Tuesday, July 24, 2012

More on QE raising bank leverage

An earlier post on how additional QE would cause bank leverage to increase, potentially curbing lending seems to have started quite a discussion, particularly on Twitter. Here is the complete quote from JPMorgan, who describe the process quite clearly:
Potential issues for the banking system

When assets on the Fed’s balance sheet increase, its liabilities will necessarily increase as well. Those liabilities are primarily reserves. Reserves can only be held by banks. Once reserves enter the banking system, no action on the part of the banks will decrease the aggregate amount of reserves. To see how this could become an issue for the banking system, consider if the Fed wished to buy $5 trillion in securities. This would imply that the aggregate balance sheet of the banking system would now have $5 trillion more of cash assets, namely, reserves. If the securities are purchases directly from the banks, there will be no change in bank balance sheets [though reserves will still go up]. However, securities purchased from nonbank investors will cause bank balance sheets to expand, as the funding will again be through reserves that cannot leave the banking system. Although this asset has zero-weighted risk, it will increase banks’ leverage ratios. For this reason, banks may be inclined to reduce other forms of credit.

Thus far, the increase in reserves has been limited enough not to be a problem. Given that much of the expansion of the Fed’s balance sheet has filled in vacuums left when banks shied away from interbank and other forms of lending, the growth in cash assets on bank balance sheets has likely simply filled in holes on the asset side of bank balance sheets. A massive further increase in Fed lending or securities purchases could be more problematic. Because TALF and, to a certain extent, the mortgage purchase programs are filling in for gaps in the “shadow banking system,” the reserves created would not necessarily supplant a contraction in bank credit.
Here is the author's information:
   Michael Feroli
   (212) 834-5523

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