald Tribune, at least initially.
However, by 1928 the volume had increased to around $100 million daily. The Tribune itself even began reporting the federal funds rate in its daily money market section that April, which included the much more studied and appreciated call money rate. The arrival of federal funds as a major money market instrument of the late 1920's meant that monetary regulations either had to welcome the innovation or seek further impediment. They obviously chose the former, including by 1930 also reclassifying federal funds loans drawn by wire as nonreservable money borrowed. The distinction here against deposits is enormous, though that isn't readily apparent by the language presented by the Fed's law department in that 1930 ruling:
"After considering this question the board is of the opinion that all such transactions should be classified in accordance with the purpose to be effected and the principles involved rather than in accordance with the mechanics of their accomplishment. Transactions of this kind are manifestly temporary loans negotiated for the purpose of avoiding the necessity of rediscounting with the Federal reserve bank or showing a deficiency in reserves. The board rules, therefore, that in every such transaction, whether effected by check, book entries, wire transfers or otherwise, and regardless of the method of repayment, the purchasing member bank should show its resulting liability to the selling member bank as money borrowed, and the selling member bank should treat the transaction as a loan made. In using the board's Form 105 for report of condition, the purchasing member bank should show the liability incurred in any such transaction under ‘bills payable and rediscounts' and the selling member bank should enter the amount of the transaction under ‘loans and discounts.'"
That was the first dramatic stirring of the ledger money system. The impetus of the growth of the system had little to do with what might be recognizable from a 21st century perspective. In fact, one of the primary selling points of introducing the Federal Reserve in the first place in 1913 was not just "currency elasticity" in bank panics, rather more immediate elasticity in seasonality. In many ways, these two forms of currency variability were linked, as Milton Friedman even noted in his seminal 1963 review A Monetary History.
"One aspect of the seasonal movement was a fluctuation in the ratio of deposits to currency, which produced recurrent ease and tightness in bank reserve positions and a sharp seasonal pattern in call money and other short-term rates. That seasonal movement was very much in the minds of the founders of the System and was an important source of their belief in the need for an ‘elastic' currency."
The agricultural basis that was still mightily important at the turn of the 19th century into the 20th meant that gold and crops flowed in the autumn - crops to be exported went mostly east while gold would be shipped to the interior. Friedman and his co-author Anna Schwartz calculated these seasonal effects for the 1920's as amounting to almost $200 million increase in Federal Reserve credit in the months of December, with an offsetting decrease in the summers, peaking right around late July/early August. There was also the largely predictable pattern of Americans holding larger cash balances outside the banking system in anticipation of the Christmas season - in order to pay for even the early 1900's version of holiday commercialism required having cash in one's pocket, thus temporarily removing it from the bank's custodial hands.
There has been no real mystery as to why bank panics always seem to have a fondness for finding October on any given calendar. That was the point where economic cash needs strained banks' collective ability to meet them the most (what is strange is how that pattern seems to have repeated long after the agricultural import faded into history, even continuing into the 21st century with the events of September/October 2008). In order to gain liquidity heading into the late autumn/Christmas season, banks would not be as amenable to further circulation of funds through the whole correspondent system.
The federal funds market seemed to be a very good tool in which to offer alleviation from seasonal strain, as banks with very low seasonal effects now had a method for supplying excess reserves on-demand. The Federal Reserve itself could play a central role in seasonal elasticity through open market operations, changing and influencing both the quantity of total accounting reserves as well as gaining some good influence on the federal funds rate without always disturbing the discount rate.
In practical terms outside of seasonality, banks simply had to work with more primitive technology as an anchor upon efficiency. The correspondent system allowed the spread of payment options across the whole of the country, which had the very positive effect of making deposit balances more durable and less subject to trade terms geographically, but it was a costly arrangement. Small banks were forced to maintain relatively large correspondent balances with city banks (and city banks with reserve city banks), meaning that funds (on account) would have to sit idle only in anticipation of clearing activity. The federal funds marketplace offered a far better liquidity option for maintaining clearing as well as reserve balances, meaning greater efficiency in bank operations if only lightly at first.
There is a great confluence of factors that created the conditions for the 1929 crash, again October, but primary among them was convertibility. The system of ledger money that was being pioneered here was not well suited as a liquidity bypass in the financial reality of the 1920's and 1930's. In other words, it was nice enough for banks to manage almost strictly regulatory affairs and profit considerations attached to them, but when a wave of depositors knocks down your doors and demands physical cash, the wire from NYC offers no help. The federal funds market was an aid in balancing the individual ledger of assets and liabilities on the books, to smooth out the rough edges of the interbank correspondent system, but that was all it was suited for.
Obviously, the Great Depression changed a lot of how banking operated before and what came and lasted thereafter. The great calamity, however, does not account for how the federal funds market went from a nice tool for seasonal elasticity of ledger balances alone to the entire basis for modern banking. How is it that for most of the nation's history, actual deposits (whether of gold or actual currency) formed both the foundation and the marginal basis for banking but in the latter two decades of the 20th century and all of the 21st everything works back to ledgers?
The short answer is convertibility; namely that everyday Americans stopped asking for physical currency to pay for much of anything. This is not to say that cash has become or is becoming extinct in merchandise trade (the Fed does report $1.368 trillion in "currency in circulation" as of the latest H.4.1) but that the margins of payment necessities are being met through other means. In terms of global banking, the reserve part of fractional reserve isn't altogether clear anymore.
The timing of this change isn't immediately noticeable, either. The 1960's clearly were important in the development of ledger systems, particularly the eurodollar market, but there is no way to date the transition between convertibility of reserves meaning physical currency and convertibility meaning almost nothing, or at least something not readily definable. You can observe the behavior of the S&L crisis and see the stirrings of the Great Contraction of 1929-33 within it, but clearly the economic results were far, far different. The Fed and monetary contemporaries of that time believed that it was they, and their sanctioning of the primitive forms of TBTF, that was the decisive factor in preventing a depression but the track of financial history in the quarter century since is far, far less assured.
In short, Greenspan believed he saved the world in the late 1980's and early 1990's but in reality it might have been this technological shift away from full convertibility (as well as the FDIC and deposit insurance). People had come to be highly complacent about payment balances and that was reflected in the lack of panic or even disorder in the general banking system in the late 1980's when S&L's were failing all too frequently.
And by 2008, despite the worst panic since 1929, far and above the S&L crisis, nobody much cared about convertibility and cash (properly defined). Banks panicked as a matter of ledger balances being not negotiable while most Americans (including the entire political apparatus) sat back, well away from any lines at the ATM's, and wondered what in the hell was going on.
The epicenter of the panic was in eurodollars, which federal funds played a role in at least breaking down the geographical divide at certain parts in the unfolding drama. In a ledger, wholesale system, there is no anchor and there are no "reserves" to be demanded. Convertibility? Into what?
That was the great failure in the policy response contemporarily, as the Fed and its global central bank counterparts had assured themselves that they were fully ready for another convertibility problem like the 1930's or even what they assumed of the 1980's. The entirety of bank regulation was focused on the deposit base and only vaguely aware of shadow constraints. Nobody could negotiate interbank flow as the tangled mess of intertwined global eurodollars came as a full surprise to almost everyone - even the financial participants themselves. Everyone simply assumed the ledger system of wholesale operation was seamless whole, but at least secondary to the now-anachronistic deposit liability base. Nobody had any intentions anywhere on cash.
Some things never much change, and it seems as if we are reliving at least the setup. Back in February, the Federal Reserve Bank of New York announced that it intends to publish a new overnight bank rate in its portfolio of metrics. Dating back to April 1, 2014, FRBNY began to track and collect transaction-level data from federal funds, eurodollars and CD's from a larger range of utilizing banks. Previously, the Fed had only received data from major interbank brokers. The intent here seems to be a belated attempt to address their prior deficiency of thinking eurodollars and federal funds to be fully integrated.
"The Fed has traditionally collected fed funds data from U.S.-based brokers and started collecting Eurodollar data from the same brokers in 2010. According to these data, the overnight brokered Eurodollar market is around three to four times larger than the overnight brokered fed funds market."
That, in reality, amounts to an admission of being so far behind the curve in 2008. Why did the Fed just start doing this in 2010? My personal opinion is that it wouldn't have made any difference then, but it might have at least jerked them out of their ridiculous complacency in order to actually try to understand what was transpiring. But the focus of this effort is actually forward-facing, relevant to the circumstances of today.
The Fed claims that it is heading toward an end to ZIRP, intent on raising the federal funds rate along with other "tools." The federal funds market is now pretty much devoid of any activity, coming almost full circle to its 20th century roots - no longer serving much of a role for elasticity. That will be undertaken by the eurodollar market, which isn't fully integrated into the Fed's architecture. Operating outside the US, the Fed depends upon rather tenuous conduits from onshore to offshore (despite both sides being classified and treated as "dollars"). As noted last week, they can thank QE for that.
There is also another problem, as money dealers prior to 2007 no longer much participate in money dealing either (again, QE). Instead, the Fed's balance sheet has become the de facto bridge in liability chains in the global liquidity role (interesting aside, what is the main idea of convertibility here where the Fed is the only real player in setting interbank liquidity?). That cannot remain in the "exit" scenario, meaning that money dealing will not be dealers or the Fed when this is all over (a better summation of the mechanics of the problem can be found here, with very good contribution and summation from Zoltan Pozsar and Perry Mehrling on the matter).
That is, if the system ever transverses that far. Dating back to November 20, 2013, it is my contention that credit and funding markets (what exists) have been increasingly bearish on the convergence of what comes next in terms of liquidity formation and the lack of economic recovery in which to aid that transition. November 2013 is inordinately important in setting those expectations because at that time credit markets were behaving as they were "supposed to." In other words, in the formulation of taper the economy was strong enough to allow for a rather quick return to financial normalcy; that should mean a steeper treasury curve and higher nominal rates.
That, indeed, happened in credit and it nearly blew somebody out - though I still cannot find any direct answer as to who or what exactly happened then. Despite that serious opacity it is obvious that something did occur, as all of the bearish trends (even in stocks, if only in terms of momentum) trace back to that point. In wider terms, it may be more than just concerns, still gaining, about federal funds and eurodollar deposits but rather recognition of the continued instability of the entire eurodollar standard, the method that replaced the gold standard in 1971, itself. After all, it's not as if complexity is creating greater efficiency anymore, which was the primary reason for ledger money adoption alongside technological advancements in the first place.
The behavior more recently in credit markets seems to suggest the interpretation where financial agents, especially participants in eurodollar funding have grown very worried about moving to whatever the next step entails - relatively minor systemic adjustment as a best case to full-blown and messy reconfiguring. This is well beyond any liftoff in nominal interest rates, as it contains far broader worries about money dealing without the current setup linked in totality to the Fed's balance sheet. Zoltan Pozsar believes that it will be money funds that perform the greater task of global interbank liquidity (and that the Fed will have to both take on $1 trillion or more in RRP's as well as make them permanent despite just last year proclaiming great disfavor for them), which presents a number of difficulties including base convertibility.
I have always stated that base liquidity in the wholesale system requires a holistic understanding to be comprehensive. Liquidity is not just the liabilities that appear on balance sheets to equal out to assets, it is the process by which liabilities and liability chains are transacted into and out of individual perceptions. That means that liquidity is more than eurodollar deposits or term agreements, there are also requirements for swaps, including OIS related to repo, and collateral flow as well as risk capacity for dealer balance sheets. And that, to me, may present the greatest challenge, as a new liquidity system run off the collective liabilities of money funds will be devoid of, and divorced from, any and all dealer activities.
Prior to 2007, dealers were taking in eurodollars and transforming them through dealer risk functions, and there is no indication as to how that might work in a fully re-privatized liquidity arrangement, globally, where dealer transformations are completely separated from funding mechanisms. This seems to be a very difficult concept to grasp and accept, but the history of 2008 and everything thereafter, especially the periodic outbreaks of further disorder, proves that liquidity is multi-dimensional - it is not enough that Bank A might have "excess liquidity" (not reserves anymore) or even a reasonable future expectation to maintain balanced liabilities, in order for Bank A to enter the wholesale liquidity market and transact in good standing (in terms of function) it needs a whole range of factors in order to do so; it requires shifting risk parameters and thus hedging balance sheet "risk", meaning trading through derivative instruments like IR swaps and even CDS, largely from dealer counterparties.
This can be seen, somewhat, in closely examining systemic problems around Bear Stearns' failure, as to prevent it the Fed might have had a far greater shot at success if it instead of reducing the federal funds target rate in the months just prior were to have underwritten, guaranteed and replaced the monolines' aggregated CDS portfolios. The shortage was not in actual funding but in the ability of the system absorb, transform and remit financial risk parameters (oversimplified as flow not stock). In fact, a more conditioned program at that time might have been to actually raise rates while absorbing the CDS market onto the Fed's balance sheet so long as the Fed continued to write options throughout.
As complex and seemingly impenetrable as all that appears, it was at least knowable in the context of the ad hoc manner in which it all arose. That operational "comfort" has been obliterated and is waiting to be obliterated yet one more time at least. I think it is driving credit bearishness to the point that credit and funding markets are upside down (Yellen says "exit" is back on and credit markets react in the opposite of both that view and what occurred in 2013 up to November, with bear flattening on the curve and lower, not higher, nominal rates). That intersects with the growing acceptance of the fact there will be no recovery, and that the danger of economic missteps especially of late are much higher (if not already apparent).
Maybe there is some positive irony in how the federal funds market failed in both 1929 and 2008 to provide elasticity, but it is important to appreciate the very different means for the letdown. In 1929, at least, federal funds were a minor affair of largely regulatory rebalancing whereas federal funds in 2008 had taken, along with eurodollars, the central role in global finance, replacing deposits as the central pillar. That is a transformation that still, somehow, is not fully appreciated especially by economists. And it will play a role in the near future (if the Fed ever gets that far) in what might replace the eurodollar standard itself. "We" had enormous trouble figuring out elasticity and convertibility parameters in 2008 and we are now presented with a challenge for a new set intruding upon far less than ideal economic circumstances.
