Right said Fed!

This graph commences in 1950 until the present time.  It measures the capital on the balance sheet of USA banks that is in excess to their requirements according to international prudential guidelines.  That is, capital not required (according to those measures) for them to run their business at optimal levels. More expressly, it is Excess Reserves of Depository Institutions (EXCRESNS), Monthly, Not Seasonally Adjusted, 1959-01-01 to 2012-03-01.  Clicking on the graph will give you a closer view. 

Since the GFC, and in prior forecasts, many people knew this was going to be a big one.  Crash, that is.  That we would be seeing volatility in data reads of extraordinary size.  But this one is just nuts. 

If you follow the blue horizontal line, you will see in late 2001 a tiny blip.  That was not long after the horrific terrorism attack in New York.  And in the few weeks that followed, at least several major US banks were bust so financially it was a very torrid time.

As you move further to the right, you will see that in late 2008 – about the time Lehman Bros was collapsing in the USA - banks started hoarding capital.  That excess now stands at about US$1.5 trillion.  In perspective, that is enough capital for another US$18.75 trillion worth of lending that they are not doing.  And that is of course how banks make profits, by lending out their money.  Well not strictly true any more, but theoretically correct.

Essentially they stopped lending to each other through the money market or interbank market because the view was trust no one.  So they started parking it with the Fed. 

By way of comparison, required reserves are about US$60 billion.  So in effect, these banks have 25 times their required reserves.  

So do they know something we do not?  Why hoard expensive capital, with the toll on profits given there is little place to invest it with much return, unless you are (i) scared out of your wits about another might downturn and massive liquidity crunch or (ii) there is a lot of short term risk (OTC derivatives?) they may have but we do not know, against which they are holding this capital (and not required by prudential standards).  There seems to be a complete loss of trust between counter parties.

Think about it this way.  You run a dairy that relies extensively on the power grid.  Now, occasionally that grid fails, so you have a large generator as a back-up.  Now just say, worst case, the generator wasn’t working, or may not work when required, and you are very cautious, then you may invest some money to have two generators on site.  As you run through this graph you will see that the US banks have the equivalent of 26 generators on the one dairy farm.  That is how cautious they are.

By any measure this is an astounding graph and data set.  And it tells us several things.  First, that the banks are scared out of their wits of the uncertain global economic future, so we should be too.  Second that if or when that hoarded capital starts hitting the streets as new lending, we are in for an almighty rise in inflation, whether in assets prices or consumption prices we should be prepared.  And finally, it really is different this time – but not for all the reasons you usually hear.  We cannot rely on how we each, as individuals, managed for our financial security in the past fifty years over the next fifty.  They will be defined as two different eras. 

Again, to provide another comparison, here is the Net Free or Borrowed Reserves of Depository Institutions (NFORBRES), Monthly, Not Seasonally Adjusted, 1959-01-01 to 2012-03-01.  As bad as things got in September October 2008, the borrowing was only minor compared to excess reserves achieved since then.  It was at about that time, that the Fed Reserve began, for the first time, to pay interest on the excess reserves that banks held with the Fed as the interbank market had pretty much collapsed.  In this they were copying New Zealand’s policies.

If you want the Fed’s research on these excess reserves you can read about it here.  It argues that the money market, which froze in 2008, has essentially been transplanted onto the Fed Reserve balance sheet.  Okay, that is my view of what they are saying.  That is rather than banks lending excess reserves to each other they now park it at the Fed.  

It also argues that when the short term interest hits zero, which it pretty much has, banks are no longer interested in lending out their money and thus generate excess reserves.  It says, “When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves.”  Not sure I agree with this, hasn’t anybody heard of risk spread to official rates?  

But it is more interesting when it gets to the topic of inflation.  It argues that because the banks are receiving interest (remember this is for the first time ever) from the Fed, then they do not have an interest in lending great swathes of money and thus creating great swathes of inflation.  It says “By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves.”  The interest rate on both required and excess reserves is 0.25%.  

This must be having a discordant impact on the economy.  For a start the money is not being deployed to boost the economy; second, the people of USA are paying for these excess reserves through the Fed;  and finally, it should be called what it is:  a giant inflation creation.  

Or a great big fat dividend coming for shareholders??  Right said Fed.