American banks are generating profits out of thin air by exploiting an emergency funding program created by the Federal Reserve after the 2023 Silicon Valley Bank crisis.
A recent Wall Street Journal article by David Benoit and Eric Wallerstein sheds light on this arbitrage practice banks are using to generate windfall profits. The reporters identified a “free-lunch” situation where banks obtain Federal Reserve funding at a lower rate than what the Fed pays them for their reserve deposits at the central bank.
As of early January 2024, U.S. banks have borrowed a staggering $141 billion from the Fed’s bank term funding program (BTFP) in just 10 months.
This program, offering loans of up to one year against collateral like U.S. Treasuries and mortgage-backed securities, charges banks an interest rate based on future expectations — specifically, the one-year overnight index swap rate plus an additional 0.1%.
While the Fed offers financing below 5% through this rescue program, it concurrently pays banks 5.4% on parked reserve balances, leading to a risk-free profit margin of about 0.4% for the banks.
The Wall Street Journal quoted Janney Montgomery Scott analyst Christopher Marinac who said banks are exploiting a positive arbitrage.
Shares in the U.S. financial sector, monitored through the Financial Select Sector SPDR Fund (NYSE:XLF), have not only recovered but also exceeded their pre-March 2023 banking crisis values. Since late October 2023, these stocks have experienced a 20% surge, outperforming the SPDR S&P 500 ETF Trust (NYSE:SPY) during the same timeframe.
In the past three months, leading U.S. banks have shown remarkable performance, with Bank of America Corp. (NYSE:BAC) gaining 25%, Citigroup Inc. (NYSE:C) rising by 30%, Goldman Sachs Inc. (NYSE:GS) increasing by 22%, and Wells Fargo Inc. (NYSE:WFC) advancing by 24%.
The Hidden Cost to U.S. Taxpayers
This lucrative situation for banks spells a cost for U.S. taxpayers. Interest payments the Fed makes on bank reserves are a liability for the central bank.
According to a November 2023 report by the Federal Reserve Bank of St. Louis, the Fed’s liabilities, primarily bank reserves and reverse repos, constituted 59.5% of its total liabilities as of Nov. 8, 2023. With rising policy rates, the Fed pays more interest on these…
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