New York Fed President John Williams said Monday that the central bank acted quickly during last week’s jolt to overnight lending markets and that the issue appears resolved for now.
However, he cautioned that short-term lending markets face another crisis, though a few years in the distance, if banks don’t prepare themselves for when the London Interbank Offer Rate, or LIBOR, is phased out. LIBOR is used as an international benchmark for overnight lending.
Williams also said that there’s potential for further disruptions at the end of the quarter Sept. 30 and that the Fed is continuing to monitor the need for more reserves in the system.
Rates in the overnight repo market, where banks go to fund their day-to-day operations, surged Monday night amid a liquidity crunch, pushing the Fed’s own funds rate above the top end of its target range. Fed officials responded with a series of operations that injected funds into capital markets, and on Friday announced that the program would continue through Oct. 10. The Fed also announced a 25 basis point cut in the funds rate Wednesday along with a 30 basis point reduction in the interest on excess bank reserves.
In a speech Monday morning in New York, Williams, who oversees the district’s pivotal trading desk, said issues has been expected in the repo market due to a confluence of factors that would sap liquidity, including corporate tax payments and settlement of Treasury auctions.
However, he conceded that the issues were worse than expected, culminating in the Tuesday morning surge that saw repo rates hit 10% as “it became clear that this situation had persisted and had the potential to become more acute.”
“This episode reminds us all of the importance of having well-functioning markets and the vital role that the Federal Reserve plays in supplying liquidity to the system when markets are under stress,” he said in prepared remarks.
“We were prepared for such an event, acted quickly and appropriately, and our actions were successful. Friday’s announcement on open market operations to address potential quarter-end funding pressures on interest rates followed this same approach: quickly diagnose the problem, develop the right action plan, and execute that plan,” Williams added.
Warning about LIBOR
However, he wasn’t as optimistic about the end of the London borrowing rate, which will be shut down on Jan. 1, 2022.
The rate comes from surveys of banks on what they will charge their peers to borrow money over short periods, like one and three months. The system had been efficient and relatively unnoticed until a scandal erupted in 2012 in which some banks were manipulating LIBOR by reporting either artificially high or low numbers in order to benefit derivatives traders.
In 2018, the New York Fed introduced a replacement, called the Secured Overnight Financing Rate, whose implementation is ongoing.
However, Williams said too many banks either are ignoring the transition or hoping LIBOR is extended. Williams said both approaches are dangerous.
“Implementation will be complex: financial contracts need to be scrutinized, operations need to be evaluated, and technology needs to be updated,” he said. “The work involves numerous jurisdictions and multiple asset classes, and will require changes from how business is conducted to how systems are built. These things take time, and time is running out.”
Banks should be working to discover where their LIBOR exposure lies and continuing to work towards the transition, Williams added, noting that contracts referencing U.S. dollar LIBOR transactions have a notional value of $200 trillion.