Every day about $1 trillion flows between financial institutions, loaned at a short-term interest rate known as the repo rate. Normally this rate hovers around 2%, but in mid-September 2019 the rates spiked to 10% and caused the Federal Reserve to intervene. Seeking the answer as to why this happened calls for a deeper understanding of the money markets.
Financial institutions need cash to keep their daily operations running. When an institution doesn’t have liquid access to cash, they will borrow against their bond holdings from cash-abundant institutions at the repo rate. Loaners make some quick capital gains, while borrowers get access to the cash they need.
The spike in the repo rate on September 16th was in part caused by financial regulations and timing issues. The result was that the supply of cash in the money market was much
lower than usual, and the price to borrow money, or the repo rate, increased. This supply-restriction is compounded by a Federal Reserve rule called the Liquidity Coverage Ratio that was put in place after the 2008 financial crisis. The rule’s purpose is risk management, but it has limited banks’ access to their reserves.
The Fed has decided to provide additional cash by buying short-term debt from banks than ease the Liquidity Coverage Ratio. That’s exactly what it did to ease the tight money market in September. The goal is to provide financial institutions with the cash they need to keep their operations, and the financial world as a whole, running smoothly.