European Liquidity Strains
After peaking at $1.71 trillion last summer, the level of reserves held at the Federal Reserve has declined. In the second half of 2011, reserve balances shrank gradually, falling to just $1.55 trillion in November and December. Given the public’s concerns about elevated reserve levels and all the new tools the Fed has developed for managing reserves, it is important for policymakers to understand where those reserves have gone. Data suggest that a large part of the decline in reserves was spurred by foreign-related banks. A quick examination of the Fed’s balance sheet, and the Fed’s data on the balance sheets of commercial banks, confirms that the likely culprit was liquidity strains in Europe.
As an accounting identity, the Fed’s assets and liabilities have to remain even with each other. When the level of reserves fell, which count as liabilities for the Fed, the asset side of the balance sheet fell as well. Part of the asset decline was a reduction in the amount of outstanding loans in the Fed’s specialized lending facilities, which had been created during the crisis. This part of the decline included lower balances in the Maiden Lane portfolios and the Term Asset-Backed Securities Loan Facility (TALF). Another sliver represented brief delays in the clearing of certain Fed security purchases, which are part of its reinvestment programs.
But these asset-side declines were not enough to keep pace with the fall in reserves. This excess slack was picked up by increases in other Federal Reserve liabilities. The two major categories that filled that hole were foreign official reverse repurchase agreements and other deposits with Fed banks. Both of these accounts deal with international institutions, like the International Monetary Fund (IMF), and foreign central banks, like the European Central Bank (ECB).
After examining Federal Reserve data on the balance sheets of depository institutions, it becomes clear that the movements in reserves were related to the liquidity strains in Europe. The data are compiled in the Fed’s H.8 data release, which looks at the assets and liabilities of commercial banks. Reserves held at the Fed accumulate in the “cash assets” account, and they make up the vast majority of those balances. Large domestic commercial banks saw a decline of $88 billion in cash assets from July to December, but foreign-related institutions declined by an even larger $220 billion over the same period.
Where these reserves have gone has depended upon the type of institution withdrawing from its account. In the case of large domestic banks, the reserves were used to expand lending operations and acquire securities holdings. For this reason, the total assets at large domestic banks remained fairly constant over the second half of 2011 and have even grown recently. However, the total assets at foreign-related institutions tumbled along with their reserve balances starting in July, and they have yet to recover.
One possible explanation for the decline in the assets of foreign-related institutions is that deposits at those banks have been shrinking. Unlike domestic banks, whose deposits are primarily composed of demand deposits, foreign-related deposits are mostly made up of time deposits. These time deposits come from a number of sources, but one major provider is money market funds.
Money market funds are typically awash in cash, since they generally are considered very safe money managers and they are restricted to holding securities that mature over short time horizons. Their investments are usually limited to risk-free securities, including government bonds and loans to highly rated companies. In 2008, one of the largest money market funds (the Reserve Primary Fund) acted as a catalyst to the financial panic when it “broke the buck,” and its net asset value fell below $1. That fund had invested in the commercial paper of Lehman Brothers. To avoid a comparable outcome with European banks, it seems as if money funds have withdrawn their funding of commercial paper for many domestic branches of foreign banks. Reports during the second half of 2011 repeatedly highlighted the removal of funds from European banking institutions by money market funds.
Federal Reserve data show that there has been a decline in large time-deposits at foreign-related institutions, which is how the sale of commercial paper is categorized on bank balance sheets. This means that domestic foreign-related banks have seen a dramatic decline in the amount of dollar liquidity they have available. To fill the gap, these foreign-owned banks have drawn down their reserve balances. Hence, the data show a decline in both cash assets and total assets for foreign-related institutions.
Another data series that supports this story is “net due to related foreign offices,” which is a measure of the flows of dollars between domestic and foreign offices of related institutions. Positive numbers represent an inflow of dollars to US banks, which will be due back to foreign offices, and negative numbers represent flows out of the US to foreign offices. To help domestic offices with the decline in money market funding, foreign parent banks have sent dollars to their US counterparts.
The timing of events in Europe matches fairly well with the data, as concerns about Italy’s finances were heightened in August and September. It is also notable that these effects have moderated recently after efforts by the Fed and the ECB to provide support to struggling banks. Specifically, the expansion of the central bank liquidity swap lines by the Fed in late December, as well as after the ECB’s long-term refinancing operations (LTRO), helped provide European banks with more liquidity.