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Chart of the day: Excess Reserves

One feature that is peculiar to the present downturn is the accumulation of reserves at the U.S. Federal Reserve.  I imagine it is no different at other central banks, though I have not seen the data. Let me tell you what this reserve accumulation means and show you a chart of excess reserves compiled by the St. Louis Fed (hat tip- hbl).

Economists would say the following: the accumulation of excess reserves demonstrates an unwillingness to lend on the part of banks and reduces the impact of high-powered money by reducing the money multiplier.  However, for most people that sentence is a bunch of mumbo jumbo and doesn’t make a whole lot of sense so let me break it down into plain English below (Note: the explanation provided below is the neo-classical explanation in which reserves create loans.  A number of economists of the post-Keynesian variety have done empirical work demonstrating that it is loans which create reserves rendering the concept of the money multiplier void.)

  1. The central bank is a monopolist which the government gave the sole right to issue legal tender — the money that is freely exchanged in the economy.  The government passes a law ruling that all other currency is illegal and forbids exchange in other currencies under penalty of law.  In prior days, many entities could issue their own competing monies, and many States did so before the 20th century in the U.S.
  2. We live in a fractional-reserve banking system.  This means that a bank is legally allowed to keep only a percentage of deposits on hand.  The rest can be lent out.  The mandated percentage of deposits are called reserves and they must be kept at the central bank for safekeeping.
  3. This control of reserves gives the central bank power over the entire banking system.  For example, if the minimum reserve ratio is 5%, then a bank can deposit $5 reserves with the central bank and lend out $95 more – making the asset to reserve ratio 20 to 1.  If the reserve ratio is increased to 10%, a bank must restrict its lending to a 10 to 1 asset ratio.
  4. Now, I mentioned that the central bank is a monopolist.  This means the central bank can print money basically when it feels like it. There are some constraints like congressional oversight, keeping money supply growth low, etc.  But, on the whole, if the central bank wants to print $100 and buy a treasury bond with that $100, it can do so.  This is called increasing the money supply.
  5. Let’s say the central bank does print $100.  Then it buys a bond from Bank A.  Now, Bank A has $100 that did not previously exist.  By law, it must deposit a percentage of these funds at the central bank (say 20%).  It is free to lend the remaining $80 out.
  6. The borrower of the $80 spends the loan money.  The recipient of the spending then deposits the money in Bank B.  Bank B is required by law to keep 20% or $16 on reserve at the central bank, but it can then lend out the remaining $64, which it does.  And this goes on and on with more lending, reserve maintenance, and re-lending. Through this mechanism, fractional reserve banking multiplies the original $100 into $500 of money in the economy (where $500 = $100 divided by the reserve ratio of 20%).  If the ratio were 10%, $100 creates $1000.  If the ratio were 5%, $100 creates $2000.

Hopefully, this example makes it clear how a central bank can put money in peoples hands (see the link to the Wikipedia entry on fractional-reserve banking for a more in-depth explanation).

Now, this is where the excess reserves come into play.  What if Bank A or Bank B was a dodgy institution that had just written down $15 billion in sub-prime mortgage-backed debt? They might not particularly feel like lending.  After all, IndyMac went bust. Wachovia and Washington Mutual already went belly up.  Citgroup almost failed but was bailed out at the last second.  Who’s to say Bank A or Bank B won’t be next.  Best to hold onto the cash and lend none of it out, just in case.

So, that is exactly what’s happening, RIGHT NOW.  Look at this chart.

This is a chart of the excess reserves held at the U.S. central bank. The chart, compiled by the St. Luis Fed demonstrates that banks always lend out nearly every dime they can so as to make a profit.  They do not hold excess reserves at the Fed, sitting around making them no money.

But, notice how the blue line is flat near zero and then it spikes up to ridiculous levels close to $300 billion in 2008.  With our reserve ratio of 10%, that’s nearly $3 trillion of lending that isn’t being done.Banks are scared out of their minds and are holding a huge amount of excess reserves…just in case — profits be damned.

This chart demonstrates that banks are not lending.  This chart explains why the money multiplier is contracting. This chart explains why we have a credit crisis. This chart explains why the Fed is pushing on a string.   This chart explains why deflation is a threat.

Sources

EXCRESNS, Excess Reserves of Depository Institutions – St. Louis Fed

Fractional-reserve banking – Wikipedia

Note: this post only discusses the supply of credit, but the lack of credit demand is more to the point in explaining why excess reserves pile up in a debt deflationary environment. It is the lack of credit demand by borrowers considered creditworthy which has been most problematic in Japan which has been suffering this problem for quite some time. And to the degree the discussion of the money multiplier makes it appear that reserves create loans, I hope the post is clear in saying it is the opposite; loans come first and reserves increase accordingly.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

5 Comments

  1. thomas crown says:

    you don’t suppose the huge spike in reserves held at the Fed has anything to do with the Fed recent change to now pay interest on reserves, do you? the excess reserves banks used to lend out in the overnight market (with counterparty risk), they can now leave all warm and snugly at Father Fed? could that be the reason?

  2. @thomas crown:
    sorry for the delayed response. you make a great point and that is very much the case that the Fed’s paying interest is partly to blame. Read the post from Macroblog from back in October: “Why is the Fed Paying Interest on Excess Reserves?” to see corroboration of your thesis.

    When I get a moment I o intend to write a follow-up demonstrating that excess reserves were also a hallmark of the depression and need to be addressed. Apparently, the excess reserves have now increased to over $600 billion, which translates into $6 trillion of lending capacity. I don’t know where I have that figure, so if someone has the link, please post it.

    thanks for the comment, thomas.

    Cheers.

    Ed

  3. Denis says:

    A friend pointed out that much of these reserves are actually locked in repo – Fed “bought” securities form banks, with a repurchase agreement for 1-20 days. So far the Fed was rolling the repo, but if it didn’t any bank without money on hand will immeidately become bankrupt. These money can not be lended out.

  4. @Denis:

    Your friend is right that much of these funds are tied up in repo agreements with the Fed with dodgy mortgage backed securities as collateral. John Mauldin has a good article on this:
    http://www.frontlinethoughts.com/article.asp?id=mwo120508

    While the Fed did create the T-bills, they did not inject new capital into the overall system. If a bank had one billion in assets and gave the Fed $100 million to get liquid T-bills, it still just has $1 billion in assets. Yes, it could sell them to someone else to get cash, but that someone else would use already existing dollars. The Fed has provided liquidity but did not inject (yet) new cash into the overall system through this program. At some point in the future, when banks are once again doing business with each other and the system is more liquid, banks will take those T-bills back to the Fed and receive back whatever collateral they used to get them in the first place.

    Nevertheless, I would argue that these repo agreements could be rolled forward and that the excess reserves could be lent against as a result. After all, the banks did own the collateral they exchanged with the Fed. You should also note the similarity in money velocity decline from the 1930s to the present episode — further evidence that lending is excessively restrictive.