By Paritosh Bansal

(Reuters) – The U.S. Federal Reserve is encouraging banks to count on its long-shunned cash backstops to support its monetary policy and financial stability goals. Its latest efforts may not move the dial much.

The Fed’s discount window and the Standing Repo Facility (SRF) are credit backstops where lenders can get cash against collateral such as Treasury bonds. They can also double as monetary policy tools, helping to keep interest rates close to the Fed’s policy rate. But banks have been reluctant to use them, as it can signal they are under stress.

In its latest effort to get past these issues, the Fed in August told banks it was okay to count on its backstops as sources of cash in internal liquidity stress tests, exercises that large banks have to do regularly to prove to their examiners that they can quickly get cash when needed. Last month, Michael Barr, the Fed’s regulatory chief, underscored that message, stating that liquidity regulations are "supportive of market functioning and the smooth implementation of monetary policy."

Over the past few weeks, I have been asking banking industry experts how effective the Fed's move might be in achieving those goals. Their overall take: While getting more banks ready to use the Fed facilities would bolster financial stability, it will be hard to remove the stigma and may not significantly affect monetary policy.

"Stigma has been around since the 20s. It's a complicated and significant problem that will require a lot of effort to address,” said Bill Nelson, chief economist at the think-tank Bank Policy Institute.

A senior executive at a large bank, who requested anonymity to speak candidly, stated there's still a difference between what a policymaker wants and what a supervisor will want. "If you were to ever, for whatever reason, access the discount window," the executive noted, "the first call is going to be from your supervisor asking, ‘What's going on?’”

POLICY IMPACT

The other intended impact of the Fed’s moves – helping its monetary policy objectives – may also be hindered. One hope behind the move is that allowing banks to rely to some extent on the backstops for liquidity would reduce their demand for reserves, or cash that they park at the central bank.

Currently, banks rely heavily on reserves to meet contingent funding requirements in the internal liquidity stress tests. With the Fed's August clarification, other easily tradable assets such as Treasury securities could become substitutes.

If it works as theorized, it could give the Fed more room for quantitative tightening. This is because the financial system needs a certain level of reserves to function smoothly, and as the Fed shrinks its balance sheet, it takes out reserves.

This would be a good time for the plan to work. SRF, which has largely been dormant, saw a surge in usage at the end of the third quarter, the highest since it was established in 2021. SRF usage has been an indicator the Fed has been watching as it looks for signs of tightening liquidity in the financial system.

The bank executive mentioned that the Fed's clarification is unlikely to make a perceptible difference. That's because the largest banks also have other liquidity tests, where they cannot count on the Fed backstops.

The banker pointed to the liquidity coverage ratio, which requires that large banks have enough high-quality liquid assets – or assets like Treasuries that can be easily traded – to meet their cash needs in times of stress.

Barr also stated in his speech that he wants to propose additional changes to liquidity regulations, some of which could lead banks to lower their holdings of Treasuries.

BIG PUSH

Where bank regulators have made a bigger dent so far is in addressing financial stability issues. They have been making a concerted push since the bank collapses of March 2023 to get more banks prepared to use the backstops should they ever need it. Silicon Valley Bank failed partly because it hadn't done the groundwork needed to borrow from the discount window, leading to fatal delays.

Barr noted in his speech that since that time, more than $1 trillion in additional collateral had been pledged to the discount window, and more banks had signed up for the SRF.

BPI's Nelson pointed out that liquidity risk results from a market failure. "That's something that happens when an institution is solvent and has assets worth more than its liabilities but is unable to convert them into liquidity quickly and at low cost," Nelson explained. "In that sense, borrowing from the discount window solves the market failure."

However, another bank regulation expert mentioned that the central bank’s focus on normalizing discount window access after the March 2023 failures is misplaced, calling instead for a greater focus on addressing interest rate risk.

"I don't believe that discount window stigma is what caused those institutions to fail," claimed Jill Cetina, a former Dallas Fed official and now a finance professor at Texas A&M University. "What caused them to fail was the excessive levels of interest rate risk and their illiquidity."