Monday, February 8, 2010

A primer on bank reserves

The $1 trillion expansion of the Federal Reserve's Balance Sheet that occurred from Sept. '08 through late last year is arguably one of the biggest monetary events to happen in the history of the U.S. This chart puts it into perspective (note that the y-axis is a logarithmic scale). Prior to this crisis, bank reserves totaled about $96 billion and hadn't grown at all since 2003; now they stand at $1,190 billion.

I like to keep big and complex things as simple as possible in order to better understand their significance, so I offer this simple description of what has happened and what it might mean. It's not meant to be a definitive analysis of the situation, but rather something that should be understandable to those with a minimal level of knowledge of monetary matters. And at the very least it provides a basis for discussion.

The Fed, responding to a huge increase in the world's demand for money and safety in the wake of the collapse of Lehman Bros., bought a trillion dollars worth of securities (mostly Treasuries and MBS, and the exact number is closer to $1.1 trillion). The Fed paid for these purchases by crediting the accounts of its member banks with reserves, which is the type of money only the Fed can create. Buying and selling securities is the traditional way that the Fed increases or reduces the supply of money to the banking system.

In short, the Fed reacted to an explosion in the demand for money by pumping an explosion of bank reserves into the system. This was the right thing to do, since to not accommodate a surge in the demand for money with a surge in the supply of money would almost certainly have resulted in a severe shortage of money and thus a monetary deflation of the sort that exacerbated the Great Depression.

To date, banks essentially haven't used any of their extra reserves to expand their lending. The reserves are sitting idle at the Fed in the form of "excess reserves," which currently total $1.06 trillion, up from roughly zero prior to Sep. '08. The Fed has increased the lending capacity of banks by an order of magnitude, but this hasn't created a flood of extra liquidity or a burst of inflation.

There are several reasons for the lack of lending. To begin with, the demand for money and safety remains high, and thus the demand for loans is still weak. To be sure, there are lots of companies that are desperate for credit to fund startups and expansions that can't find a bank willing to lend to them, but in aggregate, bank lending is weak in part because most people these days are still trying to deleverage. At the same time, banks aren't particularly anxious to lend either. They still are suspicious of the credit quality of borrowers, which is why they have raised their lending standards, and they are more risk-averse than usual, just like almost everyone. Banks aren't anxious to change this, being quite happy to keep overall risk low even if it means earning a piddling amount on all the reserves they have at the Fed.

Banks may someday decide to use their reserves, and if and when they do, they could make tons of new loans and print tons of money in the process. (This is how the fractional reserve banking system works: if you ask the bank for a loan of $1 million, the bank sets aside about $100,000 in reserves and credits your checking with $1 million.) If this were to happen it could be very inflationary. For example: $1 trillion of excess reserves could potentially support about 10 trillion of new bank deposits--a sixfold increase in bank deposits!

The Fed is naturally quite concerned about this possibility, and the markets are too. Ideally, the Fed would just reverse what they did in late 2008, and sell Treasuries and MBS in exchange for taking back the trillion dollars of excess reserves. But everyone worries that this could push interest rates sky-high, threaten the recovery, and take away the security blanket (i.e., the tons of excess reserves) that now keeps the banks warm and happy. Alternatively, as Bernanke argued in a WSJ article last summer, the Fed could allow the reserves to gradually decline over the years as the securities it holds mature or are prepaid, but this might leave too many reserves in the system for too long.

Bernanke now says that the Fed's preferred exit strategy is to continue to pay interest on reserves (an authority first granted to the Fed in the Fall of '08), even as the Fed raises short-term interest rates. That way, the theory goes, banks won't mind holding lots of excess reserves indefinitely, or at least holding a lot more than they would under a non-interest-paying regime. Bank reserves would thus become very much like T-bills, a source of bedrock security and income for banks. As the Fed ratcheted up short-term interest rates to keep inflation pressures from rising as the economy gains strength, the income on these reserves would grow commensurately. Banks would be happy to keep holding excess reserves, and the Fed wouldn't have to sell a trillion dollars of securities. The Fed would presumably pay an interest rate on reserves equal to a bit less than the desired Fed funds target rate, which in turn is what drives interest rates all along the Treasury yield curve. Between maturing debt and mortgage prepayments, the excess reserves would gradually disappear.

Without the ability to earn interest on their reserves, reserves would act like a deadweight on bank's balance sheets. Banks would either try harder to expand their lending, which could be very inflationary, or they would sell their excess reserves on the open market. The latter would severely depress the Fed funds rate, which is something the Fed doesn't want to happen. The Fed runs monetary policy by targeting the Federal funds rate, and they are going to want to raise that rate, not watch it fall.

Alternatively, the Fed could raise reserve requirements, since that would effectively soak up some portion of the excess reserves. But raising reserve requirements can't do the heavy lifting that paying interest on reserves can accomplish, because being forced to hold a lot more non-interest-paying reserves would again be a deadweight drag on banks' balance sheets.

So Bernanke's proposal to pay interest on reserves is not completely crazy. But it could become very expensive for the Fed if interest rates rose a lot, and the whole exercise takes us into uncharted waters where unintended and unforeseen consequences lurk in the depths. It would also act to legitimize the "monetization of government debt" that is the real source of all inflation.

We can only hope that the Fed is able to navigate the turbulent and uncharted waters that lie ahead, while avoiding Scylla (inflation) and Charybdis (deflation).


Barry said...

If there was such worldwide demand for money how is it that the banks could just sit on the reserves?

Dan said...

I'm not sure I am following this correctly. The Fed dumps a lot of money into Bank reserves to save the banking system. Then pays interest to the banks to keep it there? Then the banks get to make even more money lending it out at higher rates as the interest rates go up? What does the Fed (and the taxpayer for that matter) get in return?

Further evidence that the bankers / financiers really are the best scam artists in the world.

Charles said...

The Fed is long on MBSs and Treasury bonds and short on Fed Funds. As long as they are willing to pay enough interest on bank reserves, they can prevent them from being lent out. They can also sell these bonds to sop up reserves. This makes the monetary base a meaningless measure of monetary policy.

Scott Grannis said...

Barry: Your question is very good because it reveals the confusion that surrounds monetary policy. The demand for money is the polar opposite of the demand for borrowed money. If I want to be long money (own money), I want cash, money market funds, and bank deposits. I also want to reduce or pay off my debt. If I want more debt, then my demand for money is declining, and I want to be short money.

Today the world's demand for dollars is still relatively strong; similarly, the demand for loans is relatively weak. That's why the reserves are sitting idle.

Scott Grannis said...

Charles makes a good point. The base only tells you that monetary policy is potentially very inflationary. To more accurately judge whether policy is inflationary today, you have to look at market based indicators: the dollar, gold, commodity prices, the yield curve, breakeven spreads on TIPS, and credit spreads. On balance I think they are saying there is an inflationary bias to policy.

The Lantern said...

Great article, very informative!

Burak T said...

Scott, when MBS/Treasuries on Fed balance sheet matures or are prepaid, does that reduce the currency in circulation or reduce the bank reserves? Or let me rephrase my question, as I understand bank reserves (when they are utilized) are more inflationary, so inflation is still a threat even if the securities mature/prepaid with the same amount of excess reserves???

Scott Grannis said...

Burak: Good question. Think of it this way: the maturity or prepayment of debt securities held by the Fed (both of which reduce the face value of the Fed's securities holdings) is equivalent to the Fed selling some portion of its debt holdings. Anytime the Fed sells securities (or otherwise reduces its holdings of securities), that drains reserves from the banking system because banks pay the Fed with reserves, and the reserves are then extinguished.

John said...


Thanks for your valiant try to explain reserves. Some of us need more help! I have several questions.

1. You wrote about demand for money. So people [and institutions] have a bunch of money tied up in stocks and bonds, but they are afraid of the riskiness of those assets, so they want to sell them and move the sale proceeds into something safer, and that something safer might be cash [which earns nothing], or money market funds or bank deposits [which earn teeny tiny interest rates]. And these desires to move money into something safer is called “demand for money.” Is that about right?

2. You wrote, “The Fed, responding to a huge increase in the world's demand for money and safety . . . bought a trillion dollars worth of securities . . . .”

Comment: I don’t get why the Fed cares about folks out in the hinterlands of the world and their “demand for money.” So I whine [demand] that I want to sell stocks and put the money into money market funds. Why does the Fed give a whit about that?

3. I also don’t understand the step by step process. I want to put my stock-sale proceeds into money market funds. How does the Fed buying mortgage backed bonds solve my problem? There is something obvious to you in the series of transactions that is not apparent to me.

So Big Bank loans $200,000 to Home Buyer. Then Big Bank sells the loan to Freddie. Then Freddie packages up 5,000 such loans [$1 billion], cooks the package into some kind of bonds, then sells the bonds.

Does the Fed then buy these bonds? Or are other buyers and sellers involved in additional transactions before the Fed finally buys the bonds?

The Fed makes a computer entry of $1 billion on Freddie’s account as payment for the bonds, and Freddie can then transfer $200,000 to Big Bank, which can now make another home loan. Is this about right? But how does this help me to put my stock-sale proceeds into money market funds and thus solve my “demand for money”?

4. If my scenario in #3 is correct, I don’t get how Big Bank has the $200,000 it got from Freddie deemed to be in reserves. Why isn’t the money just in the Bank’s own bank account?

5. Are banks required every day to calculate all their deposits, and all other assets and liabilities and then apply some legal formula for “reserves” to calculate how much they are required to have combined in their vaults and on reserve with the Fed? If yes, then is it the fact that banks will find themselves having less than they are supposed to have that causes them to go to other banks for overnight loans or if that doesn’t work then go to the Fed discount window?

6. So is the rate for this purpose that the Fed charges always lower than the rates that banks charge each other, and that’s why the Fed is a lender of last resort? Are the rates charged by banks negotiated among them in a free market [as contrasted to set by the Fed]?

7. So “excess reserves” means that the legal minimum required by all the banks put together is some amount, and every dollar held above that is part of the “excess” that now totals over $1 trillion?

I have many more questions, and I apologize for my ignorance, but you kind of opened the door. Smiley face goes here.

John Liljegren

Scott Grannis said...

John: your questions make me realize that I didn't explain things in enough detail. So here goes some clarifications:

1) You're right about the demand for money. It's all part of a big flight to safety, people wanting to sell risky assets and pay down loans in order to increase cash.

2) At the end of the day, the Fed's job is to make sure that the amount of money it supplies to the world is exactly the amount that the world wants. If the supply of and the demand for money are in balance, then there is no inflation or deflation risk. So the Fed must be responsive to any sign that the majority of people are desirous of holding more money.

3) Imagine that tons of people all of a sudden want to sell their stock and hold cash instead. That amounts to a huge increase in the demand for cash money (or bank deposits, or CDs or MMFs). Banks can create money using reserves, but if the Fed doesn't give the banks more reserves, the banks can't increase their deposits. The Fed's provision of reserves to the banking system is the ulimate constraint on the ability of the system to create new money.

In order for Big Bank to make a 200K loan, it first needs to acquire about 20K in reserves to back up the deposit it will create in home buyer's name. It can then sell the loan to Freddie Mac, and Freddie can sell it again. But the 200K of new money created by Big Bank stays in the system no matter what. If the Fed buys the loan, then it creates more reserves in the process, and this can be used by banks to create more money.

5) yes. If banks discover that they don't have enough reserves to meet the requirements of their deposits, they need to go to the market or the Fed to get those reserves. So if the public puts a ton of money into the banks instead of spending that money, then banks suddenly find that they need a ton of new reserves. If the Fed doesn't supply the new reserves, then the interest rate on reserves (the funds rate) will skyrocket and that will signal a shortage of money that could in turn prove deflationary.

6) banks charge each other for reserves that are lent, but that rate is determined by the market. The job of the FOMC is to supply or withdraw reserves so that the market-determined federal funds rate is equal to the target rate that the Fed has determined will lead to a balance between money supply and demand. This is obviously much more an art than science, and the Fed can and does make mistakes by targeting a rate that proves to not accomplish the job it was supposed to do.

7) Excess reserves are indeed the amount by which total reserves held by banks exceeds the reserves required by banks' deposits.

狂猪 said...

Hi Scott,

I am confused by the relationship between reserve requirement and capital requirement. During this crisis, many were very concerned about the low capital requirement ratio of the banks.

Even though the Fed pumped a lot of reserve into the system, that doesn't change the capital ratio right? And if not, and if the banks' capital ratio are low, they still would not be able to lend more right?

Is it correct to consider capital ratio a measure of the "skin in the game" for the bank owners/investors? Is the relationship between capital ratio and reserve ratio independent of each other?

Scott Grannis said...

Reserve requirements allow the Fed to control the degree to which the banking system can create money by lending. Capital requirements control the degree to which banks can leverage their balance sheets by borrowing. These are separate and distinct functions.