The Banking System Was Redesigned. Did You Notice?
The banking system profoundly changed with little discussion and little fanfare. Here's what you need to know about the new system.
The Great Financial Crisis shook the financial system so badly that it prompted the Federal Reserve and the US government to fundamentally change how the banking system worked.
The changes were both subtle and profound at the same time such that nothing feels different at face value but things are very different behind the scenes.
These changes are not well known and underappreciated, despite a fundamental shift with how the financial system behaved during crises.
Textbooks have not updated, and financial commentators are still using the old system as a reference point for analyses and predictions.
Ignorance of how the new system works can result in disastrous financial decisions.
In this newsletter issue we will simply and intuitively explain:
How the old banking system worked
How the system profoundly changed
And how today’s financial system behaves in this new banking regime
Let’s start.
📜🏦 The Old Banking System
Key Points of the Old Banking System:
The Fed has two mandates: 2% inflation and max employment.
It adjusts the total amount of money in the economy to achieve its objectives. This is known as Monetary Policy.
The Fed’s primary way to implement Monetary Policy is by setting interest rates.
Interest rates are an incredibly powerful financial force. They create and destroy wealth, vastly changing the course of economies over time.
In the Old Banking System, the Fed sets interest rates by changing the level of bank reserves in the system.
This worked because bank reserves were scarce but no longer works in the New Banking System.
The Fed has two mandates: 2% inflation and max employment.
It adjusts the total amount of money in the economy to achieve its objectives. This is known as Monetary Policy.
The Fed’s primary way to implement Monetary Policy is by setting interest rates.
Interest rates are the price of money; the higher they are, the more expensive it is to borrow money, and the less money is available in the economy. Vice versa for lower interest rates.
As such, interest rates are a powerful but indirect lever to adjust the total amount of money in an economy.
They are an incredibly powerful financial force, creating and destroying wealth and vastly changing the course of economies over time. This is why the Fed’s core policies revolve around controlling interest rates.
So, how does the Fed control interest rates?
The Fed does so by changing one key interest rate in the financial system called the Fed Funds Rate.
This is known as the risk-free rate and is generally the lowest interest rate you can find in the economy. As such, by moving the Fed Funds Rate up and down, the Fed has indirect influence over other interest rates in the economy (e.g. personal loan rates, auto loan rates, mortgage rates).
But what is the Fed Funds Rate, and how does the Fed control it?
At a high level, when major financial institutions loan money to each other overnight, the interest rate they charge is the Fed Funds Rate. These loans have very little risk given their short duration and the high quality of the participants (e.g. J.P. Morgan, Citi, etc.).
This is also why the Fed Funds Rate is considered a risk-free rate.
The crux of the Old Banking System lies in how the Fed used to control the Fed Funds Rate.
The Fed did so by adjusting the total amount of bank reserves in the system.
This affected the Fed Funds Rate (interest rate for overnight loans between banks) because bank reserves were scarce.
The scarcity of bank reserves meant that financial institutions were quickly willing to pay more or less for bank reserves when level of reserves changed.
When reserves fell, financial institutions needed more reserves, and were willing to pay a higher interest rate for them. When reserves rose, financial institutions needed them less and the Fed Funds Rate fell.
The primary way the Fed adjusts the amount of bank reserves in the system is by conducting what’s known as Open Market Operations (OMO). Through OMO, the Fed buys or sells US treasuries from the market.
Since the Fed can print money and it’s just an editable database value in its systems, when the Fed buys treasuries, they are essentially giving money to the economy and when they sell treasuries, they are taking money from the economy.
These transactions of supplying money and taking money from the economy eventually end up reflecting in the total level of bank reserves.
This was the old way of doing things.
In the New Banking System, the Fed is no longer able to adjust the Fed Funds Rate by adjusting bank reserve levels.
✨🏦 The New Banking System
Key Points of the New Banking System:
The Fed could no longer adjust the total level of bank reserves to change interest rates.
This is because after the 2008 Great Financial Crisis it flooded the system with bank reserves.
When reserves are ample, banks aren’t affected by small changes to the total level of reserves and interest rates don’t budge.
As such, to change interest rates in the New Banking System, the Fed has to use new tools.
The Fed’s massively bloated balance sheet is thus not a flaw but a feature in this New Banking System. They want it to be big to keep reserves ample.
The Fed explained this new system in three notes (note 1, note 2, note 3) published in 2020 (warning: it’s super dry). We endured reading through them to write this piece.
The Fed calls the New Banking System an “Ample Reserves Regime”. You could probably guess what this means by its name.
To reduce fragility in the financial system, the Fed printed trillions of dollars to flood the system with bank reserves (print $$$ → give money to economy by buying treasuries through OMOs → this new money eventually ends up as bank reserves).
This is how the Fed’s balance sheet went from $0.9 trillion in 2008 to $4.5 trillion in 2015 and then to almost $9 trillion in 2022.
The Fed jammed its balance sheet with trillions of dollars worth of treasuries and the financial system in turn got trillions of dollars worth of bank reserves.
In other words, financial institutions are now flush with cash.
The ample amount of reserves in the system meant that the Fed could no longer move the Fed Funds Rate by adjusting reserve levels. There was simply so much reserves that small fluctuations in supply couldn’t compel financial institutions to change the rate they were willing to pay for them.
financial institutions didn’t change the rate they were willing to pay for reserves in response to small fluctuations in total supply.
In other words, the Fed couldn’t change the Fed Funds Rate from OMO. It needed new tools to control the rate.
Note: this change is so new that many financial textbooks are out-of-date and still state that the Fed uses OMO operations to adjust the Fed Funds Rate.
The Fed now uses two interest rates it has full control over to influence the Fed Funds Rate. They are the Interest On Reserve Balances (IOR) and the Overnight Reverse Repo Rate (ON RRP).
These two interest rates determine what financial institutions can earn by loaning money to the Fed. Since these are loans to the Fed, they are completely risk-free.
As such, the two interest rates create a floor for the Fed Funds Rate.
The logic goes like this: a financial institution wouldn’t loan at a lower interest rate if it can loan to the Fed at IOR or ON RRP.
On the flip side, the Fed has lending facilities like the Standing Repo Facility and the Discount Window Lending facility that create a ceiling for the Fed Funds Rate.
If a financial institution can borrow from the Fed at rates offered by the SRF and Discount Window, they wouldn’t borrow from another institution that charges a higher interest rate.
💡 This Matters A Lot, But How?
What I just described is a 10,000 foot view of the New Banking System where bank reserves are ample and where the Fed needs new tools to control interest rates.
While the differences between the new and the old feel very technical and even insignificant, its effects on the financial system are profound.
First, when bank reserves used to be scarce, the system was more fragile to shocks.
This is because the moment there’s an unexpected drop in liquidity, interest rates can spike hard as highly leveraged participants in a cash-starved system scramble for cash.
Now, with the system filled with cash, sudden liquidity shocks are rare, almost impossible.
Second, by adopting the Ample Reserves Regime, the Fed has essentially given itself a green light to print vast quantities of money, all in the name of keeping reserves in the system ample.
As such, the Fed’s first response to any shock to the system is to ramp up Quantitative Easing (print money to buy US government debt) and create arbitrary lending “facilities” to lend money to specific parts of the financial system that’s under stress.
For example, during the pandemic, the Fed created a medley of strategic lending facilities (e.g. Paycheck Protection Program Liquidity Facility, Municipal Liquidity Facility, Term Asset-Backed Securities Loan Facility and many more).
These facilities all conjured money out of thin air to lend to the economy at interest rates desired by the Fed.
As such, the main implication of this new banking system is that the financial crises of old, such as the 2008 Great Financial Crisis, where a sudden unexpected liquidity shock could literally break the system overnight, could no longer happen.
If something bad did happen, like the pandemic, the Fed would just ramp up QE and create as many lending facilities as required to flood the system with money.
Many would point to the Fed’s ballooning balance sheet, filled with trillions of dollars worth of treasuries, as a flaw in the system.
What I’m trying to impart from this newsletter issue is that a bloated Fed balance sheet is not actually a flaw, it’s a feature of the Ample Reserves Regime.
Keep this in mind the next time someone tries to peddle an impending financial disaster. The central bank has an infinitely deep bed of money and it’s designed a banking system where it’s okay to use it at any time, to any capacity.
Any minor financial system hiccups will be quickly papered over by a truckload of bank reserves.
Remember how quickly last year’s regional banking crisis resolved?
💡 What Could Possibly Go Wrong?
This brings us to the most important question: “What Could Possibly Go Wrong?”
Many of you probably have an intuition that something about this Ample Reserves Regime doesn’t sound right.
If it’s along the lines of US dollar devaluation from the Fed’s wanton money printing, you’d be right.
While printing money in theory sounds like a cure-all solution for financial crises, it’ll eventually fail if confidence in the US dollar collapses.
To facilitate a stable transition to the Ample Reserves Regime, the Fed worked with the US government to promote the rise of what’s known as the Secured Lending Standard in global US dollar funding markets through a series of new banking regulations and Fed facilities
The rapid rise of the Secured Lending Standard is beyond the scope of this newsletter issue but just know that it comes part and parcel with the Ample Reserves Regime to shore up demand for the US dollar in a system flooded with dollars.
As expected, it’s a stop-gap solution that will eventually break down if the US government remains undisciplined with printing money.
💎 Important Market Update (for paid subscribers)
For the rest of this issue, we’ll discuss how we think this market will move based on this week’s news.
We’ll update existing trade ideas while sharing new ones.
Also here’s a small win from the BABA trade idea. BABA was not a fun trade. This helped to cancel out some of the losses from the failed January BABA long.