Back in September 2011, I took a look at the growing balance of reverse repurchase agreements (RRAs) on the books of the Federal Reserve. In light of the continuing debt issues facing the Eurozone, I wanted to very briefly update the situation, particularly in light of the fact that recent overnight deposits with the European Central Bank (ECB) have been reaching new record highs on a nearly daily basis, reflecting tensions in Europe's banking system.
First, let's revisit exactly what reverse repurchase agreements are and why their growing volume should concern you. In the inimitable words of the Federal Reserve, here is how they define reverse repurchase agreements:
"Reverse repurchase agreements are transactions in which securities are sold to a set of counterparties under an agreement to buy them back from the same party on a specified date at the same price plus interest. Reverse repurchase agreements may be conducted with foreign official and international accounts as a service to the holders of these accounts. All other reverse repurchase agreements, including transactions with primary dealers and a set of eligible money market funds, are open market operations intended to manage the supply of reserve balances; reverse repurchase agreements absorb reserve balances from the banking system for the length of the agreement. As with repurchase agreements, the naming convention used here reflects the transaction from the counterparties' perspective; the Federal Reserve receives cash in a reverse repurchase agreement and provides collateral to the counterparties."
Here's my explanation from back in September:
"Reverse repurchase agreements are nothing more than the purchase of a security by a party with the agreement that the purchasing party will be able to sell them on a specific date in the future at a higher price. For the party selling the security and agreeing to repurchase it in the future, the action is known as a "repo". For the party who buys the security and agrees to sell it in the future, the action is known as a reverse repurchase agreement. According to Investopedia, these transactions are classified as money-market instruments.
In the specific case of the Federal Reserve, the central bank uses reverse repurchase agreements to temporarily add or subtract reserve balances in the open market (the amount of money in the system) and to temporarily offset swings in bank reserve levels. In 2009, the Federal Reserve used reverse repurchase agreements to drain some of the $1 trillion that they pumped into the economy during the Great Recession. By selling securities to the 18 primary dealers in the Fed's universe, they can decrease the amount of money available in the banking system. The removal of "money" can result in both an economic slowdown and inflationary pressures, one of the great concerns of removing "paper" that has been created out of thin air from the system.
That's enough background information.
Let's take a look at what has happened to RRAs, most particularly those that the Fed is holding for foreign governments, central banks and other international organizations including the IMF and the BIS (termed Reverse Repurchase Agreements - Foreign Official and International Accounts or WWRRAFOIAL), since 2003:
What alarmed me back in September was the very rapid growth in RRAs over the summer months in 2011, a situation that was parallel to what was experienced back in 2008, during the initial phase of the Great Recession, as you can see on the graph. While it looked like the volume of RRAs was dropping in the early fall, the increase in the volume of dollars invested by foreign governments and organizations has continued nearly uninterruped and is now well above the spike in 2008 and just below peak levels reached in mid-2011 excluding the spike in late 2011. You will also notice that the size of RRAs held by the Fed never declined meaningfully after the "end" of the Great Recession and that there has been another substantial step upwards. This is telling us that Europe's central banks, governments and organizations including the IMF and BIS still don't trust the security of their own banking system and that they haven’t for the past three years.
Taken in combination with record levels of deposits with the European Central Bank, the situation is starting to look very bad as shown on this graph:
European banks have deposited nearly €486 billion with the ECB at very, very low interest of only 0.25 percent since they don't trust each other, nor do they wish to loan the money to consumers or corporations. What is really odd is that the ECB just loaned 523 European banks €489 billion for three years at 1 percent to keep money flowing in the Eurozone through increased lending. This lack of liquidity is concerning since it will make it difficult for the economy to expand and keep the Eurozone out of recession.
As we can see, while the European situation has faded from the front pages of the business sections of most mainstream media outlets, the woes facing Europe are hardly behind us. As European banks trust each other less and less resulting in a tightening of the credit screws, the situation is starting to look more and more like the United States in 2008 – 2009 when bank lending froze. Unfortunately, we all know how that story ended. With the world's economy so interlinked, perhaps this time out, both Canada and the United States will be the nations suffering from collateral damage from the European banking system instead of the other way around.