Chart of the Day: Excess Reserves

Excess reserves

Since the financial crisis hit in 2008, excess reserves have piled up in the U.S. financial system. There were almost no excess reserves in the system during the period of recorded data from 1959 onwards. But after the post-Lehman Brothers panic and the Fed’s zero interest rate policy, reserves piled up.

Excess reserves 2

Fed Funds rate

The build up of excess reserves has coincided with a steep fall in the money multiplier.

In a fiat money system, there is not a very good correlation between base money and M1 and credit because reserves don’t create loans. In practice, the lending operations of commercial banks have no interaction with reserve operations. Lenders simply take applications from customers who seek loans and assess creditworthiness and lend accordingly.

In approving a loan, banks instantly create a deposit, a zero net financial asset transaction – and this happens entirely independently of the reserve requirement. In Australia, Canada, Sweden and New Zealand there are no bank reserve requirements. In periods when credit is expanding, if a banking system is at the reserve requirement limit, the central bank can either:

  • create new reserves;
  • relax the reserve ratio; or
  • refuse to create new reserves and cause a credit crunch

In practice, central banks have opted to create new reserves, which is accomplished by buying financial assets with newly created money (in the form of electronic credits on bank balance sheets).

Right now, credit growth is anaemic because of either a lack of demand by creditworthy borrowers or a fear of capital constraints at lenders. Anecdotally, both issues seem to be at play. That has meant that the Fed’s injection of reserves into the system has led to a pile up of excess reserves instead of new lending.

I have been saying QE2 will end as planned and that the Fed will pause to assess the economy before doing anything else. Based on Federal Reserve messaging, QE2 does look to be winding down on schedule. If economic growth in the U.S. does not falter in the second half of 2011, the Fed will look to drain excess reserves from the system as preparation for an interest rate hike at some unforeseeable future date.

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.