Monday, July 23, 2012

Outright asset purchases by the Fed will increase US banking system leverage ratios and potentially limit lending

There seems to be quite a bit of confusion about the impact of US banks' deposits at the Fed on the overall bank credit. People are asking "how can US banks be lending when they are keeping all this money in excess reserves (deposits) with the Federal Reserve"? "They are just hoarding cash, etc." But as discussed in this post on the ECB Deposit Facility, bank excess reserves are a function of the central bank's balance sheet, and have nothing to do with how much banks are lending. If banks in the US for example double their lending today, the deposit amount at the Fed would stay constant.

That's because if you borrow dollars from Bank A, you are going to deposit your cash at another bank (Bank B) or pay someone who will deposit this money at their bank (Bank C). Let's say Bank C buys securities with that money. But now whoever they bought securities from has that cash on deposit with Bank D, etc. Sooner or later some US bank will end up with that money and "deposit" it with the Fed - there is simply no other way around it. Here is a good quote from JPMorgan on how this works in practice:
"... increased (or decreased) lending will not change the amount of aggregate reserves within the banking system. For example, Bank A lends money to a business by writing that business a check. The business deposits that check in its own bank, Bank B, which presents that check to the Fed. The Fed then debits the reserves of Bank A and credits the reserves of Bank B. Reserves have been neither created nor destroyed, they have just changed hands. The Fed is the only institution that can change the aggregate amount of reserves."
When the Fed buys a security outright, it credits some bank the cost of the security (say X dollars) and the chain above begins until some bank (or multiple banks) ends up with that X dollars on deposit at the Fed, increasing total reserves. The only thing that could change this direct relationship between the Fed's balance sheet and bank reserves is the amount of physical cash notes under people's mattresses or in bank vaults. But that amount is small relative to the overall monetary base (total dollars) and tends to grow very gradually.
JPMorgan: - "The only thing a bank’s reserves can become—other than another bank’s reserves—is [physical] cash. ... the demand for cash changes slowly, so increasing vault cash will only increase banks’ storage and handling costs."
Fed's balance sheet vs. bank deposits at the Fed (reserves)

This means that as the Fed increases its balance sheet, it automatically raises bank reserves (deposits at the Fed) by roughly the same amount. And by doing so, the Fed grows the balance sheets of the US banking system (by increasing the amount of this particular asset banks hold). Even though deposits at the Fed do not require any regulatory capital (zero risk weighted assets), banks' reported leverage would increase, potentially causing them to limit lending activities.
JPMorgan: - "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."
This is yet another reason the Fed will try avoiding outright asset purchases (QE3) for as long as possible, developing other easing alternatives instead.
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