By Pete Schroeder
WASHINGTON (Reuters) - The U.S. Federal Reserve may have contributed to recent turmoil in overnight lending markets through oversight practices that possibly discouraged banks from investing, a senior U.S. central bank official said on Wednesday.
Testifying before the House of Representatives Financial Services Committee, Fed Vice Chair Randal Quarles said the central bank is reviewing its supervisory practices in the wake of the issues that surfaced in the "repo" market.
"We have identified some areas where our existing supervision of the regulatory framework ... may have created some incentives that were contributors," he told lawmakers. "They were probably not the decisive contributors, but they were contributors, and I think we need to examine them.
Specifically, Quarles said that internal liquidity stress tests that Fed supervisors run on large banks may have led to banks preferring to hold reserves at the central bank as opposed to other high-quality liquid assets like Treasury bonds.
Rates for those loans suddenly spiked to 10% this fall, forcing the Fed to provide liquidity for the first time since the global financial crisis more than a decade ago, and that support is still ongoing.
Reuters has previously reported that Wall Street banks believed Fed supervisors were nudging them towards holding more Treasury debt, which is a common type of collateral pledged by companies and investors in exchange for cash in such markets.
Before borrowing rates spiked in the repo market, banks had previously left interactions with Fed supervisors believing excess reserves were the preferred form of high-quality liquid assets that large banks must hold on their books.
"Some banks ... have put a heavy emphasis on central bank reserves as the most liquid assets," Quarles told the panel. "That does create a thumb on the scale."
However, Quarles did not indicate that Fed rules that serve as the foundation for bank supervisors were a significant contributor to repo market stress. Some banks have argued that liquidity requirements imposed by the Fed had contributed to market stress.