you can imagine that if you have repeated instances of the, of these spikes or the spikes are a little bit more prolonged, you could have periods where your reference rates go up quite a bit. And so I, it's just something to keep in mind when, when thinking about the use of of SOFR as a reference.
From the American Bankers Association, this is the ABA Banking Journal podcast. Welcome back. I'm Evan Sparks, and we're, I'm taking a moment here in the around the middle of 2024 to do a quick check in on what many have called the world's most important number. That's SOFR, the secured overnight financing rate.
And if you are following the ABA Daily Newsbytes, the Banking Journal, or even this podcast over the last several years, you know, we've been talking a lot about the transition away from the London interbank offered rate to SOFR, which is considered to be a more robust reference rate for transactions, but it behave, it's something that behaves a little bit differently than a credit sensitive rate that bankers were used to with LIBOR or similar types of types of products.
And so my colleague, my ABA colleague, Jeff Huther, in our office of the chief economist has taken a look at how monetary policy has affected the secured overnight financing rate, how the rate's been behaving. And he has a brand new ABA databank post that takes a look at some of these dynamics. So Jeff, really glad you're here to talk a little bit more about about the, the question of SOFR so good.
Thanks for having me.
We're well, over a year past the the discontinuation of LIBOR with the transition has been going on for several years. So we have a lot more data about how SOFR has. Has kind of has behaved in turn as a, as a reference rate. Can you kind of give our listeners a sense, an overview of what of, of how, of SOFR's performance in the over the last few years?
Sure. And I, I guess as a little bit of background the, my answer is a little bit wrapped up in the change at the fed from targeting a single interest rate, the fed funds rate. To targeting a range. Now, they still specify the Fed funds rate as their target, but in general, it's thought of as well. Maybe the Fed is also thinking about the, the secured overnight financing rate as also belonging in that range. So we've moved from the Fed trying to get to a single number.
Prior to the financial crisis to the Fed saying, well, anywhere within 25 basis points is fine that that process has played out pretty well. The challenges have been largely when the rate is falling below the Fed's target range and the the reasons have been due to broader macroeconomic issues where the Fed has in response to the pandemic inter provided so much funding that the cost of, borrowing in the secured financing market has gone down relative to the Fed's target.
So to pull the, rate up, that process has worked pretty well, but the Fed has been engaged in quantitative tightening over the last couple of years, which has started to remove that excess funding. And as a result. SOFR has started to creep up and being more solidly within the feds target range and is that that that creeping up is likely to continue going forward.
Given that SOFR is kind of creeping up within the within this target range steadily, what are the implications for banks in terms of how they are managing their portfolios? And if they're using SOFR as their as their reference rate.
So on the plus side SOFRs as it creeps up, it's going to improve the returns for banks on their on their adjustable rate. Loans, the mortgages potentially credit cards. And so there's, there's definitely a plus there.
I obviously, if, if banks are borrowing in the treasury repo market that are going to end up paying a little bit more to which, which would offset this, but it's also worth emphasizing, you know, we're talking about a, a relatively small increase that, you know, the full range is 25 basis points. And so if we pick up. 5, 10 maybe 15 basis points. That's obviously a plus, but it won't be huge on, on, on that side.
Probably what's more important for when, when loan officers and others think about SOFR is that it's likely also to become more volatile. You know, the, the underlying repo market that SOFR is derived from. Is subject to a lot of forces that kind of have, have natural flows, if you will in part, it's a, it's a critical part of the treasury financing mechanism for the U. S. treasury. And that, that those financing shocks hit a couple of times in the month and typically drive up.
So, for, for a few days, as as the market tries to digest the new supply by the U. S. treasury. You can also see positioning around reporting dates that can be important, particularly quarter ends and, and year end dates when many of the lenders in the the market pull back. And so there's.
You know, I, unlike the Fed funds targeting that happened prior to the financial crisis, where you could pretty much count on as everybody aiming for, well, this is going to be the number the Fed's going to try to hit. There's a little bit more play in the system and that could easily be reflected in a little bit more volatility in the, the reference rates that people see.
You write in your databank post about a an episode in 2019 when SOFR just shot up a, you know, more than doubled in the absence of kind of broader market turmoil, can you talk about why that happened and Why it happened, how it corrected itself, and then what, what are, what are the implications, what, what would be the implications for SOFR users of that kind of volatility taking place in the market today?
Yeah I think there, there are two stories here and the beneficials have emphasized, well, it was part of a time of quantitative tightening and there was there were fewer reserves in the system and they, as a, as a result, they're cautious about how, how much quantitative tightening to do. I think another story that may be at least as important is that bank balance sheets are constrained by various capital regulations that when market participants say they want to do additional repo transactions.
Not every bank is willing to participate anymore in the same way they would have prior to the Dodd Frank rules.
And as a result, even as arbitrage opportunities or financing opportunities, profitable opportunities arise, it's not necessarily the case that The market forces are going to step in and make those corrections because of, because they're, they're, they're capital constrained or they've got risk constraints that don't allow them to take large positions that are needed to bring the the market back into equilibrium.
So there are dangers there, I think, associated with, that are highlighted by the, the The, the spike up in 2019 and if it's just a couple of days spike where the fed steps in and says, okay, well, we're going to try to fix this. It's probably not a big deal for most banks because most banks are relying on averages over many days when setting their references rates rather than just an overnight rate.
But you can imagine that if you have repeated instances of the, of these spikes or the spikes are a little bit more prolonged, you could have periods where your reference rates go up quite a bit. And so I, it's just something to keep in mind when, when thinking about the use of of SOFR as a reference.
Yeah, you talked, you talked in the piece about the, the Fed's tools to manage. to, to maintain their, maintain stability and SOFR like the overnight reverse repo facility that, that has effectively set a floor for SOFR. And then the standing repo facility, can you talk a little bit about how that works and, and have we seen whether the standing repo facility would actually be effective in in preventing similar, you know, preventing similar spikes and SOFR in the future?
Sure. And the first, just with the, the overnight RRP, the, the reverse repo that helps to set a floor right now, the, the, the Fed has as counterparties almost all of the large money market mutual funds and who are the, the largest source of funding for, for the repo market. And as a result have the, the Fed's facility, the fed's willingness to borrow.
From the money market mutual funds is a, is a kind of a relief valve that ensures that rates won't fall too much because the, these, these money market mutual funds have an alternative to lending for at a low rate to private market participants to turning around and just lend to the Fed at its stated rate within the target range that.
That alternative ensures that rates don't fall too much below the, the, the offering rate that the, the, the, the, the feds providing on the other side on the high side the with the standing repo facility. There, the Fed's willingness to lend is limited by its, its its relationship to credit markets and there it's, it really is limited to, to banks and primary dealers. And as a result, there aren't that many.
Participants who have actually signed up to use the standing repo facility and in part because the Fed will also lend these same entities through the discount window. And in part because. There's it's, and these, and the, the banks don't see much of a, of a benefit from, from participating in, in this program because you have to have treasuries ready to lend to the Fed.
If you're a bank, you may very well just say, well, I, I, I'm almost always in a position to lend those securities into the private sector at, at better rates. And and if I need to borrow I can always turn to the, the discount window for the, using the same collateral if it came down to it.
And there's a lot less certainty that the standing repo facility will actually provide a ceiling in part because many, many of the borrowers in the repo market are not banks or primary dealers, they're, they're hedge funds, they're. Funds taking positions that are using leverage that are, that the Fed is not going to be able to, to lend directly to.
Right. Well, Jeff, that this is a, this is a terrific overview of what we're, what we're looking at and, and where things stand with the the SOFR, the change to the, with the dynamics of of SOFR. You can find more information and you can find Jeff's databank on our website at aba. com slash banking journal. You can also Take a look there through all of our SOFR and LIBOR transition coverage.
So go, go ahead and and, and read up if you if you want to catch up on where thing, where things stand, Jeff, thanks so much for being on the show today.
It's my pleasure. Thanks.
For our listeners, you can find this in previous episodes at aba. com slash banking journal podcast. You can also find us on any of your favorite favorite podcast apps or platforms. Just search for our name and click subscribe. Thanks so much for listening. And we'll be back with you again very soon.