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On May 1st, the Federal Open Market Committee announced that it would begin to taper the pace of Quantitative Tightening (QT), reducing the monthly cap on run-off from its Treasury portfolio from $60 billion to $25 billion. It will continue to let its Agency mortgage-backed securities (MBS) portfolio run down at $35 billion monthly. Still, going forward, it will reinvest all principal repayments from that portfolio that exceed the cap into Treasury securities. Notably, since QT began in June 2022, the average pace of run-off in the Fed's Agency MBS portfolio has been less than $13 billion. By contrast, Treasury run-off has averaged $56 billion monthly since QT began.

Consequently, its System Open Market Account (SOMA) portfolio of Treasurys and Agency MBS, which equaled $8.5 trillion in June 2022 and now equals $6.8 trillion, is more concentrated in Agency MBS today than it was then, increasing from 32% of SOMA when QT began to 40% of SOMA this month. In addition, because of the extension of the average life of its Agency MBS portfolio, what little reinvestment it has done in current coupon bonds has done very little to increase the average book yield on its portfolio, which only crept up from a 2.46% weighted average coupon when the Fed began QT to 2.52% this month.

In Q1 2024, the Fed earned interest income of only $39 billion on its discount window lending, the remaining balance of its Bank Term Lending Program (BTFP), which fell from $160 billion last February to $110 billion this month, and its SOMA portfolio. By contrast, it paid out $51 billion to banks as Interest on Reserve Balances (IORB) and another $12 billion to money funds and other eligible counterparties as interest on its Reverse Repo Facility (RRP). The balance of reserve deposits has remained unchanged since QT began, holding at $3.4 trillion. Still, the RRP balance, which equaled $2.4 trillion a year ago, is now down to $0.5 trillion, a level at which it appears to have stabilized in recent months.

The Fed's $24 billion net interest expense last quarter continues to build as a negative liability representing an IOU to the U.S. Treasury. This month, cumulative negative Treasury remittances reached $170 billion. Although the balance sits opposite SOMA on the liability side of the Fed's balance sheet alongside the RRP and bank reserves, as the balance grows more negative, reserve deposits increase, the same as if the Fed had increased SOMA, which is an asset, or reduced the balance of the RRP or any other liability. Given the Fed's current plans for its terminal balance sheet, it will likely take years for the Fed to reverse the negative liability on its balance sheet.

Bank treasurers continue to tell the newsletter that examiners are guiding them to preposition collateral at the Fed should they need to borrow funds in an emergency. They also discourage banks from turning to the Federal Home Loan Banks (FHLB) for an advance. Thus, commercial banks increased the collateral held at the discount window by $600 billion in 2023 to $2.6 trillion, a third of which are securities. Despite its promotion as a "lender of last resort," under Section 10B, "Advances to Individual Member Banks," section b, note 4, the Fed has discretion. It is not required to lend to a bank, regardless of its safety and soundness status.

The reserve deposits are a component of the money supply, along with currency in circulation, checking deposits, money market funds, and other forms of ready money. Yet the supply of reserves is a critical condition for the smooth operation of the financial system banks use to make payments to other institutions over Fedwire. In addition, reserves are a preferred component of a bank's high-quality liquid assets and a source of risk-free overnight interest income. On an average day, more than $3.3 trillion in interbank payments pass over Fedwire, connected to payments for securities settlement and international payments. Despite the ample supply of reserves, more than double the supply in the system before March 2020, the system is vulnerable to crisis, as banks remain reluctant to send payments on Fedwire without receiving an equal payment simultaneously. The slightest worry that a payment may not come in is enough to stop a payment from going out. The median expectation in the Fed's latest survey of market participants conducted last March before the Fed had unveiled its plan to wind down QT this year was that the Fed would not let the balance of reserves fall below $3.0 trillion.

This month's newsletter is dedicated to the memory of Gerald "Gerry" Corrigan, president of the New York Fed from 1985 to 1993. He was known as the Fed's plumber for his detailed understanding and appreciation of the mechanics of the financial system. A crisis manager, he was the Fed's eyes and ears, knowing all the key players in the markets, the banks, and the central banks to call in an emergency. His career spanned several global banking crises, primary bank legislation rolling back Glass-Steagall Act restrictions on the industry, and the introduction of Basel risk-based capital. Believing that banks are special, he greatly supported bank regulation. At the same time, he thought that because they are special, even if it is politically distasteful, the Fed has no choice but to intervene to save a bank to prevent more comprehensive damage to the financial system if it were left to fail instead.

The Bank Treasury Newsletter May 2024

Dear Bank Treasury Subscribers,

Though he never was one during his 25-year career with the Federal Reserve, Gerry Corrigan would have made a great bank treasurer. He began his career in 1968 when, as a newly minted Doctor of Economics from Fordham University in the Bronx, he went to work at the New York Fed in the economics research department. From 1988 to 1993, when your editor-in-chief was a financial analyst in the Bank Supervision Department, he was his boss’s, boss’s, boss’s, boss’s, boss’s, boss’s, boss, and so was in regular contact with the newsletter.

His career at the Fed spanned volatile interest rate cycles, market crashes, several financial crises, and headline-grabbing bank failures, including the implementation of significant legislative and regulatory changes, such as the Basel 1 Capital Accord, the relaxation of Section 20 of the Glass-Steagall Act, and the expansion of interstate branching. It coincided with the invention of new financial products, including mortgage-backed securities and interest-rate swaps.

During his tenure at the Fed, revolutionary information technology and telecommunications advances transformed the financial system, including the introduction of automated teller machines in the early 1970s. A key participant, not just a witness to this history, he retired in 1993 as the New York Fed’s sixth president, seventh if you count Benjamin Strong, who had the title of governor, not president. Born in 1942, he passed away on May 17, 2022, and is gone but not forgotten here at the newsletter.

He would have been a perfect fit to run a bank treasury department, not just because he met its minimum qualifications. Bank treasurers, for example, need to be good with math. As an economist, he would have known more than just how to add, subtract, multiply, and divide without having to take off his socks and shoes. And a solid grounding in bond math should not have been a problem for him, which is not precisely rocket science. There is no question he would have been familiar with the acronyms GDP, CPI, PPI, and NFP. And if a requirement for the job is understanding the yield curve and the term structure of interest rates, beyond maybe just which end is supposed to be up and which end down, who better than a PhD to figure out the economic arguments that balance risk and return?

An accounting background is not bad for the job, and he had a keen appreciation for accounting, having headed the New York Fed’s accounting department at one point during his career. Maybe he would not have known all the debits and credits involved in multi-layer hedge accounting or be the master at demonstrating hedge effectiveness. However, he would have appreciated why protecting the balance sheet for a scenario where the Fed indefinitely delays rate relief and possibly even raises rates a bit more might be a good idea.

When he met with bankers and board members during his time at the Fed, he had no trouble delivering blunt news and called it like he saw it. He would not have missed the financial implications of being stuck with an underwater bond portfolio locked up in held-to-maturity (HTM). Nor would he have had trouble putting it all together with concepts such as shareholder value and knowing why banks that perpetually underperform shareholder expectations do not last long as independent banks.

Mr. Corrigan, as your editor-in-chief knew him, would have checked all the boxes for the job in terms of basic knowledge. However, he would have been great mainly because he was the go-to guy who solved emergencies. If there is one requirement for the job of bank treasurer that CFOs and CEOs would list, it would be solving emergencies and heading off problems before they become full-blown emergencies. Managing a crisis in the financial system requires an understanding of its plumbing. How, for example, the shadow banks connect with the traditional banks, where flows are coming from and where they are going. Plumbers understand something about pressures and stresses in the piping, and where to find them.

He was known as the Fed’s plumber, the person the chairman would call in a crisis. A good plumber can hear a sound in the pipes and know precisely where to look for a clog. But they can do this because they know how the pipes are connected and the strength of those connections based on years of experience replacing them when they wear out, putting them together, and taking them apart.

Bank treasurers know their bank, how it makes its money and who with and why. They do not only know how much the net interest margin may have widened or narrowed last quarter and the changes in rates and volumes to explain the trend in net interest income. They know the people behind the numbers. They know by name the heads, assistant heads, and junior heads-in-training in each department who to call in the accounting, compliance, legal, risk approval, and control departments when things do not work out as planned.

And they do not only pay attention to internal connections. They spend their time talking to both sides of the balance sheet, borrowers and savers, staying in regular touch with the bank’s examiners and investors, and keeping up to date with developments in financial markets and the economy. The best bank treasurers have connections everywhere.

With this quality network at their fingertips, they have an early warning of problems before they become emergencies. They know how to untangle those inevitable snags in crossed wires that arise late in the day before a long weekend when everyone is waiting to go home. And this is why they are every CEO and CFO’s first call. They are the ones who know what to do and who to call in turn to get help when needed.

Because it takes a financial system, and they know everyone in it.

Right out of college, maybe they started in the accounting or audit department or clerked on the treasury desk. They probably all have stories about when they were junior assistant heads of bank treasury hanging out on the Fed funds desk and bonding with other junior assistant heads on a Friday late in the day, waiting to receive an incoming payment so they could send out other payments on Fedwire and go home. That is how they know how things work in the bank because they did them.

At 6’2” he spoke slowly and deliberately, his characteristic gravel voice drawing attention. Looking back on his career, he told an interviewer in 1990, he valued his diverse experiences at the Fed,

“I've had the good fortune of working in a number of very varied areas. In my early years at the New York Fed, I believe I worked in 10 or so different departments…I was president of the Federal Reserve Bank of Minneapolis…I served…as chairman of the Federal Reserve's Pricing Policy Committee…I experienced a whole raft of things I would ordinarily not have come in contact with. And that kind of experience sticks.”

Knowing everyone helped when, as president, he had to set priorities for the New York Fed and rely on a team of people to implement them. He continued,

“One thing that helps that process, at least from my perspective, is that the vast majority of the people in the New York Fed are people I've known for years; I've worked with them for years. They know me and I know them and that helps.”

The irony was that he never wanted to work at the Fed, as he told an interviewer in 2009,

“As I was finishing graduate school…I declined a job offer at the New York Fed. Instead, I chose to work with Vassil Leontief in the Commerce Department. In those days, Leontief was working on a new approach to national income accounting. To somebody fresh out of graduate school, the attraction of Leontief and that project at the Commerce Department was pretty high-profile stuff. But my wife, who was carrying our second child, had a difficult pregnancy, so moving to Washington was out of the question. I had to renege on the job at the Commerce Department. With great humility, I picked up the phone, called the New York Fed, and explained what had happened, with the hope that the job offer that had been extended to me some three months earlier was still open. It turned out that it was.”

The best bank treasurers do not necessarily come from the best graduate schools. Gerry Corrigan certainly did not match the academic pedigree of his colleagues in the New York Fed’s economic research department.

“At age 30, here I was, a kid from Fordham surrounded by all these people from Harvard, MIT, and Berkeley.”

When it comes to successful careers, it pays to be in the right place at the right time. Right after he joined the New York Fed, he caught the attention of Charlie Coombs, who ran the Fed’s foreign exchange desk, and Alan Holmes, who managed the Fed’s Open Market Account. Foreign exchange rates were volatile back then, and Coombs and Holmes were trying to devise a plan to control them. As he recounted, they put him to work as their number cruncher which gave him a seat at the conference table with the who’s who of the central banking and commercial banking worlds.

“I was doing minor tasks—putting together numbers… I was doing ministerial tasks. Somehow or other, these two guys recognized me, and, in rapid order, I found myself at the table.”

Seven years later, he became Secretary to the Board of Directors of the New York Fed, a role often bestowed by the Fed’s senior management on up-and-comers. In that position, he met Paul Volcker, who had just become the fourth president of the New York Fed in 1975.

“When Volcker arrived at the New York Fed, I was still a young guy and was the Secretary of the Bank. I had never met him before, and I didn’t know anything about him, except Alan Holmes kept telling me that he was a good guy. Within a matter of weeks or months after his arrival, Volcker called me and said, “The back office here at the New York Fed is a mess,” which it was. He said, “I need your help cleaning this up for me. For now, we’re going to put you in charge of the accounting department.” I thought, “The accounting department?” But naturally I said, “Okay, if we need to clean this up, I’ll give it my best shot.” Volcker knew what he was doing. It turned out to be an unbelievable learning experience for me. The New York Fed, through its operational presence, was the nerve center of the international financial system. I had no clue about that.”

In a separate interview, Paul Volcker remembered it much the same way,

“I realized Gerry was on top of things and was very intelligent, so I used him. I put him in several different places to broaden his experience. He ran the operations of the Bank at some point, or at least a big part of it. The New York Reserve Bank had been subpar in operations, and I took pride in improvements in efficiency. Gerry was head of personnel. That was an important position at the Reserve Bank. I think he had some operational responsibility. He never went back in research.”

The accounting department was critical to the New York Fed’s plumbing. Yes, he may not have been approving discount window loans. He did not have to worry whether to invoke rule 10B of the Federal Reserve Act, “Advances to Individual Member Banks,” section b, note 4, that says the window can deny a loan to any bank, well-capitalized or not. But as he said, what he learned in the accounting department was very educational,

“It wasn’t discount-window lending approval, but it was recording those loans, among other things, running Fedwire and the Treasury–Fed book- entry system and all that stuff. It was an unbelievable eye opener. For decades since, I have been one of the people who has put all kinds of emphasis on the “plumbing” of the financial system. Back then was when I learned about it.”

He probably would have been busy in accounting if he had remained there, as the Fed expects bank treasurers to borrow from its window when they need cash instead of the FHLBs. In addition, to increase the industry’s preparedness to use the window during an emergency, bank examiners are pushing bank treasurers to preposition more collateral with the window. Prepositioned collateral from commercial banks increased by almost $700 billion in the last year, to $2.6 trillion, of which loans accounted for two-thirds of the collateral’s value.

He went in as vice president of the accounting department and worked with Walter Rushmore, the department’s assistant vice president. It was 1975, and computer automation at the Fed was meeting resistance from people like Walter, who revered pen and paper. Walter Rushmore was old school, he recalled,

“As I recall, Walter did not have a college degree. He started as a messenger at the New York Fed, like, 45 years earlier. He had worked up through the ranks on the back-office side. One time I said to Walter, “We’re going to automate the general ledger.” Rushmore looks at me and said, “No, we’re not.” I said, “What do you mean, ‘No, we’re not’? It turned out that Rushmore’s view of the general ledger was that it had to be posted in fountain pen even if it meant posting it at three o’clock in the morning. For Rushmore…once you put those numbers in there in fountain pen, you couldn’t change them. Rushmore said to me, “You’re not going to automate the general ledger until after I retire.” And you know what? It didn’t get automated until after he retired.”

He returned from his tour of duty in accounting with a deep appreciation for how the institution operated. As he said,

“These were the kinds of things that I began to appreciate about the Federal Reserve. For me, the magic of the New York Fed was shaped by the crazy quilt patterns of these little things that happened when I was still a very young man.”

The experience prepared him for the nitty gritty details that crisis managers must handle with care in a financial crisis. Herstatt was a good example. Herstatt Bank was a small, privately owned institution based in Cologne, Germany. In 1974, it was the 35th largest bank in the country in terms of asset size. The foreign exchange markets were all over the place back then, roiled by sizeable payment imbalances between industrial countries thanks to petrodollars flooding the global markets.

Speculative trading in the foreign exchange markets surged. Unfortunately, Herstatt bet wrong big time, suffered huge losses equal to a quarter of its balance sheet, and collapsed. Like Silvergate Bank, the crypto bank that started the whole slide into mayhem last year, it was a small bank that triggered a more significant financial crisis.

It did not help that bank supervisors in Germany made the situation worse. As he began the story,

“Herstatt became an incident because the German authorities made the mistake of announcing, during a business day, that Herstatt was bankrupt and was being put in the German equivalent of receivership. We have long since learned that you don’t do that when banks are open. You wait until they’re closed.”

Which is generally true, except when bank supervisors have no choice. The FDIC closed Silicon Valley Bank (SVB) on a Friday morning, which only emphasizes the dire situation it was in when it failed. The German authorities closed Herstatt Bank at 4:30 PM local time, six time zones ahead of New York where it was still morning, but still close to closing time in Cologne, Germany. Time zones may not have mattered much to the local German banking authorities forced as they were to step in when they did. Still, in 1974 before later changes in the payment settlement process in foreign exchange eliminated what became known as Herstatt Risk, time zone differences mattered a lot.

The payment system rests on trust and a clearing house functions to bolster that trust by standing in as a counterparty to every transaction. For example, the Clearing House Interbank Payment System (CHIPS) is private and the leading international clearing house for foreign exchange transactions. Everything was going along fine until, one day, Herstatt failed. He continued with the story,

“While Herstatt was a relatively small bank, it had a significant presence in foreign exchange markets. The CHIPS was the mechanism through which…foreign exchange–related payments between banks were netted…and settled. But…for the netting down to work, because of the differences in time zones, among other things, you had to have debits and credits together at the same place and the same time so you could do the netting.”

And here is why all financial systems, from payments to trading, are vulnerable to moments of crisis,

“Suppose, for example, Lloyds Bank was owed 100 million Deutsche Marks by J.P. Morgan, and that J.P. Morgan was owed 100 million Deutsche Marks from Herstatt; then if J.P. Morgan can’t get the 100 million Deutsche Marks from Herstatt, it can’t pay Lloyds. That’s the essence of it. When the counterparties in CHIPS found out that day that Herstatt was bankrupt, all hell broke loose, because they said, “Since I don’t know if I’m going to get my money from Herstatt, what do I do about the money I owe in the CHIPS system?”

It is all about the plumbing, he continued,

“This was the first living, breathing example of a situation in which the plumbing of the system was suddenly at risk in ways that most people hadn’t even thought about. It was just an act of faith that you would receive the payments from Herstatt into CHIPS and that your own outgoing payments could be safely made with the payments you were to receive from Herstatt and other banks. All of a sudden, that act of faith was a nightmare. This was a real wake-up call.”

“Herstatt” risk could be a thing of the past in foreign exchange markets, but markets will always be vulnerable to panics. There was panic in the repo markets on September 15, 2019, when tax payments caused an increase in the Fed’s Treasury General Account, which led to a shortage in reserve deposits, which caused overnight repo rates with Treasury collateral to surge several hundred basis points above the target Fed funds rate. The Fed responded by adding more reserves and lowering the range of the target Fed funds rate.

However, more reserves and a lower Fed funds rate were not enough when the next panic came in March 2020. The market needed more comforting, and the Fed obliged by adding even more reserves and cutting rates to 0%. And then came the failure of SVB and Signature Bank last year, which might have created more problems for markets if not for the Fed’s fast response to launch the Bank Term Funding Program.

Bank behavior over Fedwire is an excellent example of how the level of reserves does not prevent its hoarding by banks, especially when they have concerns about the financial health of their counterparties. Unlike CHIPS, the Fed does not net payments on Fedwire, and it processes each payment individually during business hours from 9 AM to 7 PM EST. Fedwire handles more than $3.3 trillion in daily payment volume, so with U.S. GDP equal to $28.3 trillion, the U.S. economy turns over every eight days on the system. According to a study by the New York Fed in 2022, even with $3.4 trillion in reserve deposits, $2 trillion more than was outstanding on September 15, 2019, Bank A will only pay Bank B when it gets paid by Bank C.

As the authors found,

“Before the Global Financial Crisis (GFC), banks…maintained small reserve balances…They relied heavily on incoming payments to accumulate sufficient balances to make outgoing payments. The reliance on incoming payments implied…a high degree of strategic complementarity among system participants, whereby the willingness to make payments promptly was greater when other system participants did so. Strategic complementarity gives rise to potential gridlock scenarios whenever a cautious stance by banks that wait for sufficient incoming payments before making outgoing payments slows down the system as a whole.”

The topic of strategic complementarity faded after the GFC after the Fed adopted an ample reserve policy, but as the authors found,

“Discussion…faded from view after the GFC, with the large expansion of reserve balances at the central bank. The conventional wisdom has been that large reserve balances maintained by banks reduced or eliminated the reliance on incoming payments to make outgoing payments. This conventional wisdom turns out to be false. In an empirical investigation of the Fedwire system in the United States, we find that strategic complementarity of payments is alive and well.”

If members need to borrow funds to complete a payment in anticipation of a payment they expect to receive on the same day, they can borrow funds and repay them before the close of business. However, ample reserve policy has meant that banks borrow even less from the daylight overdraft window and still hold off making payments until payments are received (Figure 1).

Weekend hours on Fedwire may also change a bank treasurer’s appetite to hold more cash, especially before weekends when the capital markets and the FHLBs are closed, and a large payment could come through the system. To prepare, they could draw down on their FHLB advance on Fridays, or perhaps they might try out the discount window under prodding by the Fed, or maybe they will shift to generally holding more reserves instead of securities or loans. In any case, the digitalization of deposits and services, such as FedNow, will continue to push the financial system to operate 24X7, and banks stockpiling more cash on balance sheets and generating lower returns to shareholders.

Cyber risk is a topic in the Fed’s latest Financial Stability Report, underscored last year when ICBC suffered a ransomware attack that led to a brief halt in Government securities trading. However, computer system disruptions are not a new risk or concern. In 1985, a computer bug in newly installed software at the Bank of New York (BONY) nearly brought down the securities trading industry. As Mr. Corrigan told the story, when he was president of the Minneapolis Fed, he wanted to create a backup system for the Fedwire, but nobody would listen,

“There was a massive computer failure at the Bank of New York (BONY) in November 1985, 10 months after I became president of the Federal Reserve Bank in New York. The Herstatt crisis had had a big impact on me. In part because of the Herstatt crisis and a few other lesser events, I had been arguing for some time that the New York Fed had to have a fail-safe backup redundant processing system so that Fedwire simply couldn’t go down. Nobody wanted to listen to me, because, back then, such a facility would be extremely expensive.”

But then,

“But then I had the “good fortune” of the Bank of New York computer failure. As it is today, BONY was one of the two clearing banks for government securities on the Fedwire system and was the interbank correspondent bank for dozens of other banks, both foreign and domestic.”

Today, the risk that a computer failure could imperil securities clearing is even more severe than it was 39 years ago, as just one securities clearing bank remains. But it was November 21, 1985, a week before Thanksgiving, and Mr. Corrigan was just about to walk into a meeting of the New York Fed’s board of directors. Suddenly, who should appear but the New York Fed’s general counsel,

“One Thursday afternoon I was going into a regular board meeting at the New York Fed. Ernie Patrikis, who was the general counsel, stopped me when I was walking into the board meeting and said that the Bank of New York had this computer failure, and nothing was moving. BONY was supposed to process and deliver all of the transactions and government securities on the Fedwire, but nothing was happening. Because nothing was happening, BONY had a big cash overdraft in its account at the New York Fed.”

The BONY crisis was a perfect example of the benefits and perils of Fed intervention, as a 2015 study by the Richmond Fed concluded. Some banks are too big to fail, regardless of the moral hazard created by saving them. Wasting no time on such weighty dilemmas, Mr. Corrigan sprang into action and ordered Patrikis to get on the phone,

“So, I said to Patrikis, “I don’t like the sound of this. Call J. Carter Bacot.” He was then the chief executive officer of the Bank of New York. I said, “Let’s get a supplementary discount loan agreement in place for BONY where, if we had to, we can take as collateral for a discount window loan everything down to the flower pots.” Patrikis called J. Carter Bacot, and Bacot said, “Well, you know this thing will get fixed,” but he signed this supplemental discount window agreement under which we possibly could end up taking the whole bank.”

But all that did was buy time, and time ran out. The midnight hour was near, and that was the end. As Mr. Corrigan explained,

“So, this day goes on and on and on. One of the things you dread with these kinds of things is that once you get to midnight, you have a problem, because the computers start to automatically change the dates and all this kind of stuff. We reached midnight, and BONY’s overdraft on the books to the New York Fed was approximately $20 billion and rising.”

The loan was 150% of BONY’s total assets, three times as much as what Continental Illinois had borrowed the year before. Things were dire. Now what? Because of a bug in newly installed software, BONY could only receive securities but not send them. It would need more money, or it would be gone by morning. Mr. Corrigan got back on the phone,

“Finally, around two o’clock in the morning, I said to Bacot and my colleagues at the New York Fed, “We can’t let this thing go any further. The size of the overdraft is $23 billion. The value of Bank of New York as a whole, including the flowerpots, is $24 billion.” This is literally what happened. We lent BONY $22.6 billion at 2:30 in the morning on Friday.”

Here is where his accounting background helped,

“We had to backdate that loan to 11:59 p.m. on Thursday to make all the records in the computers think that the loan had been made on Thursday. “

Problem solved? Can everyone go home? Almost,

“The computers didn’t come back until about 2:30 in the afternoon on Friday, so when we started business on Friday morning, the overdraft was building up again. Volcker was in Argentina. I called him on Friday morning in Argentina and said, “You’ll never guess what happened last night. We had to make a discount loan of $22.6 billion to the Bank of New York.” Volcker screamed into the phone: “What!” It took a little time to get him to understand that there was no choice. In addition, BONY ended up with an overdraft of $1 billion, for a total of $23.6 billion of loans from the Fed. That was another one of those incidents of problems with the financial plumbing.”

One of the lessons he learned from incidents like Herstatt and BONY was that time is a crisis manager’s dearest asset in a crisis. Bank treasurers know this well. The more time you have, the more chance you have of getting out of problems. Calls to let big banks fail and political forces objecting to government intervention all miss the critical point that if public policy favors an orderly resolution, the Fed cannot just stand back and let the CHIPS or BONYs fall where they may. As he told his interviewer in 2010, looking back on the wreckage after the GFC,

“Part of what I’m trying to convince these politicians—I’ve had extensive discussions with people in the government, people in the Federal Reserve—is that you have to buy a little time. One of the reasons you don’t want to go into bankruptcy on day one is that you want to have the time to have an orderly wind-down of all those counterparty arrangements. Once you’re in bankruptcy, all the underlying contractual documents—every place in the world says the same thing: Once it’s in bankruptcy, the counterparty has the right to close out. That’s not an orderly wind-down.”

No choice. The Fed had to save BONY because it was too big to fail; no more a politically winning argument back then, as it would be today. When he was president of the Minneapolis Fed, Paul Volcker, who was chairman of the Fed at that point, asked him to write an essay titled, “Are Banks Special,” and why government intervention is justified to save them when they get into trouble. He recalled,

“That was the time when, philosophically, Volcker was more convinced than ever, using his phrase, that “banks are special.” He said to me, “We know it’s true, but it’s hard to articulate why. Why don’t you go and write something about this?” I wrote an article in the calendar year 1982 annual report of the Federal Reserve Bank of Minneapolis called “Are Banks Special?” It was published in the spring of 1983. To this day, that article is still required reading in hundreds of college and graduate school programs in finance and economics. Volcker still prods me endlessly about this stuff. He says, “I thought you were the one who said banks were special. Why are these banks doing all these crazy things today?”

Banks do three things, as he wrote back then. They offer transaction accounts to depositors payable on demand at par, are a backup source of financing, and are a transmission belt for monetary policy. He argued that if they meet these conditions, they are eligible to offer insured deposits and access to the discount window as a last resort.

And because banks perform a vital service for the economy, can offer FDIC insurance to depositors, and have access to the discount window in an emergency (assuming Rule 10B, Section B, note 4 does not apply), they require supervision through capital and liquidity regulations and guidance through the bank examinations process. But there are limits to everything, even to a bank supervisory regime’s efficacy in preventing major bank failures. The Basel 3 Endgame proposal by bank supervisors may be the bridge too far, given the pushback by the industry and their elected legislative representatives against its proposals.

The CEO and chairman of a large regional bank in the northeast attending an industry conference in Europe this month predicted that the tide had turned on the Basel 3 Endgame proposal,

“I do think there's an overreaction to the events of last year and some of these proposals are extreme and not well thought out and could have negative consequences for the economy or the supply of credit. And I think the industry has made a lot of those points and is gaining some traction to have the regulators reconsider some of those proposals. The first front was focused on capital…The next effort will be in the long-term debt proposal. And then…the rumored liquidity proposals…I mean, we're all in it together. The regulators want to save a sound banking system and we do, too, but we also want to support the economy and make sure the U.S. economy reaches its growth potential.”

Some parts of the Basel 3 Endgame proposal will pass, some will change, and some will not make it to the final draft, summed up the CFO from another large regional bank in the northeast attending the same conference,

“I think that AOCI will become effective, whether it becomes effective as a one-off or with a new proposal that would come out, I don't know. But that's a given. Probably operational risk gets in, it's watered down some, gets a little bit more rational from what was done there. And we'll just see how the other changes occur. I think people were pretty positive on the housing pieces, the gold plating and some of the equity investments.”

If banks are too big to fail, the alternative to more regulation is to make them smaller. Bank supervisors are more cautious about approving mergers and acquisitions today than they once maybe were, especially for mergers involving large banks. Lack of coordination among bank supervisors, including the Fed, the OCC, and the FDIC, has not made it any easier for applicants to navigate the bank supervisory hurdles to get to yes and permission to merge.

For example, the OCC released a draft proposal on bank mergers last January without the other bank supervisors. Then, in March, the FDIC released its version. While the proposals are generally the same, there are key differences. For example, the OCC proposes fast-track approval for mergers when the combined bank’s total assets will be less than $50 billion, while the FDIC sets that threshold below $100 billion.

According to Mr. Corrigan, the U.S. needs its big banks, and he rejected the populist call in the wake of the GFC to break up the big banks,

“If you make them smaller, and all of them are smaller, how are you going to finance governments? How are you going to finance global corporations? I don’t see how you could do it. I don’t know what the threshold is…Where is the line? One of the reasons we got out of the crisis as well as we have, relatively speaking, is that in the past 18 months, banks in the United States and elsewhere have successfully raised in excess of half a trillion dollars of fresh capital in the capital markets.”

Big banks are the ones who underwrote the economy's recovery from the GFC. Big banks are too big to fail but they are too important to the economy to be any smaller. Bigger is essential, he said, because smaller banks,

“…don’t have the scale. They don’t have the personnel. They don’t have the expertise. They don’t have the risk-management systems…The idea that you can live with a world in which there are no large integrated financial intermediaries, I think, is a fiction, even though I agree that they need to be regulated much more aggressively, they need to have more capital, they need to completely rethink the way they think about liquidity, et cetera, et cetera, et cetera.”

The problem with bank regulation is that it only applies to banks. There are no capital and liquidity requirements for nonbank, “private credit” firms, which are increasing their participation in leveraged loans, commercial real estate, and other longer-term and higher-risk investments. The Co-Founder, CEO, and Director of one such firm was optimistic about growth prospects this year and beyond,

“Our industry has amazing potential…I expect there to be very robust growth in private markets.”

There is only so much bank regulators can do to hold back the tide, as the special role of banks in the financial system blurs with the expansion of the role of nonbanks in the capital markets, the growth of money market funds, securitization, and other financing. Forty years ago, Mr. Corrigan predicted a time when nonbank firms would acquire banks and become regulated as bank holding companies. Regulations will not stop progress, he told attendees at the International Monetary Conference in June 1984,

“Even with a more restrictive definition of a bank such as is being contemplated by the Congress, many "nonbank" firms will acquire banks as bank holding companies, thereby providing these firms with indirect access to the market for deposit gathering, the operation of the payment mechanism, and elements of the public safety net historically associated with banks. The competitive and supervisory implications of these arrangements have been given a fair amount of attention. However, what has not received as much attention are the business and public policy implications of a situation in which direct and, for all practiced purposes, unlimited access to the payment mechanism can be gained via an investment in a small bank.”

Bank treasurers need to get out more, get some fresh air, something that Mr. Corrigan excelled at who was a great outdoorsman and often went fishing with Paul Volcker out west. As he told the story, one day, he walked into a coffee shop in Montana with Paul Volcker and some friends,

“Volcker didn’t have security people around him then, although, at the time, there was this image of him as Public Enemy Number One. But he really wasn’t. On June 13, 1981—I know the exact date, because it was my birthday—Volcker, Jacques de Larosière of the IMF, and I were visiting some people I knew in Montana. We were going fly fishing at a spot on the Madison River. To get to this spot, you have to go through a little town called Ennis, Montana. Pickup trucks are virtually the only vehicles in town. We were going to stop at this little coffee shop in Ennis, Montana, to get some breakfast. They had diagonal parking, and, as far as the eye could see, there were 15 or 20 pickup trucks. And every one of them had two or three rifles in the back window. I was saying to myself, “I’m not so sure about this. In those days, people often thought I was Paul’s security guard. I was a lot younger then. I was still in pretty good shape, and I had the look and the profile.”

The cattle ranchers were getting killed by the rate hikes. His story continued,

“We went into the coffee shop. We sat down in a booth in the back corner of this place. A guy who was sitting on a stool at the counter got up and started to walk over toward us. He was the perfect stereotype of the Montana cowboy rancher. He was wearing boots, a big hat, and he had a sunburned face. He was a big guy who was about the size of a Coke machine. As he walked toward us, he had his hand in his pocket, and I thought, “’This could be trouble.’”

But instead,

“When he got to the table, he pulled his hand out of his pocket. He had a $10 bill. He looked at Volcker and said, “Mr. Chairman, would you autograph this for me?” Volcker said, “Yes, yes.” Then, all of a sudden, guys were standing up, walking over, and asking Volcker to autograph dollar bills…Those ranchers had an impact on my thinking that is still with me to this day, because it serves as a reminder, once again, that we all tend to underestimate the values, the determination, and the wisdom of the regular people who make up our society.”

Hopefully, your bank’s board of directors will have the values, determination, and wisdom to understand why bank treasurers prefer to sit on cash. At the same time, the path for rate hikes remains uncertain, and the yield curve inversion continues between 3-month and 5-year Treasurys. Hopefully, they will reward you for your discipline. But let’s admit that at 5.40%, overnight reserve deposits at the Fed remain the best-paying asset on the yield curve. With those risk-free returns, there is no reason not to kick back this summer, take a break from the chaos and volatility, and enjoy the great outdoors. diner, where breakfast is served all day. The cook in the kitchen in the backroom is said to be a wizard with Belgian waffles.

The Bank Treasury Newsletter is an independent publication that welcomes comments, suggestions, and constructive criticisms from our readers in lieu of payment. Please refer this letter to members of your staff or your peers who would benefit from receiving it, and if you haven’t yet, subscribe here.

Ethan M. Heisler, CFA

Editor-in-Chief

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In This Month’s Chart Deck

The inversion of the Treasury yield curve between three months and five years continued to extend its record for 18 months, with the negative spread this month holding between 90-110 basis points and the average spread for the 18 months equal to 115 basis points (Slide 4). Contrary to the traditional interpretation of an inverted yield curve signaling an imminent recession, the U.S. economy shows no signs of trouble in consumer spending or unemployment. While at the end of last year, market participants expected the Fed to have already begun cutting rates and mortgage rates briefly rallied, in the absence of those cuts materializing, mortgage rates drifted back to 20-year highs (Slide 5) and left bank bond investment portfolios still contending significant negative fair value marks (Slide 6).

Taking advantage of the rally in Q4 2023, banks restructured their portfolios, but with the window to do more having closed in Q1 2024, bank treasurers held off on selling bonds (Slide 7). It has now been ten months since the Fed's last rate hike, and the pause is already longer than the pause the Fed took in 2019 after it hiked rates in December 2018 until it cut them at its July meeting of the Federal Open Market Committee in July 2019. After it seemed late last year that rate cuts were imminent, bank treasurers let some of the fair value hedges they put on in Q2 2023 runoff in the year's second half. With the timing of those rate cuts in doubt and bank treasurers even wondering about the higher risk for longer, they have kept their hedges in place (Slide 8).

After reaching a record $6.6 trillion at the beginning of the year, money market fund assets have since fallen back ((Slide 9), feeding back into bank deposits as suggested by data from the Fed's H.8 report, which found domestic deposits for all commercial banks edging higher since the new year. The balance of uninsured deposits also increased in Q1 2024, reversing some of the runoff that had occurred in the wake of the regional bank crisis last year (Slide 10). However, customers continue to manage their noninterest-bearing deposit balances, shifting to interest-bearing deposit products instead (Slide 11). Depositors completed most of this shift by last summer. Based on FDIC data, the ratio of noninterest-bearing deposits to total deposits is still a few percentage points above the 40-year average.

The rate environment may not have cooled the economy, but after the Fed's first hikes in 2022, bank commercial and industrial loan growth fell and has not recovered since (Slide 12). While higher rates and economic uncertainty may have dampened some customer demand for commercial loans, some of their funding needs, according to the latest data from SIFMA, must have been funded in the corporate bond market, where issuance surged this year (Slide 13).

List of Slides

3-Month-5-Year Treasury Spread, Sources: H.15 Report, Federal Reserve, The Bank Treasury Newsletter

Mortgage-Rates, Sources: FRED, St. Louis Fed, The Bank Treasury Newsletter

Unrealized Loss in Held-to-Maturity (HTM) and Available-for-Sale (AFS) Portfolios, Sources: Call Reports, FIS FedFis LLC., The Bank Treasury Newsletter

Realized Gains/Losses on Bank Investment Portfolios, Sources: Call Reports, FIS FedFis LLC., The Bank Treasury Newsletter

Interest Rate Derivatives Used For Hedging, Sources: Call Reports, FIS FedFis LLC., The Bank Treasury Newsletter

Money Market Fund Assets, Sources: U.S. Money Market Monitor, Office of Financial Research, The Bank Treasury Newsletter

Uninsured Deposits, Sources: Call Reports, FIS FedFis LLC., The Bank Treasury Newsletter

Noninterest-Bearing Domestic Deposits, Simple Average, Percent of Total Domestic Deposits, Sources: Call Reports, FIS FedFis LLC., The Bank Treasury Newsletter

Commercial and Industrial Loan Growth, Annual Percent, Sources: All Domestic Banks, H.8 Report, Federal Reserve, The Bank Treasury Newsletter

Corporate Bond Issuance, Sources: Refinitiv, FINRA, SIFMA, The Bank Treasury Newsletter