Banks Aren’t “Sitting On Their Reserves”
December 12, 2013
(This item originally appeared at Forbes.com on December 12, 2013.)
Some people are a little confused by the increasing amounts of “bank reserves” (bank deposits at the Federal reserve, a form of base money), and the rather low rate of loan growth at banks today. Let’s take a closer look.
When the Federal Reserve creates new base money by buying Treasury bonds, via its QE3 program, the exact process works something like this: the Fed buys a bond from a private market participant. The Fed pays for the bond by crediting the seller’s bank with the payment, in the form of a deposit at the Fed, known as “bank reserves.” From the point of view of the payee bank, it is no different than any other transaction. However, there was no payer bank whose account was debited. Thus, the total amount of base money increases.
Only the Fed can create or reduce base money. Regular banks cannot. If banks do not exchange these new Fed deposits for physical banknotes and coins, then they remain in the form of deposits. The total amount of base money (banknotes, coins and Fed deposits) in existence does not change. Thus, it doesn’t matter what banks do: the total amount of base money remains the same.
From this, you can see that — unless transferred into banknotes — bank reserves wouldn’t change whether banks had a high rate of loan growth or a low one. In other words, it wouldn’t change whether they were “lending aggressively” or “not making loans.”
Banks’ Fed deposits are changeable into banknotes, and vice versa, on demand. It is much like one-dollar bills and ten-dollar bills. We can change ten one-dollar bills for one ten-dollar bill on demand, at any time. You can think of bank reserves as another “denomination” of base money, albeit one that can be held only by Fed member banks.
However, this process is precipitated by banks’ customers, mostly depositors. If you went to the bank and withdrew $1000 from your checking account in the form of $20 bills, then the bank would have to acquire those bills somehow to give to you. If the bank had a shortage, it would request more $20 bills from the Treasury. The bank would “withdraw” $1 million, let’s say, from its Fed deposits, and receive them in the form of $20 bills, to give to people like you. The amount of bank reserves would go down, and the amount of banknotes would go up, but total base money (banknotes plus bank reserves) would remain the same.
Banks themselves generally won’t ask for banknotes unless prompted by their customers. They don’t have any use for them.
Actually, it seems to me that banks are actually being quite aggressive about lending to anyone that is perceived as a (marginally) decent borrower. The amount of “covenant-lite” loans made so far in 2013 exceeds all past records — including 2007, which we can now look back on as being a ridiculous extreme. Apparently, 55% of all new leveraged loans are in “cov-lite” form, exceeding the 29% ratio of 2007. LBO buyout EBITDA multiples are at record highs. Nominal yields on high-risk “junk” bonds are at all-time lows. Total high-yield bond issuance in 2013 is just behind the pace set in 2012, an all-time record. High-yield issuance in Europe is up 98% from 2012.
By all of these metrics, people are apparently falling all over themselves lending money at the worst terms in recent history.
However, the total amount of loans on banks’ balance sheets has been stagnant. Today, it is up about 2% from a year earlier, well below the 10%-per-annum pace of the 2002-2007 period and also below the recent peak around 5% from early 2012.
The reasons for this are largely that potential borrowers are not interested in borrowing money. Businesses don’t see low-risk expansion prospects. Households have too much debt already. Almost all mortgage lending these days is done via the government agencies. The Federal government also oversees student loans, a major nexus of loan growth in recent years. Auto lending is largely handled by captive auto finance companies.
In other words, banks are “pushing on a string,” which always seems to happen in these situations. The Keynesian economists like to use terms like “the transmission system is broken,” or “liquidity trap.” These don’t really mean anything except that their theories fail to describe reality.
I think the Fed will continue with its QE program for longer than most think possible. It might even get bigger in 2014. Why not? If the results are disappointing, you can always argue that you need more. It doesn’t seem to have any negative consequences. Pulling back seems to cause immediate pain. The economy is rather tepid as it is, and deteriorating gently.
With this, we drift farther into our “experiment” in money-printing. This is not the first such experiment. Other countries have tried it, and they get consistent, repeatable results. I don’t think this time is different.