Rates
Opinions
25 January 2024
The BTFF's demise can be construed as a sign of Fed confidence in the system
The Federal Reserve has changed the rate charged on the Bank Term Funding Facility (BTFF), and for good reason. Previously the reference rate was 1yr term SOFR (+10bp fee). Term rates incorporate the future, and as the market is discounting rate cuts, the 1yr term SOFR rate trades some 50bp through the overnight SOFR rate. The Fed’s action confirms that there were players in the market taking advantage of the arbitrage by borrowing on the BTFF and lending back at a higher in-arrears rate. The Fed has now floored the reference rate to the interest on excess reserves (IOER), which is currently at 5.4%. That takes away the arbitrage. Which makes eminent sense. But what about the Fed’s decision to end the facility on its one year anniversary?
Originally it was set out as a facility that would be available for a year, book ended by the Silicon Valley Bank (SVB) demise on 10 March 2023 and the one year tenor for the facility to conclude on 11 March 2024. But the Fed always had the choice to extend it. The decision not to extend it could be construed as a sign of confidence. No doubt the Fed has done its due diligence on the players that have accessed the facility, and has concluded that the need for an extension is not there.
This is good, as it points to a Fed that is not concerned about the players that have used the facility. In other words they can take it. Moreover, and by implication, the Fed does not envisage a threat of a similar ilk hitting the system down the line. And if something does hit, the Fed points to the discount window as the place to get hands on emergency liquidity. It had been noted that some of the smaller players were not used to discount window access in March last year, with some getting into difficulty that they did not need to get into.
The alternative BTFF, the story went, was an all-embracing rescue programme for some institutions that addressed the deep discount attached to many hold-to-maturity portfolios, by instantaneously liquefying them at par.
The Fed is now directing banks to access the discount window to address any stresses
With the BTFF programme now to end, the Fed directs stressed bank scenarios to the discount window. The primary funding rate there is 5.5% currently (actually flat to the new BTFF floor when the 10bp fee is included). The secondary funding rate is a tad more penal at 6%, for institutions not eligible for primary credit. And there is a seasonal credit rate that depends on circ*mstances, and now stands at 5.35%. One issue with the discount window is it does not do what the BTFF facility does, in the sense that one of the criteria is that the “securities should not be subject to any regulatory or other constraints(s) that impair their liquidation”. In its truest sense, that would exclude hold-to-maturity securities. At first glance this is indeed a problem, as one of the pain points for banks that came under pressure last March was via attempts to sell bonds in such portfolios. Accounting treatments vary here from implications of selling to re-classifying to available to sale, which then decide whether there is a hit to income or equity or both. Either way, forced liquidation or re-classification crystallises the value of the bond at its discount to par valuation, and that feeds through in a negative fashion to either net income or equity or both (depending on what has been done). In effect it makes things worse. Silicon Valley Bank saw an extreme version of this. It’s what prompted the Fed’s BTFF in the first place.
There are risks though, especially as the Fed's own rate hiking process was a contributor
Given that, is the Fed taking a risk by removing this facility? Well yes and no. The “no” revolves around the power of the discount window. While there is some fuzziness around the eligibility of hold-to-maturity securities (ineligible on a plain reading), this is offset by quite a wide array of alternative assets that can be posted at the Fed. Most of these are high grade in nature as an obvious minimum criteria. But on top of that, banks can post loans as collateral. There are a whole series of constraints to what types of loans that can be posted, but in reality any half decent bank should be in a position to conjure up a decent portfolio of loans for posting as collateral. The “yes” centers on the reason the BTFF facility was dreamt up to begin with. In March last year banks could have posted suitable collateral at the Fed to get access to emergency liquidity through the discount window. In many cases they choose not to, and some of the stressed ones engaged in fire-sales of their non-mark-to-market bond portfolios to get access to liquidity. The Fed has noted that some banks were not “in the know” with respect to discount window usage. The Fed now wants all banks to do a test access of the discount window annually, so that they are more comfortable with it, and in part to take away some of the stigma attached to accessing it.
The Fed could have softened the risks by extending by six months instead
Our take on this is the Fed could not keep the BTFF facility as a permanent mechanism, as it would change the characteristic of the hold-to-maturity portfolio. Having the capacity to liquefy this at will would allow banks to both have a stable non-mark-to-market component to its securities portfolio, and mark it to par whenever it wants. Banks could have their cake and eat it. But at the same time, the reason that hold-to-maturity portfolios are at the deep discount to par is because the Fed has hiked rates. In fact it’s been one of the most aggressive rate hiking cycles in decades. While banks should be able to deal with this, as managing interest rates risk is what they do, the Fed could also have simply extended the facility for another six months. If they did that, likely they would have been cutting rates by then, which would help to soften the (potential) "impact". In the end though, if a bank can’t cobble together a half decent loan portfolio to post at the Fed’s discount window, they should likely not be in the banking business in the first place.
Tags
Federal Reserve Bank Term Funding Facility
Download
Download opinion
As an expert in finance and banking, I can confidently analyze and provide insights into the concepts used in the article titled "The BTFF's Demise can be Construed as a Sign of Fed Confidence in the System." The article discusses the Federal Reserve's decision to change the rate charged on the Bank Term Funding Facility (BTFF) and the implications of ending the facility.
First, let's address the concept of the BTFF. The BTFF is a funding facility provided by the Federal Reserve to banks. It allows banks to borrow funds at a certain rate and use them for lending or other purposes. The reference rate for the BTFF was previously set at a 1-year term SOFR (+10bp fee), which stands for Secured Overnight Financing Rate. This rate takes into account the future expectations of interest rates in the market. However, the article mentions that the market was discounting rate cuts, causing the 1-year term SOFR rate to trade at a higher rate than the overnight SOFR rate.
The Federal Reserve's decision to change the reference rate for the BTFF to the interest on excess reserves (IOER) makes sense because it eliminates the opportunity for arbitrage. By flooring the reference rate to the IOER, which is currently at 5.4%, the Federal Reserve removes the possibility of borrowing at a lower rate and lending at a higher one, thereby taking advantage of the market's rate differentials.
Next, the article raises the question of why the Federal Reserve decided to end the facility on its one-year anniversary. Initially, the facility was set to be available for a year, starting from the Silicon Valley Bank (SVB) demise on March 10, 2023, and ending on March 11, 2024. However, the Federal Reserve had the option to extend it but chose not to. This decision can be interpreted as a sign of confidence in the banking system. The Federal Reserve likely conducted due diligence on the players accessing the facility and concluded that an extension was not necessary. This indicates that the Federal Reserve is not concerned about the banks using the facility and does not foresee any future threats to the system.
In the event of a future crisis, the Federal Reserve points to the discount window as the place for banks to obtain emergency liquidity. The discount window is another facility provided by the Federal Reserve where banks can borrow funds, but it has certain criteria and constraints. The primary funding rate at the discount window is currently at 5.5%, and there is a secondary funding rate of 6% for institutions not eligible for primary credit. The article also mentions a seasonal credit rate that depends on circ*mstances and currently stands at 5.35%.
One limitation of the discount window is that it does not address the specific needs of hold-to-maturity portfolios. Hold-to-maturity securities are bonds that banks hold until maturity, and their valuation can be affected by changes in interest rates. The article mentions that if these securities are subject to regulatory or other constraints that impair their liquidation, they may not be eligible as collateral for accessing the discount window. This can be a challenge for banks facing pressure to sell bonds in their portfolios, as it can lead to negative impacts on their net income or equity.
The article also discusses the risks associated with removing the BTFF facility. On one hand, the discount window provides an alternative source of emergency liquidity, and banks can post a variety of collateral, including loans, to access funds. On the other hand, the BTFF facility was created in response to banks' reluctance to use the discount window during the previous crisis. The Federal Reserve now wants banks to test access the discount window annually to increase their familiarity with it and reduce the stigma associated with using it.
The article suggests that the Federal Reserve could have extended the BTFF facility for another six months to soften the potential impact of its removal. By doing so, they could have allowed more time for potential rate cuts, which would have benefited banks with hold-to-maturity portfolios. However, the article also emphasizes that banks should be able to manage interest rate risks, and if they can't assemble a suitable loan portfolio for collateral, they may not be suitable for the banking business.
In conclusion, the article highlights the Federal Reserve's decision to change the rate charged on the BTFF and end the facility after one year. It suggests that this decision reflects the Federal Reserve's confidence in the banking system and its belief that the discount window can address any future liquidity needs. While there are risks associated with ending the BTFF facility, the article argues that banks should be able to navigate these risks and emphasizes the importance of banks understanding and utilizing the discount window effectively.
