by ilene - September 26th, 2009 11:24 am
Courtesy of Jesse’s Café Américain
The Fed is holding a significant amount of assets on its books in the form of Treasuries. For example, the Fed has purchased an enormous amount of US Treasury issuance in the past six months as part of its quantitative easing program, aka monetization. It has also taken on tranches of mortgage debt obligations from the banks, purportedly to improve the banks capitalization profile because of the dodgy nature of the assets.
This has added significant short term liquidity to the system, much of it held by the banks for interest at the Federal Reserve itself.
At some point the Fed will wish to reduce the levels of liquidity in the system. One way to do this is by increasing interest rate targets. It can achieve this, for example, by increasing the amount it pays for reserves.
The traditional way for the Fed to drain liquidity is to conduct what is known as a reverse repurchase agreement, or reverse repo.
In a normal repurchase agreement or repo, the Fed purchases assets held by the banks, normally Treasuries, which obviously increases the ‘cash’ being held by the bank. A repurchase agreement is by definition for a specific amount of time. At the end of the period the Fed sells the asset back to the bank. The difference in amounts is the ‘interest’ which changes hands for the transaction.
There is also a type of purchase agreement with no buyback. It is known as a PMO, or Permanent Market Operation. These are used to add liquidity as the name implies, permanently.
A reverse repo is just the opposite. In this case, the Fed sells an asset from its balance sheet to an institution for ‘cash’ and thereby drains or takes cash liquidity out of the system.
Aren’t Treasuries as good as ‘cash?’ Why does it matter whether a bank is holding Treasuries or cash on its books? Apparently not the case, at least for accounting and regulatory purposes. Remember that the next time someone tells you that banks do not need depositors. Sometimes they do.
Typically the Fed has only done this type of operation with a group of about twenty or so financial institutions known as the Primary Dealers.