The mystery of the Fed funds market experiencing a shortage of available lenders and thus trading at high rates may be because U.S. banks don’t want to risk loaning to a high risk bank whose parent is based in the EU. If the EU breaks up then the ECB central bank would be unable to continue its existence and its going out of business would be a bigger catastrophe than the Lehman bankruptcy of 2008. If a European bank defaults on a repo loan in theory the ECB could loan money to the failed bank who could then make good on their repo loan. But this rescue wouldn’t happen if the ECB is eliminated.
The global banking system is inherently fragile and is greatly supported by the anticipation that a bank failure could be prevented by a sudden loan from the central bank; if a central bank is regarded as potentially closing down this increases the risk that a failing bank will not be rescued. Thus the prudent thing is for U.S. banks to avoid loaning funds to European banks. I assume if the EU suddenly broke up that the nation states would not be able to instantly allocate central banking duties to their own national central banks in an instant, and that a period of paralysis lasting several weeks would occur, somewhat like when the Soviet Union was dissolved.
The Federal Reserve uses 24 Primary Dealers to sell or buy bonds. These dealers then sell or buy the bonds to the other institutions. 9 of these PD’s are domestic and 16 are foreign. Some of the giant Systemically Important Banks are European banks. Recently there have been news articles complaining that EU based banks have too many risky derivatives positions or too many hidden non-performing loans.
In theory there is no risk for a bank to lend money to another bank in a repo transaction because of good repo collateral. But in a banking crisis the healthy bank doing the lending needs its cash back as scheduled, instead having to seize and sell the collateral. Regulators can criticize a bank that owns a failed loan even if the lender had good collateral. The banks are required to demonstrate in a crisis they can raise 30 days worth of cash, so that would be disrupted if a bank borrowing money suddenly went bankrupt and couldn’t repay the loan back to the healthy bank.
In theory the EU based parent bank can’t get an upstream flow of funds from the U.S. based subsidiary unless U.S. regulators authorize it. But in a moment of bankruptcy panic who knows if someone will misbehave and export the cash back to the EU based parent bank. When Lehman filed bankruptcy, a few hours later an automated pre-scheduled payment of several hundred million was sent from a German bank to Lehman (no one thought to halt the payment) and was lost to the bankruptcy instead of being returned.
Thus it is rational for U.S. Primary Dealer banks to exercise caution regarding a supposedly risk free repo loan to an EU based bank.
In addition to the above risk there is also the problem that new regulations have required banks to hold more cash and thus they are forced to hoard cash rather than lend it to other banks in the Fed funds market. Apparently the regulators assumed banks were passive, mellow, non-profit organizations that wouldn’t mind if their capital was tied up in low yielding cash even though that would reduce profitability. The large banks often get an R.O.E. of 10% (assuming only modest loan defaults), so to tell banker that instead of earning 10% the banker needs to hold cash in a low yielding account at the Fed is extremely frustrating to bankers and thus they engage in hoarding cash rather than lending it to other banks.
I don’t see the Federal Reserve’s recent attempt to add liquidity to the Fed funds market as a sign of a hidden QE stimulus program. Their attempt at aiding the banks is merely a technical maneuver caused by awkward new regulations that inconvenienced the banks and resulted in a shortage of willing lenders.
Investors should realize that at the top of a long economic cycle just before crash is a bad time own financial companies since they are leveraged 12 times equity then a small loan loss can bankrupt them, making the stock worthless. Hedge funds and real estate investors, by contrast, are only leveraged 2x or 4x, so banks are overly risky. Bank stocks during a recession can incur massive losses. If someone has a bank account greater than the FDIC coverage they should move the excess funds into T-Bills. Avoid dealing with EU (or Swiss or Norwegian) based banks as they may undergo a crisis. The EU lacks a comprehensive deposit insurance program like the one available in the U.S. Investors need independent financial advice about the risks of an EU based global banking crisis.