The liquidity problems in U.S. money markets that pushed up short term interest rates in September may recur at the end of this year, despite the Federal Reserve’s move to begin regular auctions to inject cash into the banking system, according to J.P. Morgan.
The liquidity coverage requirements imposed on “too big to fail” banks, introduced by the Basle III banking rules after the 2008 financial crisis, and managed by the Federal Reserve and other banking regulators in the U.S., are likely to force lenders to curb how much they are willing to lend to cash-starved market participants in short-term funding markets, according to J.P. Morgan analyst Joshua Younger in a Friday note to clients.
That could result in higher interest rates in the repo market, where broker-dealers, hedge funds and other leveraged investors will borrow money short term to run their operations.
See: Here are 5 things to know about the recent repo market operations
Big banks typically try to shrink their balance sheets and avoid lending their funds at the end of the year or quarter when regulators take a snapshot of capital levels to decide on the “global systemically important bank” (GSIB) scores for financial institutions, a process sometimes known as window dressing.
Those GSIB scores determine the extent to which a bank is required to carry additional capital on their balance sheet. Lenders, therefore, want to avoid receiving a higher GSIB score.
This is especially pertinent for U.S. banks that have a “high repo market footprint” which saw their GSIB scores rise in the third-quarter, according to estimates from JP Morgan JPM, +0.66% .
“The activity of these banks in seeking to reduce [repo lending] exposures is likely to be the key driver of more disorderly funding markets over the turn,” said JP Morgan.
The Wall Street funding crunch in mid-September, when repo rates surged as high as 8% to 10%, was due to banks hoarding reserves well beyond their capital requirements, analysts say.
Bank executives including JPMorgan Chase & Co CEO Jamie Dimon have pointed the finger at the liquidity regulations which they say restrained them from using cash on banks’ balance sheet to soothe repo markets.
See: Dimon says money-market turmoil last month risks morphing into a crisis if Fed falters
Since September, the Federal Reserve has undertaken several measures to calm down repo markets including $60 billion of Treasury bill purchases every month at least into the second quarter of 2020.
However, thanks to the Fed’s interventions, funding markets don’t appear to reflect expectations for a surge in repo rates at the finish of 2019.
Currently the cost of funding to get through the year stood at a wide range between 3.2% to 3.7%, in line with borrowing costs around previous year-end periods, according to Tim Magnusson, senior portfolio manager at Garda Capital Partners, a fixed-income hedge fund.