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.