Is it possible that there can be too much liquidity in the banking system during such a severe economic crisis? The answer is yes when it comes to liquidity/margins and community bankers are feeling the pain, as they wait for someone in the Gov't to push the elevator "Stop" button.
We all know the FRB cut rates to between 0% and 0.25% in an effort to boost liquidity. We also know that as recent as Dec. 2008, FRB Chair Bernanke reiterated rates would be kept "exceptionally" low in order to "promote the resumption of sustainable economic growth." We are all on board with that, because at this point we want to see signs of recovery sooner rather than later.
Let's examine short-term liquidity to see if we can figure out what is going on with Fed Funds. One way investors track liquidity in the system (that as we have talked about before in this publication) is by monitoring the TED spread. The TED spread is calculated by taking the difference between the 3M Treasury rate and the 3M Eurodollar futures contract. The TED spread always fluctuates, but historically, levels below 50bp show liquidity is strong and investors are comfortable; while spreads in excess of 200bp show strains have reached significant levels in the system. As governments worldwide have flooded the market with liquidity, the TED spread has fallen from over 300bp at its peak in Oct. 2008 to around 100bp today (see below). That is a huge move and it indicates liquidity is available. The problem with the short-end of the curve, however (due to the aggressive actions by the Gov't), is that it has also resulted in unintended consequences. Before we jump back and take a look at the Fed Funds market, we need to focus in on one other issue worthy of discussion, namely the Temporary Liquidity Guarantee Program (TLGP).
TLGP was designed to provide liquidity to large banks and it has worked wonders. By attaching a "full faith and credit FDIC repayment guarantee" to their debt, large banks have found an easy way to capture unsecured funding. In fact, 73 issuers have borrowed a total of $269B under the program. That is good, but the impact on the Fed Funds market has been substantial.
The unintended consequence of this, along with substantial industry deleveraging, is that while liquidity has returned, the TLGP program has sharply reduced the number and appetite of usual buyers that support the Fed Funds market (large US banks). When you consider that the Fed Funds market historically averages about $300B per day, it is easy to see how much damage TLGP has done to community banks that frequent that market each day. It is simply the result of too much money, chasing too few large national bank buyers (already stuffed to the gills with TLGP funds). So much money is available each day in fact, that some large US banks pay as little as 1bp.
If regulators really want community banks to stockpile liquidity, it is either time for liquidity to come out of the market or for the FRB to launch another new program with fancy acronyms. The Fed Funds market needs ongoing support to ensure the overnight rate finds footing - at least at 25bp each day. Liquidity in the system is fine, but the damage to Fed Funds may soon drive community bankers to riskier options in an effort to capture any return and we would doubt regulators really want that.