NBER paper explores drivers of collateral prepositioning

Understanding Why US Banks Pledge Certain Collateral at the Federal Reserve

Research into the financial operations of US banks has shed light on an intriguing aspect: many banks choose to pledge only a portion of their unencumbered collateral at the Federal Reserve. The study, conducted by Gary Gorton, Chase Ross, and Sharon Ross, reveals that the “largest, most sophisticated” banks pledge approximately 28% of their collateral at the Fed. This finding raises important questions about the motivations and strategies of these banks.

The Mechanics of Collateral Prepositioning

The process of pledging collateral at the Federal Reserve, or collateral prepositioning, is a key aspect of a bank’s crisis management strategy. By prepositioning assets, banks enable the US central bank to value these assets quickly for use as collateral in the discount window during a financial crisis. This mechanism provides a safety net, ensuring that banks have access to emergency funding when needed.

The Puzzle of Partial Pledging

At face value, it might seem surprising that banks have quietly pledged a significant portion of their assets to the Federal Reserve. One might wonder why these banks do not pledge all of their available collateral, thus maximizing their potential access to emergency funding. The researchers’ findings suggest that the answer to this puzzle lies in the careful balancing act that banks must perform.

Strategic Asset Management

Banks must manage their assets strategically to ensure liquidity, profitability, and stability. Pledging all available collateral to the Federal Reserve could potentially limit a bank’s operational flexibility. By holding back some collateral, banks retain the ability to leverage these assets in other ways, such as securing loans or initiating investments.

Regulatory Considerations

Regulatory requirements also play a role in banks’ collateral prepositioning decisions. Banks must retain sufficient high-quality liquid assets to meet regulatory liquidity coverage ratios. Therefore, they cannot pledge all of their collateral to the Federal Reserve without falling foul of these requirements.

Crisis Management and Risk Mitigation

Finally, by pledging a portion of their collateral at the Federal Reserve, banks strengthen their crisis management and risk mitigation strategies. Having prepositioned collateral allows banks to access emergency funding quickly during a crisis, helping to maintain stability in the financial system.

Conclusion

In conclusion, the decision by US banks to pledge only a portion of their available collateral at the Federal Reserve is a strategic move that balances operational flexibility, regulatory compliance, and crisis management. This insight into the inner workings of the US banking system underscores the complexity and sophistication of financial management strategies at play in the industry.

For more detailed information on this research, you can access the original paper here.