The End of the BTFP in March 2024 Is Not a Big Deal
This week, the Federal Reserve announced a change in the interest rate on the liquidity provided through the BTFP and that the program will cease to make new loans in March 2024.
The BTFP program, which was created to deal with the banking crisis, expires on March 11th and there has been lots of talk about the disastrous consequences to the US banking sector. In this article, I will explain why the end of the BTFP program is not going to end in a disaster and provide some context. Let’s jump right in!
Collateral Valuation of the BTFP Program
The BTFP program allows U.S. federally insured depository institutions, e.g., banks or credit unions, to post U.S. Treasuries to the Federal Reserve and receive loans of up to one year against the collateral. The most interesting part about the BTFP is that collateral is valued at par. This means that when a bank holds a 30-year Treasury bond, which lost 50% of its value due to higher interest rates and trades significantly below par, the Federal Reserve still values it at par and provides more liquidity against it.
A practical example might explain it better. When a bank holds $100mm (face value = par value) of US Treasury bonds, which declined in value by 50% due to higher interest rates, the collateral would only be worth $50mm in the repo market. In other words, if there would be a run on the bank, it could give out the $50mm worth of collateral versus cash to serve cash outflows. The BTFP, however, values the collateral at $100mm and does not care about mark-to-market losses. Hence, the BTFP makes banks more “liquid” as they can convert U.S. Treasuries at par into bank reserves.
Risk-free Profits: Banks Arbitrage the Federal Reserve
The interest rate that banks had to pay on the loans was the OIS rate plus 10 basis points. This was changed this week for a very good reason: banks were able to arbitrage the Federal Reserve. The BTFP program, which was supposed to support banks in trouble turned into a new profit center. On January 24th, the Federal Reserve changed the interest rate:
“The rate for term advances will be the one-year overnight index swap rate plus 10 basis points, provided that the rate may not be lower than the IORB rate in effect on the day the advance is made; (…).” - Source: Federal Reserve Website
At the moment, the IORB (“Interest on Reserve Balances”) is 5.40%. The one-year USD OIS rate is 4.78% (plus 10bps = 4.88%). Hence, banks have to pay 5.40% on the liquidity provided through the BTFP as the IORB is larger than the one-year USD OIS rate plus 10 basis points. Banks, that could previously get a one-year loan at 4.88% and park the money at the Federal Reserve at 5.40% could make 0.52% risk-free (on Treasuries that they technically do not even own). This is not possible anymore.
I believe the change in the interest rate was a smart move from the Federal Reserve. The BTFP should not be a new profit center for banks. It was designed to be a facility that supports the financial system when there is funding stress or a bank run. The Federal Reserve was probably scared that on March 8th, the Friday before the BTFP ceases to make new loans, every eligible institution that can take advantage of the arbitrage maxes out the liquidity it can get from the BTFP and invests it at shorter maturities. But as I said, this is not possible anymore.
The End of the BTFP Is Not a Big Deal
The main reason why the end of the BTFP is not a big deal is that troubling US banks can extend the loans by another year. Therefore, on March 11th, the liquidity that was provided through the program will not be gone all of the sudden. Most of the liquidity provided through the program was for smaller banks that were impacted by the banking crisis anyways. The financial system as a whole and especially larger US banks do not rely on any emergency loans through the BTFP or the discount window.
If US banks would have problems sourcing liquidity, then this would be reflected in the percentage of domestic borrowing in the fed funds market. The fed funds market is mainly driven by foreign banks. Foreign banks source liquidity at the effective fed funds rate and park the cash elsewhere to earn a few basis points. In other words, foreign banks essentially arbitrage the fed funds market. US banks cannot do that due to assessment rates (basically a fee for FDIC insurance).
When domestic borrowing in the fed funds market increases, then this can be an indication of liquidity becoming scarce for US banks. In 2018-2019, when QT led to a 20% decline of the stock market in Q4-2018 and a spike in repo rates in Q3-2019, domestic banks accounted for 30+ % of the borrowing in the fed funds market. Nowadays, this number is around 10%, which does not reflect any funding stress in the US banking system.
Be Careful with Doomsday Narratives
Everyone (especially on Twitter/X) likes to talk about doomsday narratives - de-dollarization, problems in the financial system, high debt-to-gdp ratios, the end of the BTFP, and more. Positive developments do not get as much attention - ample liquidity in the system, a growing US economy, a tight labor market, core PCE 3-month annualized at 1.5%, and so on. In the end, the goal should be to search for „truth“, not pick evidence that supports an opinion or narrative and ignore everything else.
I hope this article explains why the end of the BTFP is not a big deal. At the moment, there are no signs of funding stress in the financial system, and last week’s economic data came in better than expected (3.3% GDP growth, 1.5% 3-month annualized core PCE, 1.9% 6-month annualized core PCE).
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