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The public is mad as hell at the banking industry for cutting back on lending after receiving government funds from the TARP and direct loans from the Federal Reserve . Banks' fear of losses has led them to tighten lending terms and standards. At the same time, demand for loans also has declined as employment, consumer spending and business inventories have all fallen. So, despite public outrage, there is no sign yet of any revival in bank lending. Indeed, the Fed reported on December 10 that net bank lending has contracted by nearly $1.5 trillion since the start of 2009, with $854 million of that decline coming in the third quarter.

Meanwhile, bank reserves (banks' deposits at the Fed plus their vault cash) have exploded upward during the financial crisis, as the Fed has pumped money into the banking industry. Banks used to maintain reserves, on average, that were just slightly higher than the Fed's minimum reserve requirements . If they lacked sufficient reserves, they would borrow in the Fed Funds market. If they held unneeded reserves, they would lend them overnight to other banks in the Fed Funds market, where they would earn interest.

But, in October, 2008, the Federal Reserve, itself, began paying interest on excess reserves for the first time. This gave the banks an incentive, based on the interest rate offered, to have some excess reserves accumulate beyond the minimum amount required by the Fed and keep them on deposit at the Fed without making them available to other banks in the Fed funds market. This change in Fed policy enabled the Fed to pump up bank capital through direct loans and Tarp injections, without having to worry about so much money getting out into the real economy via loans, where it would cause inflation.

The Fed now uses the rate on excess reserves, as well as the Fed Funds rate, to influence both bank lending and growth of the money supply. To date, the Fed has been content to see the banks retain excess reserves so as to bolster banks’ capital and improve their financial stability.

The Fed has not put any direct pressure on banks to lend out more funds. To do so, the banks would have to either cut their interest rates, lend to less creditworthy customers, or ease their terms by accepting less collateral or collateral of lower quality as a basis for their lending. Or, they could increase their financial leverage by borrowing more. Any of these courses would put the banking system at greater risk, so an ease in credit will probably have to await an improvement in economic conditions and a resurgence in business confidence.

Observers as diverse as the prominent economist Allan Meltzer and gold advocate Peter Schiff have expressed fears that the Fed will keep rates too low for too long while the expansion of excess bank reserves will be maintained and will stoke inflation. Economist Paul Krugman counters that inflation will not necessarily take off, arguing that Japan’s quantitative easing caused rapid growth in bank reserves there, without boosting inflation.

Data on the growth of bank reserves are startling (from the Fed’s H.3 publication: Aggregate Reserves of Depository Institutions and the Monetary Base ,” 11/28/2008 and 12/10/2009). The figures show that in August, 2008, a quiet month in America - just weeks before Lehman's bankruptcy - total bank reserves were $45 billion, of which $2 billion were excess reserves. As of November 18, 2009, total bank reserves stood at $1.1 trillion. That’s up nearly 25-fold. As Paul Kasriel of Northern Trust has pointed out previously, the bulk of this year’s increase in bank reserves has been accounted for by the increase in excess reserves beyond what the Fed requires the banks to hold. The recent Fed H.3 data goes on to show that excess reserves rocketed from $2 billion in August, 2008 to over $1 trillion, up 500-fold, as of November 18, 2009.

How serious is the danger that banks will draw on the more than $1 trillion in newly created excess reserves and lend the money out into the real economy, wreaking inflationary havoc? The answer is: no chance at all, as long as the Fed has the will to prevent it. The Fed will use the Fed Funds rate as well as the interest rate it pays banks for excess reserves as levers to control any expansion of credit.

The provision of credit though the banking system remains a demand-driven system. Borrowers apply for loans, depending on their desire for money and the prevailing interest rates. Banks consider their requests, setting the rates and terms of any loans granted. As credit expands, borrowers borrow more, with banks first using their own funds, then borrowing excess reserves from other banks in the Fed Funds market, as needed. If increased borrowing puts upward pressure on rates in the Fed Funds market, the Fed, through its Open Market Committee, pumps new money into the Fed Funds market if it wishes to expand credit while holding interest rates stable. Alternatively, if the Fed wants to rein in bank lending, it raises the Fed Funds target rate, which raises rates to borrowers and limits their demand for loans. In this way, the Fed controls the expansion of credit.

The recent piling up of excess bank reserves does nothing to diminish this role of the Fed because the Fed still sets the Fed Funds target rate, while its setting of the rate on excess reserves influences the amount of excess reserves the banks wish to retain.

If banks, for some reason, failed to respond to the Fed’s strong interest rate incentives in favor of going wild with lending irresponsibly (would banks ever do that?) , the Fed could simply call in its loans to the banks, which would drain excess reserves from the system while impairing banks’ liquidity. That would put a damper on excessive lending, wouldn’t it? Furthermore, the Fed has the ability to "lock down" lending in the Fed Funds market by raising the rate it pays on excess reserves to a level that is higher than the Fed Funds rate. Banks would prefer to lend risk-free to the Fed, rather than lend at a lower rate to other banks. This would effectively freeze excess reserves and banks would find it difficult to secure additional funds in the Fed Funds market in order to lend amounts beyond their other sources of capital and their own surplus reserves.

The Fed’s challenge remains to get credit flowing in the economy again without going overboard. The accumulation of excess bank reserves has strengthened banks’ financial stability and it poses no special risk of an outbreak of runaway inflation. As in the twentieth century, prospects for future inflation continue to reside in the Fed’s setting of the Fed Funds target rate, as it influences the flow of credit and money in the U.S. economy.

Disclosure: No names of securities mentioned in this article