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Excess Reserves: Bankers Grow Fat While Public Starves at Trader’s Narrative

As a response to the credit crunch the Federal Reserve, along with all major central banks around the world, stepped in and injected an astronomical amount of liquidity into the US banking system. Usually this results in excess reserves that eventually find their way into the real economy or are mopped up by the Fed as their need recedes (and to prevent inflation).

But that isn’t happening now. As you can see from the chart below, aggregate excess reserves in the US banking system peaked in late 2008 and have been fairly level. They are once again approaching $1 trillion dollars. What is more astonishing is just how much of an excess this really is:

aggregate bank reserves NY Fed Jan 2010

But what is really going on? and of what significance, if any, is this?

Not surprisingly, the New York Fed is taking the side of the bankers and arguing against Econ 101 (monetary multipliers) and all manner of common sense to arrive at a conclusion that all is well after all:

While the level of required reserves may change modestly with changes in bank lending behavior, the vast majority of the newly created reserves will end up being held as excess reserves regardless of how banks react to the new programs. In other words, the substantial buildup of reserves depicted in the chart reflects the large scale of the Federal Reserve’s policy initiatives, but says little or nothing about the programs’ effects on bank lending or on the economy more broadly.

The above excerpt is from the comment titled “Why Are Banks Holding So Many Excess Reserves?” and is written by Todd Keister and James J. McAndrews. You can download it from the NY Fed’s website. It concludes that:

The dramatic buildup of excess reserves reflects the large scale of the Federal Reserve’s policy initiatives; it conveys no information about the effects of these initiatives on bank lending or on the level of economic activity.

Oh really?

contraction in bank credit Gluskin Sheff Jan 2010
Source: Gluskin Sheff

1 For Me; 0 For You
Banks are not lending because they are following the simple forces at work. They have no compelling incentives to lend and many incentives to sit on their cash. For starters, in October 2008, for the first time ever, the Federal Reserve started to pay interest on reserves. That itself is of course a powerful reason to hold as much as you possibly can. After all, if you can earn a return without taking absolutely any risk why wouldn’t you?

FDIC Lottery
The FDIC is providing an even more lucrative reason for banks to hold large reserves. As a banker from California commented to Mish recently, a healthy balance sheet puts banks at the top of the list to receive the loans and deposits of failed banks. Strong banks therefore are competing with each other to receive the spoils of their fallen peers.

Again, why would you go through the costly and risky endeavor of actually lending money to people and businesses when you can just sit back? Here’s a list of failed banks from FDIC’s website. Last week 5 failed - I mean, 5 lucky “healthy” banks won the FDIC lottery.

The end result is that what we end up with is larger and larger institutions who are playing a shell game to further their own ends without really playing a role that contributes in a positive way to the general good. Banks grow larger and larger by feeding off the faltering, smaller, banks. So we have a concentration of risk instead of diluting it.

Actual lending and credit which is in reality the reason why these institutions exist in the first place have become a quaint sideshow. Instead they are now glorified hedge funds suckling at the teets of government. Privatized profits, socialized losses. And the bonuses keep on flowing at an ever growing rate. And to top it off we have government institutions like the Federal Reserve, FDIC and the Treasury who are cheering on the whole show.

If this was a movie we’d all walk out. Suspension of belief for entertainment is one thing, this is just nuts.

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10 Responses to “Excess Reserves: Bankers Grow Fat While Public Starves”  

  1. 1 tony holland

    great post. I wasn’t aware they paid interest on reserves
    If I were a bank I wouldn’t lend money either. The banks have been getting burned by bad loans and lending to the public is still risky.

  2. 2 MachineGhost

    Actually, I believe the banks have been buying Treasuries with the reserves, not just sitting on it. This is similar to what happened in the early 90’s after the Savings and Loan implosion, except the yield curve was a lot higher than now. Arbitraging failed banks and Treasuries is how banks repair their balance sheets in a low risk way to get back into a position of lending credit again.

    A huge problem will manifest once the economy recovers for real, the money velocity starts increasing again and the banks start selling off their reserve-invested Treasuries… TO WHOM?

  3. 3 rtpjr

    This chart would be way more interesting to me if it showed required bank reserves now and before glass-steagle was repealed.

  4. 4 flow5

    If one just looks at comparative yields and instruments @.25% on riskless guaranteed excess reserves it’s obvious why the volume of excess reserves approaches c. trillion. However, this isn’t a policy that promotes lending & investing.

  5. 5 sow

    I’m having trouble understanding where the banks got the excess reserve money in the first place. I think they either sold their junk to the fed for full face value, or the fed “loaned” the money to them with the junk being the collateral. If the latter, wouldn’t the banks owe the fed interest and not the other way around?

  6. 6 MachineGhost

    sow, when the Fed does open market operations, it can increase the monetary base (which is the 1% reserve requirement) by monetizing Treasuries from the banks in exchange for currency. That currency then became the bank reserves. During the crisis, the Fed expanded beyond Treasuries and also monetized the Freddie Mac and Fannie Mae mortgage bonds. Essentially, the Fed bailed out the banks instead of them taking a haircut. The monetary base doesn’t really effect much anymore, though, since reserve requirements were abolished in the early 90’s on everything but demand checking accounts.

  7. 7 sow

    With all the reading I’m doing to understand how money is created, along with your response, it is becoming more clear. Thanks for the quick answers.

    So I understand the concept of monetization being creating new money to buy these various bonds vs. using existing money in the system. The unclear point is how the banks get bailed out with it. Specifically, I’m thinking about the case where the Fed buys T-bills. I have a picture of the printing presses spitting out money (I know not literally) which then flows to the treasury which then uses it to pay for government operation (stimulus, etc.). So newly printed money just flowed into the system and all other things being equal, presumably we just created inflation.

    Here’s where I get confused though: How do the reserves come into play at this point and how are the banks bailed out here?

    Or is the bank bailing out specifically TARP which is funded by the new treasury money? I thought the banks have largely paid that money back.

    I’m really trying to understand how where the bad assets of the banks are lying and who is the current owner? If the banks, how have they been saved by all this? If the Fed, what mechanism was used to transfer those toxic assets to them (let’s set aside Maiden Lane assets since they appear to be chump change).

    It would be great if there was a place that explained the money creation all the way up to the questions I’m asking in laymen’s terms to help the average person get their arms around the real facts of the bailout (and what it means for the future in terms of inflation, bank solvency, etc.).

    Thanks again!

  8. 8 MachineGhost

    The Fed bailed out the banks by buying the agency mortgage bonds and taking it off their balance sheets. Although for a bank to repair its balance sheet over time (by allowing the bad debt to attrition), it does need to have more assets to stay ahead of bankruptcy/liquidation (equity is wiped out). One way of doing that is stuffing the balance sheet with Treasuries.

    Nothing flows to the Treasury from the Fed other than 95% of its yearly revenues, so you have it backwards. The whole system is based on debt issuance (Treasuries) by the Treasury for revenue as well as taxes collected by the IRS, a department of the Treasury. They work in tandem to keep inflation in check. All the Fed does is determine fiscal policy, i.e. whether or not the public holds Treasuries or currency. That’s all it can do other than act as a lender of last resort. The Fed is not a division of the Treasury, it is the U.S. government’s monopolistic banker.

    The Fed via the Treasury can direct the U.S. mint to print new currency, but that is very insignificant and just happens to replace aging currency. It has no bearing on the monetary base in-so-far as the reserves are composed of Treasuries. Since the reserve requirement is only 1%, there is not a lot of anything at bank to begin with. The reserve requirement is just the minimum assets the bank has to have on its balance sheet to be able to lend against. This is where the “money multiplier theory” comes into play which doesn’t have much real world evidence anymore (it may have been different in the past when reserve requirements were more encompassing to different account types).

    Inflation does not happen just because the Treasury issues more debt than the market is demanding (remember the Fed merely deteremines the form of the money, it doesn’t issue it). If the excess Treasuries are hoarded like in Japan, the velocity of money will remain deflated. It is only when the demand for money increases (velocity goes up), that you will have the hot potato syndrome of too much money chasing too much goods/services and prices will then adjust upwards to reflect too much supply vs demand, i.e. inflation. The Weimar Republic hyperinflation was caused by the German government issuing bonds to pay their government workers, not currency. The form of money is irrelevant, but too much of it is not.

    TARP is just a Treasury-Congressional authorization/accounting gimmick funded by the usual Treasury issuances. I believe there is some controversy as whether or not the banks have really paid it back or whether it was just another accounting gimmick. The TARP, I believe, was specifically to buy off the bad mortgage bonds off the bank’s balance sheets. I don’t recall at this point if the Fed monetized via TARP or they bought in addition to TARP.

    Keep in mind there was a difference between the investment banks and commercial banks. The Fed didn’t expressly have authorization over the investment banks and the FDIC didn’t either, so their hands were tied and had to resort to unconstitutional gimmicks to “save them” all so their bondholders wouldn’t take a haircut (the equity may have been wiped out but the bonds were more than enough for liquidation, all without risk to the system). If you can’t liquidate an investment bank in an orderly fashion because you lacked the legal authority and continued to respect that, the whole system would have truly collapsed unless you got innovative. But as usual, it was incompetence all around when we’re talking about career politicians, unelected bureaucrats and rich Wall Street bankers.

    As for an “idiot’s guide to money”, this is what the Fed used to produce:

  9. 9 MachineGhost

    Oops, I meant to say “All the Fed does is determine monetary policy” not fiscal policy.

    Also, keep in mind that “Modern Money Mechanics” is a hypothesis or theory on how fractional reserve banking works. Evidence from the real world over time hasn’t exactly supported it. But the how’s doesn’t really matter as much as the continual negative effects of having a central bank constantly bail out insolvent banks and governments.

    As for the why’s, if you want the early 1900’s conspiracists point of view, then I recommend you read “The Creature from Jekyll Island” as the best work on the subject.

  10. 10 sow

    Wow, that was a very generous response. I’m still trying to digest it all. Just when I thought I was making progress in understanding all this…

    I may be back with more questions if you don’t mind. If I can’t figure this out with the effort I’ve put forth, I can understand why most people don’t even bother. And this undoubtedly is one of the reasons the system persists.

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