Now, if a bank is one of the largest in the US and thus already holds very large sums in deposits and reserves (from the deposits and a decade of QE), then the expiry of the Fed’s concession leaves them in a difficult position.

On one hand, they find themselves with no lack of funding (the large sums of deposits and reserves mentioned above), and on the other, they have to pay a regulatory cost for being overfunded. 

Given this reality, it is no wonder that instead of seeking out new corporate deposits, some of the largest banks in America are encouraging their largest corporate depositors to place their cash elsewhere.

Where exactly?

Money market funds. Which is where the second order effects kick in.   

Consider a scenario where billions in corporate deposits move into money market funds.

This will drive up demand for money market instruments, the most desirable of which are US Treasury Bills. The most obvious effect of this is that short term rates will be pushed even lower, which is a consequence that will ripple through the rest of the system.

Firstly, even lower short term rates means even cheaper capital for those lucky enough to have access to it.

This could lead to even more speculative capital flooding into the already hot US housing market, not to mention further compressing spreads in the high yield corporate bond market.

Do asset markets, at their current levels of exuberance, really need more leverage in them?

Secondly, the billions in extra demand for T Bills will exacerbate the shortage of premium collateral in the repo market.

Every T Bill that is purchased by a money market fund flush with corporate cash that banks have turned away is a T Bill that is not available to repo dealers and repo market participants.

While this is a second order effect that is much less obvious than, say, an even more exuberant US housing market, it is much more dangerous.

Since the repo market is where financial market participants go when they need to borrow cash quickly and easily, a collateral shortage here means a less liquid market. A less liquid repo market is one which, in times of stress, cannot meet the borrowing needs of its participants.

This directly impacts traders and investors, who, if they are in a position of needing to roll over their borrowings but are unable to because of liquidity issues, will find themselves having to liquidate positions.

This is a very dangerous situation which can snowball very quickly into mass selloffs across different markets all across the globe; March 2020 being the most recent example of how quickly and internationally financial dominoes can fall.

Consequently, banks turning away new corporate deposits from their largest customers can directly contribute to higher levels of systemic fragility.

Imagine the repo market failing at the same time leverage in asset markets like stocks, housing, fixed income markets, etc, climb to ever higher levels.

That’s a lot of defaults waiting to happen at the same time, in markets that are already trading at very lofty valuations.

Together, it all has the potential to create a conflagration that would make the March 2020 selloff look small in comparison!