The Bank Term Financing Plan (BTFP), an emergency financing tool launched last year to rescue the banking industry, has now become a "arbitrage paradise" for many institutions in the expectation of interest rate cuts. The Federal Reserve finally had no patience to wait for its automatic current period on Wednesday and decided to "take action" to adjust it first
The Federal Reserve announced on its official website on Wednesday local time that from now on, the adjusted BTFP interest rate will not be lower than the effective reserve balance interest rate on the day of loan disbursement.
The Federal Reserve's bank term financing program was launched during the regional banking crisis triggered by the Silicon Valley bank crash last year to alleviate financial system pressure - it allows banks and credit cooperatives to borrow funds with a maturity of no more than one year by pledging US Treasury bonds and institutional bonds at face value.
Prior to the latest changes on Wednesday, the BTFP interest rate was the one-year overnight index swap rate (OIS)+10 basis points. According to Wednesday's quotation, the BTFP interest rate for that day is approximately 4.88%. In contrast, the reserve interest rate is currently around 5.4% - which typically moves in sync with the Federal Reserve's benchmark federal funds rate target.
This means that financial institutions can enjoy risk-free arbitrage of over 50 basis points by borrowing funds through the BTFP program and placing them in reserve balances. After Wednesday's adjustment, the BTFP interest rate will be raised by at least 50 basis points, leaving no room for arbitrage.
The Federal Reserve stated in a statement that "adjusting the interest rates of bank term financing programs is to ensure continued support for the program's goals in the current interest rate environment.". The Federal Reserve added that the other terms of the plan have not changed.
It is worth mentioning that the Federal Reserve has also announced, as expected by the market, that this temporary tool will end on March 11th as originally planned and stop issuing new loans. Earlier this month, senior Federal Reserve officials announced that the plan would not be extended after the March 11 deadline.
The Federal Reserve is no longer willing to sit idly by and let "arbitrage paradise" thrive
In fact, since the end of last year, there have been constant doubts about the Federal Reserve's banking rescue plan becoming an arbitrage tool for financial institutions.
Institutions have found that due to the expected increase in interest rate cuts, the OIS interest rate has plummeted. Borrowing cash through this newer lending mechanism is cheaper than borrowing cash through traditional discount windows, which currently have an interest rate of 5.5%. As of the week ending January 17th, the amount of funds utilized by banks through the discount window was only $2.3 billion, far below the historical high of $153 billion set in March last year.
For banks, the decrease in BTFP interest rates also means greater arbitrage opportunities. Institutions can borrow from this tool and deposit the funds into the Federal Reserve's account, easily earning the interest rate difference with the reserve rate.
According to data from the Federal Reserve, the amount of funds borrowed from the BTFP reached a record breaking $162 billion in the week ending on January 17th (last Wednesday). And the previous week's record high was just set at $147 billion.
Steven Kelly, Deputy Director of Financial Stability Program Research at Yale University, said of this move, "Considering negative public opinion and real arbitrage behavior, this (the latest move by the Federal Reserve) does not surprise me. The Federal Reserve does not want to 'print money' for banks in this way. They will not wait until March."
Federal Reserve officials, including Federal Reserve Vice Chairman Barr, who is responsible for financial regulation, and New York Fed Chairman Williams, have previously stated that the BTFP is a response to "emergency situations" with the aim of providing liquidity at critical moments.
For a long time, the Federal Reserve has regarded the discount window as a long-term alternative to meeting such liquidity needs.
The Federal Reserve stated in its press release that during the tense period of last spring, bank term financing programs helped ensure the stability of the banking system and provided support for the economy. After March 11th, banks and other deposit taking institutions will continue to be able to use discount windows at any time to meet liquidity needs.