This blogpost is a brief summary of the book titled, “Central Banking 101”, written by Joseph Wang.

Types of Money

  • Three types of money
    1. Fiat Currency: Dollars in your wallet
    2. Bank Deposits: The numbers you see in your bank account are called bank deposits, a separate type of money that is created by commercial banks
      • A bank deposit is an IOU from a bank that can become worthless if the issuing bank goes bankrupt
    3. Central bank reserves, a special type of money issued by Fed that only commercial banks can hold
      • Much like a customer’s bank deposit is an IOU from a commercial bank, a central bank reserve is an IOU from Fed
    4. Treasury securities - a type of money that also pays interest
  • Central bank reserves are created when central bank buys financial assets or makes loans. The central bank is the only entity that can create central bank reserves, so the total amount of reserves in the financial system is completely determined by central bank actions
  • Central bank reserves never leave the Fed’s balance sheet, but they get shuffled around daily as commercial banks settle payments with each other
  • Bank deposits - bank simply creates bank deposits out of thin air when it makes a loan
  • The central bank acts as a bank to commercial banks, and commercial banks acts as a bank to nonbanks like individuals and corporations
  • Bank deposits are the most common form of money, they are also the least secure
  • There is a difference in the degree of moneyness of Treasuries when compared to other types of money
  • Treasury securities are how the U.S Treasury creates money
  • Treasury market broke for a brief period during COVID-19 panic of March 2020
  • There are 15 billion 100 dollar bills as compared to 13 billion 1 dollar bills and 11.5 20 dollar bills
  • Despite the large number of 100 dollar bills in circulation, most Americans rarely use or see a 100 dollar bill in their day to day life. Research suggest this is because most of the 100 dollar bills are held abroad

Money Creators

  • There are three entities that can create money: Fed, Commercial Banks and Treasury
  • Fed creates money by buying treasuries and then increasing the reserves of the bank from which it is buying the treasuries or increase the reserves of the non-financial entity’s bank.
  • Fed also offers a discount window from which banks can directly exchange their treasuries to money at a discounted rate
  • Commercial banks operate fractional lending. This means that if they have $5 dollars of deposits, they can actually lend $100 worth of loans
  • The two main risks of a commercial bank are insolvency and lack of liquidity
  • Fed has a duel mandate - full employment and stable prices
  • Longer dated Treasury securities are less sensitive to changes in the overnight interest rate, so the Fed tries to indirectly influence them through QE
  • Open Markets Desk at Fed does two things
    • Executing open market operations like quantitative easing and collecting market intelligence
  • Fed’s goal with QE is to lower longer-term interest rates, with the increase in reserves and bank deposits being a necessary byproduct
  • QE converts Treasuries into bank deposits and reserves, thus forcing commercial banks as a whole to hold more of their money in the form of central bank reserves
    • Forced to trade treasuries for bank deposits, nonbanks can trade their bank deposits for external high yield instruments
  • Treasury does not decide how much debt to issue; that is determined by the federal government deficit, which is a result of decisions by Congress
  • Treasury decides how it will go about funding the deficit
  • Fed usually looks at issuing short-term debt to meet unexpected adjustments
  • Banks consider discount window as the last option as that would signal to the market that something is wrong with the bank and there could be bank run

The Shadow Banks

  • Shadow banks are non-commercial-bank businesses that engage in banking-like activity
  • They cannot create bank deposits the way commercial banks can, so instead, they borrow from investors to fund their assets
  • Shadow banks generally operate under less restrictions. They do not have access to discount window and have to rely on alternative private sector protections
  • The basic business model of a shadow bank is to use shorter-term loans to invest in longer-dated assets.
  • Shadow banking system includes dealers, money market funds, ETFs, investment funds and securitization vehicles
  • Primary Dealers
    • Group of dealers that have the privilege of trading directly with Fed.
    • There are 24 primary dealers mostly associated with large foreign or domestic banks
    • They also act as financial intermediaries
    • There are situations where Fed had to bail out primary dealers(Bear Stearns)
  • Money Market Funds
    • Investment vehicle that invests only in short-term securities and allows investors to withdraw their money at any time with next-business-day availability
    • MMFs are subject to regulations that tightly control the credit quality and tenor of the investments they can make
    • They are broadly divided in to govt MMFs and prime MMFs
    • Mostly short term with a max of 397 days duration
  • ETFs
    • In the 2020 COVID-19 panic, investors sold ETF shares so aggressively that many ETFs were trading significantly below fund asset values
    • Institutional investors were having trouble arbitraging because the underlying stocks were not liquid
  • Mortgage REITs
    • These are investment funds that invest in MBS, usually Agency MBS guaranteed by Fannie Mae or Freddie Mac. They are classic shadow banks that take out very short-term loands to invest in long term assets.
    • They also take up massive leverage to give attractive yields
    • During the 2020 Covid-19 panic, there were significant dislocations across markets, including the usually very liquid Agency MBS market. Over a course of few weeks, mREIT investors lost over half of their investment
  • Private Investment Funds
  • Securitization

Eurodollar Market

  • Eurodollars are U.S dollars held outside the United States. They are called Eurodollars because the first offshore dollars appeared in Europe in 1956
  • Eurodollar futures inferred yield curve gives an indicator of the interest rate that non-US investors have to pay today to secure a US loan in the future
  • It is estimated to be 13T
  • Many countries find it easier to issue dollar denominated debt even when the funding need is in the local currency. Once the dollar debt is issued, they look out for parties that can help them do a swap transaction
  • Why do Chinese hold treasuries ? Because of TINA
  • Onshore deposit taking institutions have around 20T usd in dollar liabilities. Foreign bank dollar liabilities booked outside of the US are around 10T usd. FDIC reports sow that 1.4T usd is in deposits in their offshore branches
  • Stricter regulatory requirements as compared to offshore regulations meant the banks were trying to open up offshore branches to shore up their deposit bases.
  • Fed has been willing to be lender of last resort to foreign banks too, in times of crisis
  • All the US dollar transactions happening anywhere in the world should ultimately flow through US. Hence US has tremendous power to shut anyone out of the banking system
  • Offshore U.S Dollar Capital Markets
    • Borrowers can also obtain dollars by issuing dollar-denominated bonds outside the US.

Interest Rates

  • The Fed controls short-term interest rates through its control over overnight interest rates. By setting a target range for the federal funds rate, the Fed is able to exert influence through the short-term interest curve as market participants use the overnight rate as a reference for what the rate for slightly longer tenors should be.
  • Fed controlled the fed funds rates by controlling the quantity of bank reserves in the banking system. However after QE, that method became ineffective
  • In the current world with very high level of reserves, Fed controls the fedfunds rate by adjusting the interest rate it offers on the Reverse Repo Facility and the interest it pays on reserves that banks hold in their Fed account
  • RRP puts a floor on the interest rate
  • Old school fed funds rate as a policy tool
    • Influence the Interbank lending rate
    • Print money, buys Tbills under 1 year of duration, investors deposits the money at banks and now banks are awash with money. The larger supply of money brings down the price of money and hence drives the interest rate
  • New school post GFC
    • Fed prints money and buys long term debt. They inject money in to the system that fed funds rate could be massively low. To limit the fed fund rate a floor, Fed pays IOER, interest on excess reserves to the banks that park their reserves
    • The above works as a floor for fed funds rate in a way. But there are shadow banks that cannot park at Fed. So, there is a chance that they can crash the short term rates. Fed controls via reverse repo market and hence controls the floor of Fed Funds rate. This makes sure that Fed funds rate is with in the permissible limit
    • Discount rate - This is the rate at which distressed bank can knock on Fed’s door and get money
    • Repo Market - Anyone can play in this market. Banks are buying and selling with each other.
  • Repo
    • Big bank parks its treasuries at Fed and in turn gets dollars
    • The next day, the money goes back to Fed and the securities go back to the Big bank
    • There could be term repos
    • Net effect is to move treasuries in to Fed’s balance sheet and move money to big banks balance sheet
  • Reverse Repo
    • Flip side to repo where Fed moves treasuries to bank and sucks up liquidity from the banks
  • Why Reverse Repo has hit 2 T ?
    • Banks have too much in deposits
    • Commercial banks have deposits as a liability
    • Huge surge of deposits - Larger balance sheets
    • Bank reserves have spiked is about 3.3T
    • Put your money in money market funds
      • Money market funds had have huge set of inflows
      • They are using reverse repo markets
    • Rise of stable coins
      • These coins are also using reverse repo markets
    • From the view of money market fund manager, reverse repo gives greater yield to 1 month treasury
    • Less issuance of T Bills
    • 2yr, 3yr, 5yr, 7yr, 10yr have been increasing
    • Very clear demand supply among the various duration bills
    • Money market funds make up the bulk of reverse repo markets
    • People are derisking portfolios and moving in to money market funds. This has increased demand for reverse repo markets.

Money Markets and Capital Markets

  • Markets for short-term loans with maturities that range from overnight to around a year
  • There are secured and unsecured money markets.
  • Secured money markets are markets for short-term loans that are secured with financial assets as collateral
  • The two largest segments of secured money markets are the repo market and FX-swap market
  • Repo transaction structure is advantageous from a bankruptcy law standpoint; even if the borrower files for bankruptcy, the lender will be allowed to seize the collateral because it has technically been sold to them. If the transaction were structured as a secured loan, then the lender would have to to go through bankruptcy court before seizing the collateral. In practice most repo transactions are overnight loans collateralized by safe assets including U.S Treasuries and Agency MBS
  • Size of repo market is about 3.4T usd
  • Pre 2020, hedge funds are big buyers of treasuries - cash futures trade
  • Mar 2020: Many funds got broke because of cash futures arb
  • Smooth QT can happen only if hedge funds buy treasuries
  • Repo market is the essential link that allows Treasury securities to be “money”
  • Repo market allows a borrower to take a large position with just a little bit of their own money
  • Primary cash lenders in the repo market are money market funds, who lend around 1T usd each day
  • In the recent years, the Fed has become an active borrower and lender in the repo market through its Repo and Reverse Repo facilities. The two facilities are used by the Fed to control repo rates. The reverse repo markets helps the Fed maintain a floor for repo rates because it provides money funds with strong bargaining power against dealers. The repo facility acts as a soft ceiling for repo rates
  • Every day repo markets trade 2 to 4 trillion dollars every day
  • Repo markets as a short term loan
  • Reverse repo markets helps one to get some juice out of the cash lying
  • Repo markets are usually over collaterized
  • Fed buys bonds to inject cash in to the system. Fed could sell bonds to suck cash from the system
  • Repo market has three major segments - Tri-party, uncleared bilateral and cleared FICC
    • Triparty (2.2T usd)
    • Cleared FICC(1T usd)
    • Uncleared (No available data)
  • Agency ABS are mortgage-backed securities guaranteed by the government.
    • Second largest market for bonds in the U.S with over 8.5 T usd outstanding
    • Minimal credit risk and are very liquid
    • Slightly higher return than Treasuries
    • Significant demand worlwide
    • In early 2000s, there was a booming market for securitized private-label mortgage-backed securities
  • Corporate Bonds
    • Market is divided into an investment-grade universe and a high-yield universe
    • About 85 percent of corporate bonds are investment grade and the rest are high yield
  • Debt Capital markets
    • The bond market is segmented into different subclasses, the largest of which are Treasury securities, mortgage-backed securities, and corporate debt. Other notable segments are municipal bonds and asset-backed securities

Crisis Monetary Policy

  • Post GFC, Fed set up lending facilities for the primary dealers, for money market funds, and securitization vehicles
  • Fed became the lenders of last resort not just to the commercial banks, but also to the shadow banks
  • Fed decided to lend to foreign banks by establishing central bank swap lines with a roster of friendly foreign central banks
  • Fed chose to address moral hazard in another way: regulation. In the aftermath of the crisis, the Fed and regulators across the world enacted much more stringent regulation on banks such that they would be unable to undertake the levels of risk they had before.
  • Fed’s new tools - forward guidance and quantitative easing
  • QE - amount of money did not change - only the composition changed. There were fewer treasury securities and more central bank reserves
  • Yield curve control is one of the new monetary policy tools gaining traction in the central banking community

How to Fed Watch ?

  • FOMC Statement
    • highly classified but is declassified to the public several years after publication
  • FOMC Press conference
  • FOMC Minutes
    • Released three weeks after the FOMC meeting
  • FOMC Dot plot
  • Federal reserve speeches
  • Desk Operating Statements
  • Fed Balance Sheet
  • Desk Surveys
  • Federal Reserve Research by 400 PhDs in Fed
  • Federal Reserve Surveys
  • On Aug 27, 2020, Chair Powell announced the Fed’s new monetary policy framework at the annual Jackson Hole Economic Policy Symposium. The framework made two significant changes to how the Fed conducts monetary policy
    • average inflation targeting: The Fed has officially adopted an average inflation targeting framework where past undershoots of its inflation target would be met with overshoots, such that the average inflation over a period of time would be around 2 pct.
    • asymmetry in maximum employment: Employment higher than the Fed’s estimated maximum level would not encourage the Fed to raise its policy rate. Low unemployment rate will no longer factor into its decision in tightening monetary policy
  • MMT is an ascendent school of economic thought that is laying the theoretical framework for a revolution in fiscal policy. MMT postulates that a government issuer of fiat currency is not constrained by taxation or debt, but only by inflation. Taxation and debt issuance are merely tools through which the government manages inflation.

Notes from fedguy.com and Others

  • M2 has exploded by 3T usd in 2020
  • M2 largely comprises different types of bank deposits including demand deposits, saving deposits and time deposits
  • Banks create money but banks are subject to regulations on the size and composition of their balance sheet. The regulatory costs must be taken into account whenever the bank makes a business decision to borrow or lend
  • The purpose of these regulation is to make the banking sector safer, with many enacted in response to GFC in a package of reforms known as Basel III
  • There are many constraints
    • Asset Quality
    • Size
    • Liquidity
  • Banks Create Money
    • Bank creates a money out of thin air when it creates a loan
    • It does not need to borrow to lend
    • But the power to create money comes with a lot of regulation
    • After the loan is made, the bank increases the balance sheet. On the liability side, it creates a entry of new deposits
  • Capital Ratios
    • Capital ratios are intended to make sure a bank has a cushion to absorb potential losses on its assets. It is calculated on a risk weighted basis, where riskier assets require a higher capital cushion
    • Capital - absorbs the losses on assets so that depositors do not take losses
    • A typical capital ration is a bank’s capital divided by its risk weighted assets
    • If two banks have the same liability profile and have different asset profiles the capital ratios are different
  • Leverage Ratio
    • A constraint on the ratio between assets and capital(usually equity). This is to create a cushion where losses on assets will be absorbed by capital before hurting depositors
    • Leverage ratios are not risk weighted, so don’t account for how risky assets are. It is intended more as a backstop for risk weighted regulations
    • All U.S bank subject to minimum 4 percentage FDIC leverage ratio
  • Liquidity constraints
    • Basel III regulations force banks to 1) hold lots of high quality liquid assets and 2) reduce short-term borrowing
  • CME FedWatch tool used 30 day fed fund futures price to gauge the probability of an upcoming rate hike
  • FedWatch tool culls out probabilities from Fed Funds Rate futures contracts traded in the market
  • Treasury accepts payments only in reserves
  • Money never leaves a reserve account. It is a closed account
  • Only Fed can increase the level of reserves by creating money out of thin air
  • Fed’s checking account is called Treasury General Account
  • QE needs to be understood by what happens to the assets and liabilities of a balance sheet for four different cases
    • Bank Investor does a transaction with a bank primary dealer
    • Bank Investor does a transaction with a non-bank primary dealer
    • Non Bank Investor does a transaction with a bank primary dealer
    • Non Bank Investor does a transaction with a non-bank primary dealer

Takeaways

I have learned a ton of stuff from this book. I had a vague sense of the “what central banking is and what it does ?”. Reading this book definitely helped me get a bit more clarity on the purpose of Fed. This book is a well written book that explains the mechanics of Fed in simplified language. The book uses balance sheet illustrations in the initial chapters of the book that are very helpful to any reader in getting a good grasp of the various interactions between Fed and other market players. The book also goes on to give a decent overview of various types of markets. The last section of the book also gives a set of tools and pointers to understand the implications of various policy measures. Overall, a wonderful book to read and possibly re-read at frequent intervals. Fed being the lender of last resort for pretty much all sorts of markets in US is a powerful entity. Day in day out, there are articles/blogs/videos talking about Fed’s actions. This book helps the reader to understand the basics around central banking and make him or more educated about this topic. I am definitely going to re-read it sometime in the future.