Fear And Hoarding: The Reverse Money Multiplier Effect And Capital Punishment

Includes: TOL, XHB
by: James Brettonwoods

The lack of commercial bank lending to the small business sector in the US is, in my opinion, killing the economic recovery. I have done extensive research of real life examples where I can see a direct correlation to a lack of bank business lending to private non rated companies and how it affects the economy, especially eradicating the well known concept of the money multiplier effect which underpins the banking system. First let's take a look what the multiplier effect should do in a banking system as defined in this Investopedia article summarized below:

"Definition of 'Multiplier Effect'

The expansion of a country's money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.

"Investopedia explains 'Multiplier Effect'

The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues - as more people deposit money and more banks continue lending it - until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect.

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited."

The 2008 global financial meltdown has created an environment where banks do not want to lend money to any business where this type of phenomenon thrives because they are afraid of the drastic effects these loans may have on the reserve (capital) requirement described above. The reserve requirement has many different names in banking and regulatory bodies internationally. It is really the capital ratio required by the particular banking regulator and gets many adjustments depending on what a bank's asset portfolio is comprised of and the duration of these assets in terms of maturity and interest rate sensitivity. Basel I, II and III is an attempt to put an international guideline for all banking regulators, but as we all know, regulations do get "lost in translation" when implemented on a country by country basis.

The money multiplier only works in an environment where money is 'created' by a bank as described in the money multiplier definition above. It does not come into play when investors buy bonds or other debt instruments from companies who have access to Wall Street because those investors are using existing money and not money created by the banking system. A lot has been written about the mortgage securitization of loans and how these were at the core of the 2008 global financial meltdown, but what has not really been fully explained is how commercial loan securitization has really changed the landscape for the money multiplier effect. The plain fact is that banks do not want to make loans that can't be securitized because they hurt their capital ratios required by Basel and impede their ability to show profits and pay dividends. Many consumers and investors get confused by what is regarded as bank capital. Capital is not the deposits a bank holds which are really liabilities on banks' balance sheets. A bank's capital, aka 'reserves', is a very complex regulatory calculation which takes in all the factors I describe above and ultimately handicapped by a banking regulator in charge of a particular bank institution. We think Paul Krugman actually helps confuse his readers as evidenced by his recent article rebutting SA writer Cullen Roche. He writes:

"Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks' portfolio - they're holding fewer securities and more reserve - and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That's all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment."

He is confusing everyone with his use of the above word in bold 'reserves' here. Reserves are not created, they can't be until they are earned in terms of profits. Reserves in banking economics is capital, the word 'liquidity' is what he should be using in this paragraph. I am sure he knows what he means, but he confuses the public by not being clear and consistent in his writing. Non-securitized and standalone non-rated loans on a bank's balance sheet are highly susceptible to their regulators handicapping judgment calls and therefore leave a lot of room for dispute between the bank and its regulator on the amount of capital that should support this loan and in a crisis mode may cause a significant risk to an institution's capital position. Therefore banks like to put their money into easily securitized investments which they can buy and sell freely and which are easily priced and insured against using default swaps. These are the type of loans Krugman describes above that they can sell or pledge to the Fed. This phenomenon leaves us with a banking system reluctant to make loans to small to medium sized businesses other than those they can get guaranteed by the government's highly regulated Small Business Administration (SBA). The SBA defines small business as a company with up to 1500 employees or a maximum of $35.5 million in annual revenues depending on its industry activity here. These loans are very restrictive and limited as reading between the lines in "Some Myths about Small Business Administration (SBA) Loans" will show you. I think the process is akin to a visit to your dentist. The bottom line is business finance is a "tale of two cities". One is being infused with cheap credit and they don't need it, that's the world of rated and securitized paper by issuers (businesses) who can access Wall Street and those who can't get any credit because they are smaller borrowers who before the crisis depended on commercial bank lending which has dried up due to the capital ratio paranoia. So what happens to the money multiplier effect when there is no real commercial lending? The answer is it turns into a decelerator of the economy and acts as a headwind to growth as we are experiencing here in the US. Hence what I call the reverse money multiplier effect which is what Fed Chairman Bernanke is trying to fight with QE I,II,III and so on. Moreover, we still have an older credit that was in place before the crisis that banks are still trying to dispose of rather than fix. This can cause distress situations which cause small businesses to continue to scale back their operations due to hardball policies from these once friendly bankers. I think the real drag on the economy is still the housing sector. What has been hailed by many as a housing rebound is really a far cry from a rebound. Take a look at a chart prepared by the National Association of Homebuilders about the historic and current contribution of housing to GDP growth:

A recent Bloomberg report of homebuilding stated:

"Purchases of new U.S. homes plunged 13.4 percent in July, the most in more than three years, raising concern higher mortgage rates will slow the real-estate rebound.

Sales fell to a 394,000 annualized pace, Commerce Department figures showed today in Washington. The reading was the weakest since October and was lower than any of the forecasts by 74 economists Bloomberg surveyed."

I show below how this revised annual pace of 394,000 compares historically from the Census Bureau:

The Bloomberg article above also goes on to quote large home builders like Toll Brothers (NYSE:TOL) and others as being optimistic. But given the historical chart from the census bureau above, the logical question is why? The reason for builders' optimism lies in the lack of small business lending and more specifically financing unavailability to privately held home builders who provide competition to the large national homebuilders such as TOL. This factoid is not readily understood by most. With banks reluctant to provide commercial loans to smaller builders because of the unfavorable capital treatment aka 'punishment', large homebuilders with access to cheap credit will get virtually all the sales and profits of new homes for themselves. So while the housing 'recovery' languishes, the national players will most likely chug along nicely.

Another report from Morningstar's Robert Johnson on August 24th, highlights my view of the soft economic reality:

I believe the softening is real and that even my conservative 2% GDP growth rate for 2013 forecast may be at risk. However, I will wait to see the July consumption numbers, the August auto sales report, and August employment data before I make a move. My caution flag has been up since this spring, and this week's announcements seem to indicate the U.S. economy has taken a turn for the worse. While a lot of people are excited about Europe and stronger manufacturing data, it is the consumer and maybe housing that are driving the ship, and those numbers have not been pretty. While the market might be temporarily excited by the push-off in the tapering program that may ensue if the economy slows as I surmise, investors will eventually realize the economic weakness isn't so fun after all.

Conclusion And Suggestions

The sad truth is we won't be able to get the wheels of the economy churning out growth until we fix the money multiplier that will provide real credit expansion which will ripple through the economy and start creating the jobs that are dearly needed. Even former FDIC head Sheila Bair has complained that banks are not lending to small business. Isn't it about time we fix that problem? Until we get the banks who are hoarding their cash deposits and using them to buy government guaranteed debt with zero risk weighting on their capital and make true new loans to the companies that need it, the concept of the money multiplier effect will be stuck in reverse fighting against the intended effects of QE.

Some possible solutions:

1. Have the Fed buy the distressed portfolios of these banks at the price they have them marked on their books, conditioned on them making new non-securitization loans within 120 days.

2. Lower the risk weighting by 75% on non-securitized commercial loans for 5 years and let them slowly go back to that level using a straight line methodology over the next 5 years (15% per year) and let them count these loans against their respective CRE requirements under the Community Reinvestment Act.

3. Give banks the use of the 30% investment tax credits for every dollar they put into these small business commercial loans.

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. I have no business relationship with any company whose stock is mentioned in this article.