No Hokum: No Stock Investments With Excess Reserves

by: Martin Lowy

On January 14, 2013, Seeking Alpha published "Repoed! How The Fed And Depositors Fund Banks' Big Bets" by Colin Lokey. That article was based in part on an article from Zero Hedge. Both of these articles are logically reasoned and apparently learned. Unfortunately, the law is different from what Mr. Lokey and Zero Hedge suppose it is.

The premise of the articles is as follows:

  1. By purchasing securities from banks, the Fed is creating excess reserves on the books of the banks.
  2. In order to be able to use these reserves for speculative purposes, the banks buy U.S. Treasury securities and repo them to obtain "laundered" cash that they are free to use to speculate.
  3. That process, the articles suggest, has fueled the gains in the U.S. stock market over recent weeks.

There are several flaws in this tale. First, a bank may lawfully invest excess reserves in anything it may lawfully invest in. One dollar of assets is like another dollar of assets. They are fungible. There are no special restrictions on excess reserves.

Second, banks are allowed to invest only in certain kinds of securities. These do not include equity securities. Yes, NO COMMON STOCKS. PERIOD. Section 24 of the National Bank Act gives national banks their powers. Paragraph seven of that section gives national banks their investment powers. The only general purpose securities they may invest in are debt securities that are denominated investment securities by the Comptroller of the Currency. Basically, this means securities that are rated investment grade by the major rating agencies. This limitation applies to all Fed member banks, courtesy of the Federal Reserve Act. Therefore, no large American bank is buying common stocks for its own account. That would be illegal, has been illegal since 1933, and that part of the law was not changed by the revisions to Glass-Steagall made by the Gramm-Leach-Bliley Act of 1999.

Third, if you thought a bank could do this through its holding company or an affiliate of its holding company (which neither Mr. Lokey nor Zero Hedge said), you would be wrong. No bank can lend more than 10% of its capital to its holding company. And if it does, such a loan has to be secured by high-quality collateral. It is not a happening thing. Take a look at Federal Reserve Act Section 23A. A bank has no way, except via a dividend, to get a large amount of money into its holding company. And dividends can only be declared out of profits and only if the bank, after the dividend, meets its regulatory capital requirements.

So please do not worry that whatever bank you have invested in is using the devices described in the Lokey and Zero Hedge articles to gamble with excess reserves or depositors' money.

That does not mean that they are not gambling with excess reserves or depositors' money. It only means that they are not doing it through the stock market, and that they do not have to engage in repos to obtain "clean" cash in order to do so.

Why do banks engage in repo transactions, then? The transactions are in the form of a loan, except that rather than lending money, the banks are lending securities. They lend the securities because some party that is engaged in the securities business or is otherwise shorting or engaged in derivative transactions needs the government securities temporarily. As a consequence, the bank's counterparty is willing to pay more than the underlying rate of interest on the securities in order to hold them. The bank makes a profit, usually a small one, but there is no regulatory capital charge for this small profit. Therefore, it has an infinite apparent ROE. Repos do have risks, but they are pretty small when the bank is holding cash as collateral. I would not lose any sleep over these transactions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.