Excess Reserves Go Berserk As Lending Flatlines
It's not too often that you see a chart that looks like this. So when Noah found it he sent me an e-mail asking for a plausible explanation as to what is going on with excess bank reserves.
The guy I talked to at the St. Louis Fed on Friday couldn't explain much about excess reserves and why they might be so elevated, except to say that the Board of Governors collected these data, not the St. Louis Fed, and that it was reserves held on deposit with the bank. So I had to go to a different source for more insight.
According to Wikipedia, excess reserves are bank reserves in excess of the minimum reserve requirements set by a central bank. These reserves held on deposit were generally considered uneconomical as they earn no interest. For this reason, the Wiki contributor avers, banks minimize their excess reserve amounts by putting them to more productive use, usually by making overnight loans on the fed funds market to other banks who may be short their reserve requirements, on that particular evening. A good, succinct definition, but unsatisfying with regard to the current situation. So I dove into a little history.
Recall that back in May of 2008 the Fed asked Congress to allow them to pay interest on bank reserves (Noah discussed this in October, "Serenity Now...Thoughts out Loud" with the unintended side effect of hoarding cash in reserves rather then lend to deteriorating consumer). Permission for this had actually been given back in 2006, with a target date for implementation of 2011. The theory was that it would allow the Fed to better control the fed funds rate set by the Fed, but traded by the market. In times when banks had excess reserves and wanted to put them to work, they might actually be tempted to lend them out at less than the going fed funds rate. In fact, back in 2007 when the financial crisis was just getting started there were a couple of episodes where fed funds rates plunged to zero on a few trades when volumes were low.
According to a Wall Street Journal Online article in May of 2008 regarding the new reserve interest paying policy:
"In addition, the Fed could theoretically combat the credit crunch by buying securities or extending loans without limit without causing the Federal-Funds rate to fall to zero, something that could fuel inflation or distort markets."So now that we have a picture of how banks deal with excess reserves in normal times, and a clue as to why the Fed wanted to be able to pay interest on bank reserves in normal times, let's focus on what is going on now in Abby Normal times, as Igor would say.
The Fed began paying interest on excess reserve balances on October 9, 2008 after the passage of the Emergency Economic Stabilization Act. Initially, the rate paid on excess balances had been set at fed funds minus 75 basis points, but that was quickly changed to fed funds less 35 basis points, starting October 23. The Fed judged that the narrower spread would "help foster trading in the funds market at rates closer to the target rate." Just to clarify here, the Fed wants to be able to control fed funds rates better, so it is paying a return on any excess reserves a bank happens to have, so that banks won't lend out their excess capital in the fed funds market at less than the stated fed funds rate.
Here is an explanation for the Fed's policy of paying interest on excess reserves in its own words. According to the Federal Reserve Bank of New York:
Without authority to pay interest on reserves, from time to time the Desk has been unable to prevent the federal funds rate from falling to very low levels. With the payment of interest on excess balances, market participants will have little incentive for arranging federal funds transactions at rates below the rate paid on excess. By helping set a floor on market rates in this way, payment of interest on excess balances will enhance the Desk’s ability to keep the federal funds rate around the target for the federal funds rate. Recently the Desk has encountered difficulty achieving the operating target for the federal funds rate set by the FOMC, because the expansion of the Federal Reserve’s various liquidity facilities has caused a large increase in excess balances. The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Paying interest on excess reserves will better enable the Desk to achieve the target for the federal funds rate, even if further use of Federal Reserve liquidity facilities, such as the recently announced increases in the amounts being offered through the Term Auction Facility, results in higher levels of excess balances.
Full Stop: Please Understand What This Means! If banks can't find any use for their capital i.e., lending it out to borrowers at rates well above fed funds, they could previously have kept this money on deposit at the Fed as excess reserves, and earned nothing for their trouble, or they could have lent the money out to other banks overnight in the Fed Funds market. Recall that a few months ago banks were afraid to lend to each other overnight, because they were terrified that the counter-party bank could go tapioca at a moments' notice. However, as the Fed has virtually guaranteed to rescue any large bank, it seems that a different problem has developed: keeping Fed Funds rates from going through the floor because banks don't really want to lend out any of their capital to real economy borrowers and are willing to settle for puny overnight rates paid by other banks. Additionally, as implied by the New York Fed's explanation concerning further use of Federal Reserve liquidity facilities, as the Fed keeps pumping up banks' capital bases by allowing them to swap bad paper as collateral for borrowing of safe treasury securities this problem is potentially exacerbated.
Now let's step back for a minute and think about what the Fed really hopes to achieve here. Some would argue that banks have more losses to recognize over the next couple of years than their entire capital bases (including all the preferred and common equity they have issued so far). The Fed has been allowing the banks to temporarily offload their bad paper onto its books in order to keep from having markdowns take their capital bases below the levels set by the OCC, Treasury etc. The way losses are normally absorbed is for them to be netted against bank earnings over time. There are three ways that losses will likely be recognized:
1) Presumably some of the bad paper the Fed is renting right now will go back on bank balance sheets as their earnings recover and there are enough profits for these losses to be netted against.
2) Some of the bad paper will actually be purchased outright by the Fed (taxpayers), removed from the banking system altogether and will be written off by the government.
3) Some of the bad paper that is STILL on bank balance sheets will be netted against new TARP funds that were taken in by the banks (essentially through preferred equity offerings to Uncle Sam) and the TARP funds taken in will melt away.
Just to be fair, the ultimate losses on the paper may be much lower with a government-managed process of this sort, than if all the banks went bust and vulture investors bought the paper at cents on the dollar in liquidations.
So how can the Fed help banks earn enough to offset all their losses and digest them without their capital bases ever falling so much that the regulators have to call them insolvent and close them? (So far the regulators have been afraid to even allow failures of big banks so they just arrange shotgun marriages before the bad news gets out).
1) The Fed allows the banks to borrow from the discount window at near-zero rates (ZIRP) and lend to the very best of borrowers for a spread above treasuries
2) The banks can just lend money back to Uncle Sam by buying treasuries.
3) If they don't like either of these options they can let their now-excessive un-lent capital sit as excess reserves at the Fed and get paid interest on them.
This is the reason for the mountain of excess reserves in the chart above. This chart also means that the fed is "pushing on a string" all the stimulus of TARP, Liquidity Facilities and ZIRP are just pumping up excess bank reserves right now, the funds are NOT getting into the market and therefore NOT having their intended multiplier effect (high velocity money).
Among the alternatives, only the spreads from lending to real borrowers are attractive to banks today due to the headlong rush by financial players into treasuries, but banks are still afraid to lend to all but the very best borrowers (and many of the lesser quality potential borrowers don't want to borrow), hence the explosion of excess reserves on bank balance sheets despite all the efforts to resucitate lending. Some would assume that this mountain of reserves will get put to work in the credit markets at some point and cause economic activity to go wild. My guess is that these excess reserves will be melted away as banks absorb losses on delinquent loans and as marked down securities see their income streams actually collapse.
Eventually, bank balance sheets will be cleaned up, the economic outlook will brighten and banks will start making well underwritten loans to worthwhile borrowers who are ready to invest in reasonable risk/reward opportunities. By that time some of the charged off real estate still on bank balance sheets may be found to have greater value than banks expected, but all of these would appear to be a long way down the tracks. At least that's my interpretation. In my view, any effort to force banks to lend out these reserves before the clean-up (recognition of losses) is finished will just cause more uneconomic loans to be made and ultimately prolong the pain. Banks are in intensive care and the excess reserve build we are seeing is like a measure of all the medicine being pumped in to save their lives. They are not ready to get up off the bed and run around the room yet. But we will keep watching this chart as a decline in excess reserves will probably signal that losses are being charged off as needed and eventually will signal that money is being lent out.