FedNow, capital kanban and the art of discouraging bank runs

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Letting people at their money is risky for banks. That’s the unsurprising conclusion of a note from Barclays, a bank, which looks the benefits and consequences of friction-free cash transfers.

The hook is FedNow, the Federal Reserve’s unified realtime payments system, which went live this month.

Anyone who needs to know about the mechanics of deposit clearing and settlement probably does already, so we’ll keep the explanation brief. All banks keep their own ledgers of depositor account balances. Every payment instruction needs to be checked against ledgers kept by the sender and receiver, as well as against the Fed’s master-ledger of bank settlement balances.

In practice, the volume of transactions requires a daily totalling up of inflows and outflows so the balance can be netted off with the Fed. Nothing moves until all three ledgers match, so not much can happen during bank holidays or outside regular daylight hours.

FedNow makes payment instructions instant, 24/7. This isn’t the tokenised solution promised by retail CBDCs, nor is it the halfway-house of a single-ledger regulated liability network currently being discussed. The important development is that everything on FedNow, even the smallest transactions, can be tracked in realtime on a gross basis.

That alone is going to change how investors think about cash and precautionary liquidity, says Barclays analyst Joseph Abate:

If balances can be moved into position instantly, there is less need to pre-position it in accounts ahead of time. Instead, it will be possible to coordinate inflows and outflows simultaneously for instant settlement while eliminating (or at least, lowering) the risk of overdrafts. Coordinated instant settlement means that depositors do not need to maintain extra cash in their transactions accounts to avoid potential overdrafts created from the mis-timing of payment flows. Likewise, banks would not need as large reserve balances at the Fed, for the same reason. Just-in-time payments should reduce aggregate demand for liquid balances. 

We think this has two implications. First, it means that the demand for bank transaction deposits is lower. Clients can now sweep money into these accounts on an as-needed basis. They can move more of their cash toward higher-yielding alternatives while simultaneously reducing overdrafts in their transactions accounts. Banks, in turn, would lose a portion of the roughly $4.5tn in low-cost sticky deposits.

Of course, this also applies to the banks themselves. Banks no longer need to keep as much idle cash in their accounts at the Fed; as a result, their demand for reserves is lower. In turn, the Fed could operate with a smaller balance sheet; ie, QT could continue for longer, as the least comfortable level of reserves (LCLoR) is lower. 

The parallel Barclays draws is with kanban, or just-in-time inventory management most closely associated with the auto industry. Reduced friction in the payments system allows investors and banks to minimise “inventories” of low-yielding cash in clearing balances, it says. The “shipments”, or balance transfers, happen only when payments are required. 

In the wake of the GFC, the Fed has been pushing for banks to reduce borrowings from intraday credit providers (known as tri-party repo banks) in anticipation of the settlement of their funding trades. It’s been fairly successful . . . 

. . . but not for efficiency reasons. Instead, QE created slush funds. As Barclays says:

The Fed’s asset purchases pushed bank reserves to over $4tn in 2022, and banks’ clearing balances became significantly overstocked.

Just-in-time payments, however, are more effective in reducing intraday liquidity needs and counterparty credit risk. This is because the extra liquidity created by the Fed’s asset purchases increased banks’ capital costs. Since 2021, bank reserves (and Treasuries) have been included in large banks’ SLR [Supplementary Leverage Ratio] capital charge. As a result, just like better inventory management can free up working capital, our sense is that more efficient cash management frees up bank capital. 

Great! Whatever might be the catch?

Of course, banks’ demand for reserves is not solely determined by their need for clearing balances. It is probably more closely tied to liquidity regulations. Moreover, while payment flows may be more coordinated in the future, a 24/7 cycle of instant access to balances likely means that banks are more vulnerable to deposit runs: balance withdrawals will no longer be limited to banking hours. [ . . . ]

We think this makes regulators somewhat leery of lowering liquidity just as we suspect that banks are not disposed to reduce their internal liquidity stress-testing metrics. Thin inventories that were overly reliant on speedy parts deliveries to keep the production line moving likely added to the supply crunch following the invasion of the Ukraine. To prevent cascading liquidity effects, our sense is that the Fed and other regulators may need to create governors or limits on payments to slow or short-circuit outflows in order to prevent instantaneous bank runs that can occur 24/7.

Engineering natural friction out of the system then replacing it with artificial friction is an odd sort of solution when trying to inspire confidence among depositors, but there we are.

Further reading:
— Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank