High Reverse Repo Levels Could Hinder U.S. Banks

The Federal Reserve reverse repurchase facility (RRP) contains $2 trillion in overnight cash, aiming to manage excess liquidity in the financial system. But could it make trouble for banks?

Following the 75-basis-point interest rate hike in late July, the Fed is paying a record reverse repo rate of 2.3%. Daily reverse repo levels could hit $3 trillion by the end of 2022, according to Barclays. The rate refers to the pace at which the central bank borrows money from commercial banks to control the money supply.

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Investors, according to Reuters, are rerouting deposits from banks into government money market funds, which invest mainly in Treasuries and repos. These money funds then send the cash to the Fed’s reverse repurchase facility overnight window. Repo allocations from government money market funds have increased to nearly 40% of their assets, up 10% since the beginning of 2022, Barclays said.

When the Fed starts to lower its balance sheet by $95 billion per month beginning in September, accelerating "quantitative tightening," banks may worry that the outflow of deposits from banks into money market funds could quickly reduce reserves, hampering lending activities to financial markets and the broader economy. This could lead to a spike in repo and fed funds rate.

"The drift of reserves into money market funds and away from banks constitute movement of money away from financial markets," said Matt Smith, Investment Director at London investment management firm Ruffer LLP.

Since December, bank reserves have dwindled about 23%, from a high point of nearly $4.3 trillion. Currently, reserves are at $3.3 trillion.

Asset re-allocations and loan demand have also contributed to the decline in bank reserves, analysts told Reuters.

"The Fed's QT will shrink its balance sheet quickly. But bank reserves are set to fall much faster as cash shifts out of bank deposits to government-only money funds. We expect money funds to put this cash in the RRP," wrote Joseph Abate, Managing Director at Barclays, in a research note.