Monetary Matters with Jack Farley

Dr. Darrell Duffie on Liquidity Strains at Year-End/Quarter-End and When Fed Reserves Will No Longer Be Ample

Dec 29, 2024

Darrell Duffie, a finance and economics professor at Stanford, dives into liquidity strains at quarter-end, exploring the complexities of SOFR/IOR spreads. He discusses how bank payment timing is a better stress predictor than spread itself. Duffie also critiques current debt-to-GDP levels and suggests the Treasury's 'stealth QE' tactics. He explains the evolving treasury strategy for short-term needs and its effects on market dynamics, alongside the implications of transitioning from LIBOR to SOFR for banks and corporate borrowing.

01:10:05

Episode guests

Darrell Duffie

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Episode notes

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Quick takeaways

Darrell Duffie emphasizes that liquidity strains typically escalate at quarter- and year-end due to capital requirement pressures and foreign bank practices.

The divergence between SOFR and IOR rates signals underlying market stresses, highlighting the effects of banks' cautious lending behavior during regulatory deadlines.

A novel technique based on payment timing in the repo market serves as an early warning for banks regarding potential liquidity shortages.

Deep dives

Interest Rate Discrepancies Explained

The podcast highlights the differences between the Interest on Reserves (IOR) and the Secured Overnight Financing Rate (SOFR), emphasizing that these two rates should ideally be identical under perfect market conditions. However, the discussion notes how these rates diverge, especially around quarter ends, due to foreign banks engaging in practices like 'window dressing' to improve their capital positions. This practice leads to reduced funding availability in the repo market, causing U.S. banks to increase financing rates as they are cautious about their balance sheets. As a result, the spread between SOFR and IOR can widen significantly, reflecting underlying market stresses and capital requirement pressures.

Intro

5min

Banking Liquidity Dynamics: Capital and Reserves

30min

Understanding Reverse Repo Mechanics

8min

Treasury Bills vs. Long-Term Bonds: Implications and Intent

6min

Treasury Strategy Shift

5min

The Debt Dilemma: Crowding Out and Fiscal Sustainability

7min

Treasury Securities and Market Stress

4min

Exploring Bank Funding Risks and Corporate Borrowing Dynamics

5min

With the end of year approaching and SOFR/IOR spreads widening, Darrell Duffie, renowned and prolific monetary scholar, joins Monetary Matters to share his views on why liquidity strains often appear at quarter- and year-end. Duffie explains his work on the September 2019 repo blowout and shares his findings that timing of bank payments is a better predictor of SOFR/IOR stress than the SOFR/IOR spread itself. Duffie also shares his views on debt-to-GDP levels, the theory that the Treasury has engaged in “stealth QE,” and the impact of SOFR transition on bank funding costs. Recorded on December 27, 2024.

Duffie Piece On Reserves Discussed For Most Of Interview (“Reserves Were Not So Ample After All”): https://www.newyorkfed.org/research/staff_reports/sr974

Duffie Piece on SOFR vs. LIBOR impact on bank debt-overhang cost (discussed at end, “Bank Funding Risk, Reference Rates, and Credit Supply”): https://www.newyorkfed.org/research/staff_reports/sr1042

Darrell Duffie’s website https://www.darrellduffie.com/

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