Falling U.S. Bank Reserves Add Pressure On Disputed Debt Ceiling Crisis

A sharp fall in bank reserves held at the Federal Reserve, coinciding with an expected shortage of U.S. Treasury bills as the debt ceiling battle looms, has sparked concerns from investors about possible stress in financial markets.

Reserves, which are funds the Fed asks banks to hold as balances at the central bank, have dropped due to the impact of the central bank’s program to trim its swollen balance sheet, known as quantitative tightening (QT). Bank deposits, which are part of reserves, also fell with customers asking for higher-yielding alternatives for their cash.

A continuous fall in reserves has major implications for the economy. Lower reserves restrict banks’ balance sheets, impeding their ability to lend to finance corporate growth and expansions, analysts said.

The Fed’s balance sheet grew during the pandemic as it purchased securities under its quantitative easing (QE) program, as did reserves at the central bank. That is currently being unwound with QT, which was meant to remove that stimulus from the financial system.

As of March 8, bank reserves during the week totaled $2.999 trillion, according to Fed data, dropping around $1.3 trillion from a peak of $4.3 trillion in December 2021. In the last QT cycle, $1.3 trillion in liquidity was drained in five years.

“In the event of a liquidity crisis in markets, the banking system is much less ready and able to battle those shocks because of the declining level of reserves,” said Matt Smith, investment director at asset manager Ruffer in London.

One such shock was Friday’s shutdown of SVB Financial Group (SIVB.O), a startup-focused lender, which has sparked concerns about its effect on the broader financial sector.

The last time the Fed took on QT, it ended suddenly after bank reserves fell in September 2019 under the minimum required to ensure the smooth running of short-term funding markets. That led to a spike in repo rates and pushed the Fed to provide additional reserves to the banking system.

An expected shortage of bills as the United States reaches the debt ceiling and the Treasury must rein in borrowing, is also seen to decrease reserves further. The U.S. government came nearer to its $31.4 trillion debt limit earlier in February, prompting a Treasury warning that it may not be able to avoid default past early June.

“If the Treasury is unable to issue bills because of the debt ceiling, then you get more cash into reverse repos and that brings reserves down further,” said John Velis, FX and macro strategist at BNY Mellon in New York.

In a reverse repo, market players lend overnight cash to the Fed at a 4.55% rate in exchange for Treasuries with a promise to purchase them back.

Investors have been channeling cash into reverse repos or into money market funds that have access to these repos, instead of putting the money as deposits in banks, analysts said. Volumes on reverse repos have reached north of $2 trillion since June 2022, even as bank reserves have fallen.

Deposit Outflows, Silicon Valley Bank

Deposit rates, with the current average savings rate at about 0.2% per annum, have not matched the surge in the fed funds rate that accompanied multiple Fed rises. Analysts ascribed that to people over-depositing during the QE period amid all the government stimulus during the pandemic.

That low deposit rate has caused deposit outflows. Deposits have been falling since the second quarter of 2022, Fed data on banks’ assets and liabilities showed.

Joseph Abate, managing director at Barclays, in a research note, wrote that excess deposits granted banks more power to set deposit rates and decide how aggressive they require to be to compete for funding.

SVB Financial’s saga that began on Thursday is the most recent example of how deposit outflows could negatively impact smaller banks.

California banking regulators on Friday shut down SVB, which operates as Silicon Valley Bank amid a run on deposits. Among other issues, SVB struggled with falling deposits from startups competing for funds.

“Banks with good liquidity and funding profiles should be able to withstand the decline (in deposits),” said Julie Solar, group credit officer at Fitch’s credit policy group.

“But banks reliant on non-core funding, have deposit concentrations, or large unrealized losses in their securities portfolios could face more pressure in this environment.”

Reverse repos, deposit outflows, and bank reserves are all inter-related. Deposits are finding their way into money market funds which invest in reverse repos. Higher reverse repo usage, in turn, effectively reduces reserves.

The current level of reserves though is still higher compared to 2019 when they fell to $2 trillion due to massive withdrawals for tax payments and analysts agreed that the market is not necessarily in a panic situation just yet.

But the minimum level of reserves under the current QT is possibly higher than the previous cycle since the Fed’s balance sheet has grown significantly more than the last one given a huge QE program.

“All balance sheets have grown since then, so we don’t know where the biting point is,” said Ruffer’s Smith.