Fed steps into overnight lending markets

3 Minute Read

Earlier this week, the US federal reserve stepped in to provide billions of dollars in liquidity to overnight lending markets, the first time since the financial crisis of 2008.

This action led to some pretty scary media headlines, so I wanted to take the time to explain exactly what happened, and its implications on our economy and investment portfolios.

What are overnight lending markets?
Banks around the country lend each other money overnight to fund business activities and to meet regulatory reserve requirements.  They charge each other a small amount of interest, usually around 2%, and pay back the money the next day.

What exactly happened?
Interest rates spiked to almost 10% because there was a shortage of cash.  The fed stepped in to provide cash and get the interest rates back down to normal levels of around 2%.

Why was there a shortage of cash?
We don’t exactly know, but it could have been a combination of factors including:

  • 3rd quarter corporate tax payments due.
  • High demand for mortgages.
  • Spike in oil prices following the Saudi Arabia drone attack.
  • The Fed taking money out of the system over the past several years.
  • Unnecessarily high bank reserve requirements.

Since the financial crisis of 2008 the Fed has been pumping money into our banking system to spur economic growth.  With the economy on solid footing, it has reversed course and began pulling money out over the past couple of years to try and curb future inflation.  For context, there is still $1.4 trillion of extra money in our banking system.

What likely happened is a handful of banks mismanaged their daily cash flow and got caught in a cash crunch.  Instead of letting the market run its course and teach these banks a lesson, the Fed stepped in to bail them out.

When there was lots of extra money in the banking system, banks could be looser with their daily cash flow.  Now that there is less, they have to be more diligent, just like you and I with our everyday income, expenses, and savings.

Another argument could be made that the regulations governing how much banks are required to have in reserves are too high.  Yes, there is $1.4 trillion in extra money in the system, but a good chunk of that has to stay in bank reserves and cannot be used for lending and other business activities.   A loosening of those regulations could provide additional liquidity, particularly during an economic downturn when liquidity is needed most.

While the headlines were scary, this action by the Fed actually had little impact on equity markets, and our investment portfolios.  The larger question is how much should the Fed be intervening in our everyday markets, and could bailing out poorly managed banks become a larger issue down the road?

I hope this update was helpful, if you have any questions at all please do not hesitate to contact me at the office.