Fed Rate Cut Signals Banks’ Exit from Emergency Facility, Easing Liquidity

With the Federal Reserve's recent rate cut, banks that borrowed from the Bank Term Funding Program (BTFP), established after the collapse of Silicon Valley Bank, may start repaying their loans faster. This could lead to a drain in liquidity from the financial system, according to RBC Capital Markets strategist Izaac Brook.

The BTFP, launched in 2023 to support struggling financial institutions, surged in popularity, with borrowing peaking at US$168 billion earlier this year. However, after the Fed slashed rates by half a percentage point, the program’s attractiveness has waned. Brook noted that we might soon see an increase in early loan repayments as the cost of borrowing through the BTFP is now less appealing.

Many financial institutions tapped the program to take advantage of its favorable terms, which included a one-year overnight index swap rate plus 10 basis points and no penalty for early repayment. However, borrowing has since declined, with the latest data showing a balance of US$94.8 billion through the week ending Sept 18.

As these loans are repaid, liquidity will be drained from money markets, potentially affecting bank reserves and the Fed’s reverse repurchase agreement facility (RRP). Brook suggests that many smaller banks, which tapped into the BTFP, might turn to Federal Home Loan Banks (FHLB) for future funding rather than other Fed facilities, which would only be used if the banks faced severe financial stress.

While this shift in borrowing may create some short-term funding pressures, it is not expected to significantly impact the Fed’s broader strategy to reduce its bond holdings or unwind its balance sheet, a process known as quantitative tightening (QT). Brook predicts that QT will likely continue until the second half of 2025, despite these temporary pressures.