Trying to Overcome My Ignorance on the Banking System

Over the last year, I have learned that those of us who took economics back in the 1980's with textbooks written in the 1960's and 1970's are not very well prepared to understand the modern banking system.  This was a pretty good article that whetted my appetite for understanding what has changed.  A couple of interesting bits from the piece:

One cannot think straight about the future impact of different exit strategies without understanding of the role of bank reserves in today’s financial markets.

  • Banking and money creation has not worked for at least two decades in the way that most people learned in school.

The old system was rather simple in the textbooks. The basic assumptions were (i) all credit was provided by banks; (ii) all bank credit (assets) were funded by the issuance, or creation, of depository liabilities (money) subject to a reserve requirement; and (iii) central banks controlled credit/money/inflation by rationing bank reserves. A stable 'money multiplier' was hypothesised to allow central banks to accurately predict the eventual impact of changes in bank reserves on money and credit.

The problem with the old theory of monetary operations is that none of the three assumptions has been true for at least a generation.
Most credit in the US is created by nonbanks; virtually all bank lending is funded by the creation of liabilities that are not subject to reserve requirements,3 and central banks do not ration reserves. In fact they take great pains to provide banks with the amount of reserves they desire. Central banks influence credit not by rationing the quantity of reserves but by altering the interest rate that banks must pay to obtain the quantity of reserves they desire.

  • Today, credit creation in general and money creation in particular are no longer tied to the stock of reserves (i.e. the stock of banks’ deposits at the Fed).

This gets to the heart of the question of why over $2 trillion in excess bank deposits built up at the Fed over the last 4 years are not really moving the needle on bank lending  (of course, this is a supply AND demand problem, and part of the issue with flat bank lending is tie to lack of demand as many businesses deleverage).  But in terms of supply, I am increasingly coming to terms with the following statement which seems counter-intuitive to someone who studied banking 30 years ago

One of the unintended consequences of Fed LSAPs has been the withdrawal of high quality liquid collateral such as US Treasuries from the financial markets paid for by crediting commercial bank reserve accounts. As discussed above, the banking system as a whole cannot dispose of these assets (reserves). At the same time, banks are under massive pressure world-wide to deleverage. This can take place either by increasing capital (a bank liability), which is costly to shareholders, or by reducing assets. Thus banks’ massive holdings of reserves at the Fed are ‘deadwood’ as far as the banks and their credit-creation capacity are concerned. They may crowd out credit.

The deadwood problem will get worse if the US tightens regulatory leverage ratios – that is, reduces the maximum ratio permitted between a bank’s total assets and capital.6

There is a great irony in the journalistic history of monetary policy. What many are calling central bank “money creation” “helicopter money” or “rolling the printing presses” may – in combination with tighter leverage ratios – lead to a tightening of bank credit and deflationary pressures.  And all this is occurring while the spectre of uncontrolled credit expansion and monetary debasement are being decried countless times by those who have not recognized that yesteryear’s monetary paradigm is defunct.

Interesting.  I hear this from a lot of people in the know about the system.  The author suggests one solution is having the Fed begin to do reverse repos with non-banks, which would drain excess reserves while adding high quality collateral back to the banking system which would allow more lending.  Which appears to be exactly what the Fed is considering.

I am reading this article next to see if I can get a better handle on how all this works.  I will let you know if I find it useful.

  • morganovich

    by sucking up all the high quality liquid collateral in QE programs, the fed has demolished the swaps market. the effects of sequestering collateral are amplified by the process of rehypothecation in the swaps market. (you can re lend 80% of the collateral). every dollar of collateral you suck out of the system wipes out about $2.70 in lending.

    this is why the swaps market has been roughly cut in half (lost $10 trillion in size)

    this is not the world of Samuelson anymore. that text book bears little resemblance to modern reality.

    the fed is destroying credit, not increasing it.

    they are destroying income for bond holders and market confidence for those who wish to invest in business assets through regime uncertainty.

    they are inflating horrible asset bubbles and have really painted themselves into a corner while enabling truly awful federal fiscal policy and hiding the costs in the short run.

    this is what you get when you fill the fed with academics and not with people who actually know how markets work.

  • Richard Quigley

    This might help. :)

    – here is Punch’s take on the banks from April 1957*:

    Q: What are banks for?

    A: To make money.

    Q: For the customers?

    A: For the banks.

    Q: Why doesn’t bank advertising mention this ?

    A: It wouldn’t be in good taste. But it is mentioned by implication in references to reserves of $249,000,000 or thereabouts. That is the money they have made.

    Q: Out of the customers?

    A: I suppose so.

    Q: They also mention Assets of $500,000,000 or thereabouts. Have they made that too ? A: Not exactly. That is the money they use to make money.

    Q: I see. And they keep it in a safe somewhere?

    A: Not at all. They lend it to customers.

    Q: Then they haven’t got it?

    A: No.

    Q: Then how is it Assets?

    A: They maintain that it would be if they got it back.

    Q: But they must have some money in a safe somewhere?

    A: Yes, usually $500,000,000 or thereabouts. This is called Liabilities.

    Q: But if they’ve got it, how can they be liable for it?

    A: Because it isn’t theirs.

    Q: Then why do they have it?

    A: It has been lent to them by customers.

    Q: You mean customers lend banks money?

    A: In effect. They put money into their accounts, so it is really lent to the banks.

    Q: And what do the banks do with it?

    A: Lend it to other customers.

    Q: But you said that money they lent to other people was Assets?

    A: Yes.

    Q: Then Assets and Liabilities must be the same thing.

    A: You can’t really say that.

    Q: But you’ve just said it. If I put $100 into my account the bank is liable to have to pay it back, so it’s Liabilities. But they go and lend it to someone else, and he is liable to pay it back, so it’s Assets. It’s the same $100, isn’t it?

    A: Yes, but..

    Q: Then it cancels out. It means, doesn’t it, that banks don’t really have any money at all?

    A: Theoretically..

    Q: Never mind theoretically. And if they haven’t any money, where do they get their Reserves of $249,000,000 or thereabouts?

    A: I told you. That is the money they’ve made.

    Q: How?

    A: Well, when they lend your $100 to someone they charge him interest.

    Q: How much?

    A: It depends on the Bank rate. Say five and a half percent. That’s their profit.

    Q: Why isn’t it my profit ? Isn’t it my money ?

    A: It’s the theory of banking practice that..

    Q: When I lend them my $100 why don’t I charge them interest?

    A: You do.

    Q: You don’t say. How much?

    A: It depends on the Bank rate. Say half a percent.

    Q: Grasping of me, rather?

    A: But that’s only if you’re not going to draw the money out again.

    Q: But of course I’m going to draw it out again. If I hadn’t wanted to draw it out again I could have buried it in the garden, couldn’t I ?

    A: They wouldn’t like you to draw it out again.

    Q: Why not? If I keep it there you say it’s a Liability. Wouldn’t they be glad if I reduced their Liabilities by removing it?

    A: No. Because if you remove it they can’t lend it to anyone else.

    Q: But if I wanted to remove it they’d have to let me?

    A: Certainly.

    Q: But suppose they’ve already lent it to another customer?

    A: Then they’ll let you have someone else’s money.

    Q: But suppose he wants his too.. and they’ve let me have it?

    A: You’re being purposely obtuse.

    Q: I think I’m being acute. What if everyone wanted their money at once?

    A: It’s the theory of banking practice that they never would.

    Q: So what banks bank on is not having to meet their commitments?

    A: I wouldn’t say that.

    Q: Naturally. Well, if there’s nothing else you think you can tell me..

    A: Quite so. Now you can go off and open a banking account.

    Q: Just one last question.

    A: Of course.

    Q: Wouldn’t I do better to go off and open up a bank?

    *Cited in G. Edward Griffin’s history of the Fed, ‘The Creature From Jekyll Island’.

  • MingoV

    "... why over $2 trillion in excess bank deposits built up at the Fed over
    the last 4 years are not really moving the needle on bank lending..."

    The federal reserve paid interest to commercial banks to take this money. The interest rate was low but guaranteed, and there was little incentive to lend the money.

    The smaller banks, that could have borrowed money from the commercial banks, didn't do so because:
    1. Businesses were afraid to expand or retool.
    2. Investors did not want to use loans to buy investments.
    3. The new mortgage rules blocked out a large number of people who were fully qualified pre-Obama.
    4. Entrepreneurs were uninterested or unable to build start-up companies in a business-unfriendly climate. (Here's a real example of adverse climate change.)

  • Matthew Slyfield

    "The old system was rather simple in the textbooks. The basic
    assumptions were (i) all credit was provided by banks; (ii) all bank
    credit (assets) were funded by the issuance, or creation, of depository
    liabilities (money) subject to a reserve requirement; and (iii) central
    banks controlled credit/money/inflation by rationing bank reserves. A
    stable 'money multiplier' was hypothesised to allow central banks to
    accurately predict the eventual impact of changes in bank reserves on
    money and credit.

    The problem with the old theory of monetary operations is that none
    of the three assumptions has been true for at least a generation."

    I would suggest at least considering the possibility that the three assumptions in the old theory were never true.

  • mesocyclone

    When you figure it out, please post your analysis. I just read the paper, found it pretty scary, but I didn't come close to fully digesting it.

  • obloodyhell

    What does MOM say about this?
    http://maxedoutmama.blogspot.com/

  • JoshK

    I think this is not a good representation of what actually happens. Banks are having their balance sheet leverage reduced, which reduces their capacity to lend, but that's driven by regulation, regardless of how many TSY's are out there.

    There are lots of other folks who could lend or invest. Private equity and sov weath have lots of capacity. Something in the environment (new regs, subsidisation of unemployment, etc, etc) is causing slower groth. Having more repos shouldn't help.

    Also, regarding the swap comment above, the switch to SEF's I think drives that a lot. I know at work all the time now we are dealing with those kind of issues. We used to be able to trade swaps out of 30 different entities and now just one is set up with all of the legal stuff you need.

  • regularjoeski

    How about a simpler explanation. Instead of TARP, which worked, we got a rerun of the Japanese save the banks but kill the economy for 20+ years system.

  • irandom419

    That is about my understanding of the situation. I found a reference to loans under $1e6 are not doing too well, while the lending rate in higher valued loans are back to normal. Supposedly, loan rates are limited by the discount rate and as that falls so does the ability to absorb risk. I've heard something about no one wanting to study the the effect of banking on the stock market which might explain some of the bizarre things the fed does.