Last of the Required Reservists
The RBA abandoning required reserves shows that the only constant is change
If we’re talking about Macroeconomics and Finance, then a lot of the time we’re really talking about central banks. The superpower of these entities is to take any financial asset and replace it with high powered money at market price. This is such a game changing ability that it’s been taken out of the hands of politicians and is subject to regimes of rules. When these regimes shift, it changes not only prices of financial instruments, but the meaning of them and their relationship to the economy. Covid19 policy responses have meant a bunch of such shifts, but one interests me in particular because it represents the last gasp of an old regime.
Before March 19th, the RBA had a required reserves regime. This used to be the norm for developed economies. Central banks set interest rates and keep them there by use of their superpower. They lend at their target rate or above it, and borrow at or below it. That way, if commercial banks have a lot of demand to borrow above the target rate, they can satisfy that demand from the central bank ad infinitum, so the rate stays close to target. In a required reserves regime, the central bank sets a minimum amount of high powered money each commercial bank must hold, adds up those requirements across all banks, and makes sure enough reserves are supplied to meet that minimum. Up to their minimum requirement, the central bank pays its target rate. Anything above the minimum gets a penalty rate, a little below the target rate. Banks have no reason to hold more than the minimum so they’ll happily lend to each other around the target rate - and on a given day any bank with more reserves than they need for their minimum requirement will find a borrower who’s short and trade with them. For years in Australia, that was the system and the actual borrowing rates in the market tracked the RBAs target rate perfectly.
After 2008, most countries abandoned this regime out of neccesity. That need came from QE, where the superpower was used liberally to take government bonds out of circulation and replace them with bank reserves. That meant a tonne more reserves than banks needed to meet their minimum requirements set by the CBs, so the rules had to change. Reserves started getting lent out like hot potatoes to avoid penalty rates - so CBs started remunerating excess reserves at something better than the penalty rate to maintain control, or abolishing penalty rates altogether. The situation changed again with the implementation of Basel 2 - an international regulatory regime designed to ensure banks had enough liquidity to survive shocks. This meant banks had to hold a whole heap of reserves - especially over quarter end. Now, reserves which had been ample were nowhere to be found in money markets, and couldn’t be obtained over quarter end for love nor money. That brings us to the Libor and Repo explosions of 2017 and 2019 - and the response of the Fed to halt its program of unwinding QE despite a strong economy, growing the quantity of reserves from September onwards.
The RBA never had to engage in these shenanigans because they never did QE in response to 2008. When Basel 2 meant their banks would need more reserves than existed as required reserves, they sensibly set up a facility where the banks could pay a tiny fee to have a guaranteed lending facility that would kick in in a crisis - and declared this to be in compliance with the Basel requirements. A neat and cheap way to stay in line with the rules whilst avoiding the excess reserves mess that the rest of the world struggled with.
Covid19 has put an end to all that. The RBA announced a package of measures on the 19th of March that included QE, a funding for lending scheme and to accompany all of this new high powered money, an interest on excess reserves (IOER) rate. Reserves stood at 30bio before the announcement, and have almost quadrupled to 114bio as of the 15th of April. Predictably (and hopefully some readers will recall my prediction on this) the cash rate is now below the RBA’s target rate of 0.25%, and as QE progresses will converge on the IOER rate.
This has changed the meaning of certain indications that we used to use. The basis between the 3m bill rate and the cash rate used to measure the price of a term loan compared to the policy rate, but now represents the fair spread between 3m of one day loans and a 3m loan. This difference is important because now, things that ease the funding conditions of Australian banks may not cause this basis to tighten any more - because both sides of the basis are now a market rate. Both are subject to shocks. Clearly the basis is still a measure of funding stress in the sense that it is riskier to lend for 3m than overnight, but it’s not so simple. Things that affect credit risk for banks will impact more than quantity effects. Frustratingly for me, this makes one of my better tools for analysing the basis less useful. Looking at the monthly financial stats from the RBA and comparing new loans to new deposits, it was possible to get a 2 month lagged look at banks net wholesale funding requirements and judge its impact on the basis market. Now, a large wholesale funding requirement might well be met in the overnight market and have no impact at all on the basis.
But enough about me and my gripes, the point here is that the game has changed. The RBA was almost the last bank standing using required reserves, and thereby having full control over interest rates. Now they stand with the rest of the world, abandoning full control over interest rates in order to ensure the quantity of reserves is ample. Of course, they can re-assert control at any time by changing the rules again - which is the great thing about macro analysis and investing. There’s no absolute power or cast iron rules, just a dance where powerful actors change the rules to try and shape outcomes.
- The RBA changed from required reserves to excess reserves
- Most central banks already had to do this because of QE and Basel rules
- The cash rate will now be below the target in AUD
- The BillsOIS basis no longer captures as much variation in funding stress
- The only constant in macro is change!
NB: This post is not investment advice and is not a trade recommendation. The views expressed here are my own and do not reflect those of my employer.