Why are banks purchasing more government bonds?

On October 14, money market funds and other institutions will face a tougher regulation on their capital requirement. In anticipating the change, institutions are putting their excess cash into Repo Markets, or Reverse Repo Markets to be more precise, to increase their equity buffer.

To illustrate this point, let's look at Common Equity Tier 1 (CET1) capital ratio. The current Basel-III states that institutions are required to hold CET1 of 4.5% + 2.5% additional buffer. It means that at least 7% of their Risk-Weighted Assets (RWA) must be CET1-qualifiable equity. In order to increase this rate, there are basically two ways to achieve it: increase CET1-qulifiable equity or lower RWA. What is qualifiable for CET1 is less important here, so I'll jump straight to the next point.

How do we lower RWA? First, you have to look at how RWA is calculated. The fundamental definition of RWA is that it re-values the book value of assets based on their riskiness. For example, if a company has assets of $100 with $50 cash and $50 investment securities, RWA is $50, assuming that cash has 0% riskiness and investment securities 100%. Now, whenever institutions have excess cash, they typically make loans to finance securities dealers as well as their hedge fund clients and other leveraged investors. These loans are risky and therefore added to RWA. If RWA increases, CET1 ratio decreases, and that's bad for institutions.

So instead of making these more-profitable-but-riskier loans, institutions are purchasing more government bonds, which have 0% risk weight. This allows institutions reduce, or not to be forced to increase, RWA. Maintaining a higher level of CET1 is important for institutions right now because they are uncertain of what the new regulation is going to be. Whether the new rules are going to be much stricter or not, they want to lessen the impact.

So how are the institutions purchasing government bonds? Right now they are purchasing through Reverse Repo Markets (or RRP). Through this program, institutions deposit money into central banks in exchange for government bonds. They are required to sell back these bonds to central banks, while collecting a nominal interest rate of 0.25% on the deposits. This arrangement can last up to 65 days, though it is rare to go over 14 days.

Source:
WSJ article "Fed 'Repo' Program Swells"on 10/3/2016
NY Fed article "Repurchase and Reverse Repurchase Transactions": https://www.newyorkfed.org/aboutthefed/fedpoint/fed04.html