Deposit flows after a pair of high-profile bank failures last month have renewed a debate about the Federal Reserve's support of money market funds and whether that support harms banks.
Between March 8 and March 22, total commercial bank deposits declined by $300 billion, according to Fed data. During that same period, money market funds ticked up $238 billion.
It is unclear how many of those deposits went directly from banks to money market funds, but some in and around the banking sector worry that the Fed's Overnight Reverse Repurchase Program has made it easier for funds to move in that direction.
Also known as the ON RRP, the facility allows money market funds and other entities to purchase securities from the Fed and sell them back the next day at a fixed, higher price. The Fed created the ON RRP facility in 2013. The idea behind it was to create a channel through which the central bank could convey its monetary policy to market participants other than banks. It was conceived as the Fed was preparing to raise interest rates from their lower bound, where they had been since 2008.
Money market funds were not the intended beneficiary of the program, but they have taken advantage of it more than almost any other type of counterparty.
Between March 8 and March 22, total ON RRP usage — which includes activity by government-sponsored entities and some banks — only increased by $47 billion. But since March 2021, the facility has swollen from zero to roughly $2.2 trillion per day, and has remained at that level since last June.
Some of the sharpest criticism of the facilities growth has come from the Bank Policy Institute, a bank lobbying organization, which accused the Fed last week of "abetting a draining of deposits from banks."
Policy experts outside the banking industry also say the Fed's engagement with money market funds, through both its ON RRP facility and other actions, have given those funds advantages over banks, ones that do not always benefit the broader economy.
"The whole [ON RRP] facility should be unwound," Karen Petrou, managing partner of Federal Financial Analytics, said. "Similarly, the Fed should stop sitting on trillions in bank deposits. It's a huge distortion."
Historically, money market funds have increased the availability of credit by purchasing short term corporate loans — known as commercial paper — and Treasury bills, which are government bonds with maturities of less than one year. Funds still engage in this activity, but their ability to earn interest simply by engaging in these purchase agreements with the Fed diminishes their economic impact, Petrou said.
"The Fed is supporting funds flowing out of the banking system, where they support macroeconomic activities, into the funds sector, then looping them back into the Fed where they support the Fed's portfolio and government borrowing," she said. "That's a really altered state that nobody's quite focused on."
Fed officials, including Gov. Christopher Waller, have described increased use of the ON RRP facility — which has primarily been driven by money market funds — as excess liquidity in the financial system. Because of this, he said, the $2 trillion regularly tied up in that facility
However, some economists worry what the growth of that facility will mean for bank funding, especially if economic conditions worsen. To this, Waller has said it will be up to the banks to attract depositors back from funds by paying higher interest rates.
"At some point, as reserves are draining out, it'll come out of the banks and then the banks, if they need reserves, it's sitting over there on this ON RRP being handed over by money market mutual funds," he said during a public appearance in January. "You're going to have to go compete to get those funds back."
But doing so may be easier said than done, given how many bank balance sheets are weighed down by long-duration legacy assets — loans and securities — that are paying low fixed rates. If banks start paying more to depositors, they diminish the net interest margins that support their profitability.
This could be especially problematic for banks that see outflows of current depositors who are being paid minimal interest on their deposits, said Michael Redmond, an economist with Medley Advisors who previously worked at Federal Reserve Bank of Kansas City and the U.S. Treasury.
"There's a limit on how much banks can adjust their deposit rates higher if their existing deposit base does turnover, and that's why a lot of economists think there is going to be credit contraction," Redmond said. "Rather than only adjusting on the liability side of their balance sheet, banks might also try to curtail some of the activity on the asset side of their balance sheets as well."
Money market funds tend to pay significantly higher interest rates than banks. This happens for a few key reasons.
The fund model is simpler than that of a bank. Funds profit off fees charged to investors who, in turn, are paid using proceeds from the fund's investments. Banks, meanwhile, largely profit from the difference between the interest they collected from their assets and the amount paid out to depositors, also known as their net interest margin.
Instead of conducting maturity transformation — using short-term deposits to create long-term loans — money market funds use investor money to buy public or private debt. Because these funds invest in short-term instruments, investors are generally able to redeem their deposits at any time.
However, that redemption is not technically guaranteed. Money market funds are less tightly regulated than banks and they do not have to carry insurance for their deposits. This results in lower operating costs for funds relative to banks, but also increases the risk associated with their model. Investors, in theory, are paid a premium for taking on that additional risk.
But whether investments in money market funds are actually at risk is debatable, said Aaron Klein, a senior fellow at the Brookings Institution and a Treasury official during the Obama administration.
"For an institution run by economists, the Fed seems to struggle with the concept that greater return implies greater risk," Klein said.
Following the collapse of the investment bank Lehman Brothers in 2008 and the onset of the COVID-19 pandemic in 2020, the Fed and the Treasury Department guaranteed money market investors that they would be made whole. The actions were taken under systemic risk declarations by the agencies to prevent a run by depositors.
Klein said these actions have signaled to market participants that money market funds will have the implicit backing of the federal government in times of distress. For uninsured depositors — such as those who fled Silicon Valley Bank
"Ask yourself today what is more implicitly guaranteed by the Federal Reserve: money market mutual funds or uninsured bank deposits? If you can't find a difference in the level of implicit guarantee, that's quite telling," Klein said. "The Federal Reserve's repeated bailouts of money market mutual funds, which are owned by the wealthy, makes our financial system less stable and, in the long run, our economy more unequal."
As a tool for implementing monetary policy, the facility has been effective, said Bill English, a finance professor at the Yale School of Management and a former monetary official at the Fed. But the program looks quite a bit different than when it was initially introduced.
Instead of setting the rate for the facility a quarter percentage point below the federal funds rate, the Fed now pays about 10 basis points less for its repurchases, English said. It also lifted the $300 billion cap that the program first featured and now offers unlimited use.
Like others, English says the facility could benefit from some revisions, such as a reducing the rate paid to counterparties. Doing so, he added, could be beneficial to the Fed's monetary goals by allowing it to shrink its balance sheet more swiftly.
Ultimately, he said, banks should not count on changes to the Fed's ON RRP facility changing the competitive landscape for deposits.
"Banks may have to get used to the idea that the safe, stable, low-cost funding that they get from their retail deposit franchise is just less than was the case 20 years ago,"English said. "And this interest rate cycle is showing that."
