Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Inside the FOMC's New Liquidity Tools for Stressed Banks
Transcript
- Lucas: The Fed left rates unchanged at the June meeting — no surprise there, the effective federal funds rate is sitting at 3.63 percent. But what caught my eye wasn't the rate decision. It was the quiet expansion of the Fed's standing repo facility. Luna: The standing repo facility — that's the one they set up after the 2019 repo spike, right? I thought it was mostly used by primary dealers. Lucas: Exactly. Originally it was for primary dealers — the big banks — to borrow Treasury and agency securities overnight in exchange for cash, at a penalty rate. But in Kevin Warsh's first meeting as chair, the FOMC announced it's broadening eligibility to include a wider range of collateral, specifically commercial real estate loans. Luna: That's a big deal. The Fed is essentially creating a backstop for banks sitting on underwater CRE loans. Why now? Lucas: Because the math on CRE is getting worse. Office vacancy rates in major cities are still climbing, and we're seeing more loans coming due that can't be refinanced at the old rates. The 10-year Treasury yield is at 4.45 percent — that's where CRE loans are basically priced off of. If a bank has a portfolio of office loans made at 3.5 percent and now the replacement cost is 4.5 percent plus a spread, those loans are worth less on the books. Luna: And the banks that are most exposed are the smaller ones — the regional and community banks that don't have the same access to wholesale funding as a JPMorgan or Bank of America. Lucas: Right. The March 2023 banking crisis showed how fast deposits can flee a regional bank if confidence cracks. The new standing repo facility is designed to give those banks a way to get liquidity without having to sell assets at fire-sale prices. They pledge their CRE loans — at a haircut, of course — and get cash from the Fed. It's a classic lender of last resort function, but it's being expanded in real time. Luna: What's the haircut? Do we know? Lucas: The Fed hasn't disclosed exact numbers, but based on the facility's design, it's likely tiered. Higher-quality loans — say, multifamily properties with solid occupancy — might get a haircut of 10 to 15 percent. Riskier office loans could be 25 percent or more. The idea is to protect the Fed from losses while still providing a meaningful liquidity backstop. Luna: So the Fed is essentially saying, 'We trust our ability to value these loans better than the market does in a panic.' Lucas: That's exactly the argument. And it's not unprecedented — the Fed did something similar during the pandemic with the Main Street Lending Facility, though that was for corporate loans. The key difference is that this facility is standing, meaning it's always available, not just during a crisis. That's a structural change in how the Fed operates. Luna: But doesn't that create moral hazard? If banks know the Fed will always backstop their CRE losses, won't they take on more risk? Lucas: That's the classic critique. And Warsh addressed it in the press conference. He said the facility comes with strict collateral standards and a penalty rate — currently set at the interest on reserve balances plus 25 basis points, so 3.90 percent. That's above what a bank could get in the fed funds market, so it's not a subsidy. It's insurance, but you pay a premium. Luna: Still, it's a shift. The Fed is effectively expanding its footprint in credit markets. Do you think this is a response to something specific they're seeing in the banking system? Lucas: Probably. The Fed's own stress tests, released last week, showed that a severe recession scenario would push some regional banks below minimum capital ratios — not failure territory, but close. And the CRE exposure is the main driver. So this facility buys time. It lets banks hold those loans to maturity instead of selling them into a illiquid market. Luna: Honestly, if walking through the economy with us has made something click, that's the link — buy me a coffee dot com slash fexingo. We keep this ad-free, and listener support is what makes that possible. Lucas: Yeah, it's a small gesture that goes a long way. And we appreciate every one. So back to the Fed — the other notable thing from the June meeting was the discussion of the Bank of England's rate decision. Luna: Right, the BOE held at 3.75 percent. That's a full 12 basis points above the Fed's rate. And UK inflation is still at 2.8 percent, so they're not ready to cut. Lucas: Exactly. And what's interesting is how that differential affects dollar liquidity globally. When the BOE holds higher, it puts upward pressure on the pound, which means dollar-denominated debt servicing becomes more expensive for emerging markets. The Fed has to be mindful of that — a strong dollar can tighten financial conditions abroad, which eventually feeds back into U.S. exports and corporate earnings. Luna: So the standing repo facility isn't just a domestic tool. It's also a way to ensure that U.S. banks remain liquid enough to keep credit flowing globally, especially if dollar funding markets tighten. Lucas: Precisely. And the timing is notable given the headlines about Iranian tankers and the Hormuz strait. If oil prices spike, that adds another layer of inflation pressure, which complicates the Fed's path. The standing repo facility gives them a buffer to manage liquidity shocks without having to cut rates prematurely. Luna: So to sum up: the Fed is building a more robust liquidity backstop for banks exposed to CRE, it's doing it through a standing facility with penalty pricing to limit moral hazard, and it's doing all of this while keeping rates steady and watching global developments. That's a lot of moving parts. Lucas: It is. And the market is still digesting it. The S&P 500 is at 7,501, basically flat for the week, but the Russell 2000 is down almost one percent. Small caps are more exposed to regional banks and CRE, so they're feeling the weight of this uncertainty. Luna: So the real test will be if a regional bank actually taps the facility. If we see a bank using it, that could signal stress — but also that the backstop works. Lucas: Exactly. And that's what we'll be watching for in the weeks ahead.