Issue #30: Monetary Policies, Primary Dealers, Banks, and Reserves
In this issue of Monetary Mechanics, I am going to talk about something that has been personally perplexing since I started learning about the plumbing of the modern financial system, as well as the implementation of monetary policies, on a much deeper level. I am also going to publish a follow-up piece to this issue of Monetary Mechanics in a few days in which I will focus on the importance of primary dealers (and more generally broker-dealers) to the modern financial system. Admittedly, this is something that I do not fully understand myself, so I may in fact be missing something very obvious here. If that is the case, please feel free to point it out to me.
In previous issues of Monetary Mechanics, Issue #10 and Issue #12, I mentioned that the Federal Reserve implements monetary policies through the manipulation of various short-term interest rates. However, most people do not think too deeply about precisely how this happens. In truth, the pre-GFC money market hierarchy was maintained via the ability and willingness of financial market participants to arbitrage interest rate spreads whenever they were perceived to be “out of line.” For example, if the interest rate on 3-month negotiable certificates of deposit (CDs) ever rose too high, banks could and would basically just increase their borrowings of federal funds to compensate until there is a price correction.
However, this quickly becomes complicated because there are two major types of participants that directly assist with or are directly influenced/impacted by the implementation of monetary policies: commercial banks and primary dealers. These two major types of participants are frequently lumped together into one category because almost all the world’s largest banks also have broker-dealer subsidiaries while many large primary dealers also are part of larger banks. However, I believe that there is a fundamental misalignment of incentives between these two financial entities that most people do not think too deeply about.
The Federal Reserve implements monetary policies through primary dealers, who are the counterparty to the Federal Reserve Bank of New York’s open market operations. Thus, when the Federal Reserve wants to manipulate the quantity of reserve balances in the banking system via temporary open market operations (TOMOs) or permanent open market operations (POMOs), the Federal Reserve must do so via the primary dealers. They are not legally allowed to transact with anyone else for these operations. While they can interact with banks via the discount window, and have also created other facilities to interact with other counterparties (e.g. the reverse repo facility and money market funds), textbook open market operations, whether temporary or permanent, are done exclusively via the primary dealers.
Prior to the GFC, the manipulation of reserve balances was done via daily or weekly repo and reverse repo operations with the primary dealers as the intermediary. These operations were intended to increase or decrease the level of reserve balances in the banking system to maintain a federal funds rate that was in line with the Federal Reserve’s target. What incentives did the primary dealers have to transact with the Federal Reserve? They were making markets on behalf of the Federal Reserve Bank of New York, as well as whichever bank needed extra reserve balances. However, they were provisioning balance sheet space in order for this transaction to occur while they themselves were not even the primary beneficiary of this transaction. Hence, this situation constituted a fundamental misalignment of incentives.
Consider a scenario in which a bank desperately needs to replenish its reserve balance buffers. The Federal Reserve, realizing that liquidity is becoming tight, would like to increase reserve balances to maintain the federal funds target. The Federal Reserve, however, would not want the bank in question to overbid for federal funds in an open market with tight liquidity conditions, because that would cause the Effective Federal Funds Rate (EFFR) to jump out of line with the federal funds target. What is the bank in question supposed to do if (worse comes to worst) all the regular primary dealers, being relatively satisfied with their current risk profiles and balance sheet sizes, would prefer to not absorb any additional risk exposures at the moment?
