(Bloomberg) -- Wall Street banks are hunting for alternative ways to shore up their coffers as an emergency lending tool that helped resolve last year’s regional banking crisis expires.
The Bank Term Funding Program, which was established in March 2023 to restore confidence in the financial system after the collapse of Silicon Valley Bank, is set to stop doling out loans by Monday’s close. That’s reigniting the debate over whether the US financial system has the tools it needs to keep ample cash on hand.
It’s a crucial test for the Federal Reserve, which is still shrinking its balance sheet via so-called quantitative tightening after years of stimulus meant to spur a pandemic recovery. If cracks start to appear in the funding market, that process stands to stall — and the stability of the banking system could teeter again.
“Even though funding conditions are stable, banks are still desiring elevated liquidity buffers,” said Mark Cabana, head of US rates strategy at Bank of America Corp. “BTFP was just one reflection of that.”
To some on Wall Street, the BTFP was a solution to one of the financial system’s main challenges of 2023: It gave banks and credit unions the ability to borrow funds for up to one year, pledging US Treasuries and agency debt as collateral valued at par.
But the program attracted controversy late last year when institutions started tapping it to fund an arbitrage opportunity, prompting the Fed to increase the cost to borrow. About $164 billion was lent out through the program as of last Wednesday, according to Fed data.
Banks must now either allow those loans to roll off or find another source of financing. How they do so will determine whether the amount of liquidity in the system remains plentiful. It’ll also have an impact on whether the Fed can continue its balance-sheet unwind as planned — or if the central bank needs to slow the process down.
“We’re not exactly in scarcity land, but we’re getting closer so it does make sense to slow down,” said Gennadiy Goldberg, head of US interest rate strategy at TD Securities.
‘Appropriate Reaction’
Banks choosing not to replace their BTFP loans would likely drain reserve balances, or the capital they put aside to ensure they can weather unexpected shocks.
While that would be a concern for the Fed, on the whole, financial institutions have become more sensitive to holding higher levels of reserves in the shadow of last year’s regional banking turmoil, said Steven Kelly, associate director of research at the Yale Program on Financial Stability.
“Some of it is an appropriate reaction to the sense of fragility in the system by banks,” he said.
As a result, many of the loans will likely be replaced with other sources of funding. One option is the Fed’s discount window — long seen by markets as a last resort and signal of distress — which the central bank is trying to rebrand as an everyday tool.
Fed Chair Jerome Powell last week told lawmakers the central bank needs to boost the facility’s reputation.
“The stigma is that it’s the lender of last resort,” William Demchak, chairman and chief executive officer of PNC Bank National Association, said during a panel at the Brookings Institution last week. “The day you hit it for anything other than a test you effectively told the world you failed.”
US regulators have been working to introduce a plan to require banks to tap the Fed’s facility at least once a year, Bloomberg reported in January.
A more palatable alternative is funding from Federal Home Loan Banks. FHLB debt increased by about $12 billion over January and February, an indication that demand for short-term loans has been flourishing. That’s even as the Federal Housing Financing Agency has joined other authorities in trying to push firms toward the central bank’s discount window.
In November, the agency offered a blueprint for overhauling the system, which would cap access to loans from FHLBs. But Wall Street strategists argue that banks are still so sour on the central bank’s discount window that they’d likely choose instead to stockpile cash during times of crisis.
For now, though, activity in funding markets suggests that bank reserves remain abundant. But the theme will remain top of mind for Fed policymakers as they gather for the March interest-rate decision.
An embrace of other sources of funding by banks may ultimately yank cash from the central bank’s overnight reverse repurchase agreement facility, known as the RRP. Policymakers are closely watching the RRP as a nearly empty facility means QT will start depleting bank reserves.
Dallas Fed President Lorie Logan has said the central bank will likely be able to slow the pace at which it shrinks its balance sheet as the RRP facility empties. She’s also said that slowing the pace of QT doesn’t mean the Fed will stop letting maturing assets roll off altogether. A slower pace may allow the the runoff to continue for longer, and stands to mitigate the risk of liquidity stress.
Powell has said officials will have an in-depth discussion about the balance sheet at the March meeting, a conversation that can’t come soon enough given the pace of the RRP runoff and next month’s tax collection deadline since payments tend to come mostly out of the banks instead of money-market funds.
“All eyes are on upcoming tax dates,” BofA’s Cabana said. “Typically that comes out of reserves, but there’s more questions this year.”
By Alexandra Harris
