Wednesday, December 16, 2009


Talk to Me Like I'm a 4-Year-Old: Why Aren't Banks Putting Those Reserves to Work?

Carlos Lara and I just spent 5 hours in the car driving to an undisclosed location in Indiana to meet with some life insurance people for our forthcoming book. Not surprisingly, we talked about the $1.1 trillion in excess reserves, and what it would take for them to start trickling (gushing?) out.

I explained that I have always found this typical explanation incomplete: "The banks can't lend right now because they fear another wave of defaults and so they have to be ready for their balance sheets to take another huge hit."

I don't think that can be the whole story. I don't doubt that this is basically correct, but I'm an economist so I need it to be right in theory before I can accept it even if I'm sure it's right in practice.

Specifically, here's my problem: Suppose the banks didn't fear any future defaults. Then they'd start making new loans and earning a lot more than Bernanke's piddling interest payments. So their balance sheets would get better more quickly than if they kept their reserves parked at the Fed.

OK, so if the way to increase your shareholders' equity (i.e. gap between assets and liabilities) in normal times is to lend out excess reserves, that fact isn't changed per se by the possibility that a bunch of your assets are bad. In fact it should make you even more eager to seek the most profitable use of your reserves.

Like I said, I know there is something wrong with my argument; I believe the people who are saying the banks aren't making new loans because they're worried that a bunch of their current loans will stop performing. But I just want to hear the explanation spelled out a little more.

For example, is it really like this: The banks are like households, and they have standard operating expenses. Right now they have cash coming in the door every month from people paying down their credit cards, mortgages, car loans, etc. But if those people get laid off and stop making payments, now the banks can't pay their leases, utility bills, employees, etc. So if they have a stockpile of reserves, they can start drawing them down. But, if they had foolishly invested all of their excess reserves even in super great projects yielding 80% over 5 years, they would have to shut down if those projects were illiquid and they couldn't meet their basic expenses.

Is the above paragraph in the right spirit?

Last point: If indeed it's true that the banks are keeping their reserves on hand, in case they need to draw them down to cover their operating expenses, then...

Doesn't that mean prolonged unemployment will lead to those reserves getting back into the hands of the public??

That has been my interpretation of the argument as well.

If that theory is correct, would inflation force the hands of the banks to let loose the money in order to have a chance at keeping up with the loses?

I just imagine a situation where the banks realize that there will be no chance to just get by until things get better and they will be forced to take bigger risks. I think they are waiting for the politicians to turn the heat up on them. That way they could say, "see we told you we shouldn't be making loans right now".
I think the reserves were increased in October last year to help banks pay depositors in case of a run on the banks or even meet an increased demand to hold cash and still remain within the current rules as adequately reserved. Ofcourse back then excess reserves were barely $2 billion and would've never met this demand if it materialized.

Also, this could be a clever way of bailing out the FDIC. Banks could pay out cash and if their equity went to zero, the FDIC would just merge them with JPMorgan or Wells Fargo. Those banks also have excess reserves to meet the demand deposit/reserves requirement and the FDIC wouldn't have to pony up.

Perhaps banks feel that because they are sitting on bad assets and defaults will rise, they are expecting a run on the bank in the near future or at least an increased demand for cash.

At some point, all the defaults would've stopped or Bernanke would've purchased all the junk assets in the system and the banks would still be sitting on reserves. That's when lending and inflation would kick into high gear.


My view is that because the banks are operating in a totally different environment from pre-credit crunch when they were naturally chasing business, they are now cautious.

Also zero interst rates compounds the problem, becase they encourage the credit-worthy to pay down debt rather than increase their deposits at the bank. Furthermore the banker will try to maintain some balance between his customer deposits and his lending, so to that extent excess reserves do not come into the picture.

The banker is further discouraged from lending because most loan applications are from individuals and businesses who are in a debt trap, and therefore not creditworthy.

Finally, looking at overall risk, it is better to play with short-term financial transactions than enter into loan transactions where a) you cannot be sure of the exit, and b) for regulatory purposes you have to take a haircut.

This combination of circumstances induces a psychology fundamentally different from that of a credit bubble.
Also, what is the distribution of excess reserves. Are they uniformly held, or are they held by only a few large banks?

As a community banker, outside the lower 48, I can tell you that if we had quality loan demand at the right price, then we would loan that money out. If we had bank-eligible bond investments that were quality and priced right, we would buy those. We do not like holding excess reserves at the Fed, but it's better than holding them at Federal Home Loan bank of Seattle, in which we would earn 0.01% versus the Fed's 0.25%.

What would you do with a spare $15 million if you were running a bank? Lend to over-leveraged households and businesses, or lend to over-leveraged governments in the bond market for depressed rates, thanks to a 3.25% prime rate and a near zero Fed Funds rate?

How we got this excess is from a variety of places, mostly bond investments that were called or mortgage-backed securities that prepaid at a much higher speed this year than usual. We have the Fed's perennial cheap money policy to thank for that. In addition, people are holding cash more as they are adjusting their own balance sheets, paying down debt, liquidating soured investments, and the like.

You can't be in business long making 0.25%, but neither can you do so by making risky loans and investments at artifically low rates instituted by all those smart guys out east.

It is from across the banking spectrum that are holding the excess reserves, for the reasons I expressed above.
To tack on to Mike in Alaska's comments see Caroline Baum's commentary today at (here's the link The gist of her article is that there is little demand from quality borrowers right now. What the government wants is the free wheeling lending days of 3 to 5 years ago but is demanding caution at the same time.
I also don't think its an issue of lenders suddenly becoming cautious but becoming realistic. I'm a commercial real estate attorney in the DC area. Two years ago vacant office buildings were being snapped up with multiple bidders for each building. The types of loans that were being made were structured purely on the presumption that the value of the building would increase and either the loan could be easily refinanced through the securitizaiton markets or the building sould for a significant profit. One building I worked remained vacant 10 months after completion and yet sold for 30% more than the land acquisition and construction costs. That was then.

My sense is that right now banks are more conservative beyond normal business practices because we're still in a recession and its unclear whether the economy has truly turned a corner (health care legislation and environmental legislation don't boost anyone's confidence that the economy will fully recover).I just closed on the refinancing of an existing building which had a 15-year operating history and great tenants. The owner could not find a single bank to refinance the loan. The existing lender ultimately agreed to refinance the loan BUT only at 50% of the building's fair market value. Conveniently, the 50% of the building's fair market value turned out to be the outstanding principal balance of the loan. From the bank's perspective, they were willing to make the loan but only if it could be assured that if the borrower defaulted the bank could sell the building during a down market and still pay off the loan. Clearly banks are no longer willing to finance a borrower's equity in its assets. My guess is that if the economy were strong the lender would have agreed to refinance up to a much higher threshold of the building's fair market value and let the owner take out some of the equity.

That is a great column in Bloomburg--almost too great. For if the knucleheads in Washington truly understood things and saw that they have conflicting agendas as regulators and as 'master' loan officers, they would see their folly and stick to what they know: being scoundrels.

I do not have much hope for the future based on the Sunday '60 Minutes' piece and the Monday spanking. Those two episodes tell me that Obama, Geithner, and Bernanke (and all their Mandarins) have no clue on what they are doing.

There's no one flying the plane...
Isn't the Fed paying intrest on reserves now?
Here's Robert Wenzel's theory on why the reserves are there:

It's very interesting. Any opinions on this?

The Fed is paying 25 basis points, 0.25% which they started paying late last year.

Regarding the article...

I can speak to my situation as an officer at a community bank on this.

As I mentioned above, we have this excess cash due to customer higher cash balances, bonds being called, and mortgage-backed securities paying off at higher speeds, not because the Fed loaned us any money. That money on deposit is ours, not theirs. If they want it, they'll have to sell some securities we deem appropriate, at a price we're willing to pay.

It is the Fed's ongoing cheap money policy that is causing mortgage rates to be artifically low--we're certainly not going to originate 4.875% mortgage loans and hold them, we'll let Fannie and Freddie bear that risk.

As you can see, our experience differs greatly from the thesis in Wenzel's article.

Hope this is beneficial.
I think it is quite simply that there are not enough credit-worthy applicants for loans. There was no real credit crunch; it was really a case of tightening lending standards, and that's what we are seeing today. My guess is they can eventually start relaxing the standards again (back to bubble mentality), or government will introduce some sort of guarantee for debtors (a sort of payor of last resort).
Annon (Art)-

We haven't changed, but the world around us surely has. We're the most profitable and most capitalized bank in the state. We got here by being conservative over a very long period of time, not when it became fashionable to do so.

Trust me, we would love nothing more than to lend to credit worthy households and businesses, or purchase high-quality, decent yielding bonds.

The Fed going out and over-paying for mortgage backed securities may have had the desired effect of lowering mortgage borrowing costs, but at the expense of weakening banks by taking away their cash flow streams when mortgage backed securities they hold pay off early. Now we hold deposits at the Fed earning 25 basis points.

Without writing a whole dissertation on the subject, the Fed is essentially painting itself into a corner from which getting out will be difficult and liable to cause more problems. The economy can't continue on cheap money, but they're (the economy) drunk from the stuff. If the Fed keeps pouring the whiskey, they'll further weaken the financial system and crash the dollar from the fiat money creation. [That was my Peter Schiff moment]

To close with a Misesian thought: We should've done nothing, sooner.
To Mike in Alaska

I always listen with respect to someone at the coal-face, and I think what you have said in your posts broadly supports my earlier comment (third down). I also think your comment on excess reserves is particularly important: Wentzel is right to point out that excess reserves are money not in circulation, but wrong to imply that the Fed can neutralise it at will. This money is not the Fed's, it belongs to commercial banks and it is their decision. Furthermore, the history of the Fed's management of the nation's money does not fill me with confidence.

Not enough attention is paid to the unintended consequences of zero rates, and your explanation of the resulting distortions in mortgate and other lending should be given far greater circulation.

My view is similar to what Mike in Alaska is describing. So, I'll just augment his comments with a simple example:

Suppose that you can lend someone money at 5% interest, and believe that there's a 10% chance of a total default. In that case, you expect to end up with $1 * 1.05 * .9 = $.945 for every $1 you lend. Since you can do better by just keeping the dollar, you decide to do that.

The problem, of course, is that in such a world we'd just expect the supply of loans to collapse, driving interest rates up to where loans are expected to be profitable. I think part of the problem is that demand for loans is quite low at the moment. (Low interest rates + decreasing loan activity => falling loan demand)

Here, I think Mike in Alaska has a good answer. Interest rates don't just rise to offset the odds of default because there are institutions like Freddie and Fannie providing cheap loans to the people that want them, so banks have to compete with that.
If I'm a bank paying depositors ~1% interest (or in my case 5.5%), how do I stay in business if their deposits make me 0.25% interest? It would seem that eventually I'll be in trouble.

You're right, you won't be long for this world if you continue earning 25 basis points at the Fed.

What it (the current situation) can do is force banks to take on more risk: loan more to over-leveraged households and businesses and buy long-term debt securities that are yielding terribly now. The timing couldn't be worse.

You can't imagine what mixed messages banks, like ours, are getting right now. We have the FDIC and other bank regulators telling us to behave at the same time you have others in the Asylumn telling us to lend like it's 1999.
Mike @ AK

You mean the FedGov wants to have its cake and eat it too? I'm SHOCKED!

Good thing we have them to tell us how to live our lives, or we'd just be unable to figure it all out.
I was under the impression that the banks are not lending because by law they have to have X amount of capital against to which to make loans and their capital was annihilated over the last few years so regardless of what they have in reserves, they can't loan it out until their capital position can sustain loans.
Michael, that was the case for a few banks, but the ones that are left ARE lending, at insanely low rates. The thing is, no one wants to borrow who isn't a huge credit risk.
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