Friday, December 18, 2009

Part 2 - The Bernanke Bluff: On the Trillion Dollars of Excess Reserves

Yesterday, I commented on a new report by Fed economists Todd Keister and James McAndrews in which they said that the trillion dollars in excess reserves has not had, and will not have, an impact on the economy. I agree with this assessment, despite the fact that economist after economist has obsessed with the growth in the monetary base as a result of these excess reserves (See for example O'Driscoll, Kudlow, Rozeff). The money is simply not in the system. As Keister and McAndrews write:
The high level of reserves in the U.S. banking system during the financial crisis reflects the large scale of the Federal Reserve’s policy initiatives, it conveys no information about the effect of these initiatives on bank lending or on the level of economic activity.
This is not to say the fund injection served no purpose. As Keister and McAndrews point out, a shortage of Fed funds at the time would have forced some banks to wind down loans if the Fed did not provide some emergency credit facilities. In that sense the added reserves stabilized the system. It didn't result in the expansion of a yacht. It plugged a hole in the current yacht.

Keister and McAndrews do not provide us with any figures as to how much of the excess reserves are currently held by banks who were unwilling to loan the funds out last year and how many are held by banks who have actively borrowed at the facilities to earn the spread between the borrowing cost and what can be earned on funds left on deposit at the Fed as excess reserves. This is important. Very important. To the degree the funds are held by banks earning the spread, they know they are going to be called on the funds and will keep them as excess reserves until they have to pay them back.

However, without providing evidence to the size of such activities, Keister and McAndrews imply that those holding the excess reserves are a different set from those that borrowed money from the credit facilities. A commenter at Bob Murphy's web site provides insight into the thinking of such bankers that would be holding excess reserves:

Mike in Alaska said...

Regarding the article...

I can speak to my situation as an officer at a community bank on this.

As I mentioned above, we have this excess cash due to customer higher cash balances, bonds being called, and mortgage-backed securities paying off at higher speeds, not because the Fed loaned us any money. That money on deposit is ours, not theirs. If they want it, they'll have to sell some securities we deem appropriate, at a price we're willing to pay.

It is the Fed's ongoing cheap money policy that is causing mortgage rates to be artificially low--we're certainly not going to originate 4.875% mortgage loans and hold them, we'll let Fannie and Freddie bear that risk.

As you can see, our experience differs greatly from the thesis in Wenzel's article.

Hope this is beneficial.

December 17, 2009 7:05 PM
To the extent the excess reserves are held by bankers like "Mike in Alaska" (MIA) Bernanke is going to have trouble draining the reserves. It will mean that the bankers that will owe the Fed money will have to borrow it from bankers with the mind set of MIA. It doesn't sound like MIA is going to want to loan out that money any time soon at the current effective Fed funds rate of 0.13%.

This would mean that the rate would have to shift high enough to induce MIA and his like thinking buddies to move a trillion dollars out of the safe haven of the Fed and into the hands of maniac bankers that would desperately need the reserves. A trillion f'ing dollars going from conservative bankers to the maniacs! At what rate do you think that would happen? (Note: Bernanke could speed the process a bit by cutting the interest rate on excess reserves to zero. This would move some out of the safe arms of the Fed, but these are conservative guys. Even at zero per cent, I don't see these guys moving unless Fed funds rocket.) This is a nightmare scenario for Bernanke.

However, I suspect that the real case is that most of the excess reserves are being held by bankers that are the ones that will be forced to pay back on the winding down of credit facilities. If you think back to that period, there was a lot of propaganda to get banks to borrow from the facilities. It started off slow. It wasn't bankers, overall, in a panic to get the money. Some banks surely needed it, but for the most part, I think it was banks taking the money and throwing it on deposit at the Fed, and earning the spread. The Fed wanted this to disguise how much real demand there was for panic reserves and also show Congress and the world how Bernanke was stepping up to provide liquidity. I tell you, don't play poker against Bernanke.

So here you have the two scenarios:

1. The trillion is completely sitting with conservative bankers, who are not going to give it up to the maniacs when Bernanke starts to drain, unless Fed Funds go through the roof. (Doubtful)

2. The money for the most part is not with conservative bankers but with those who went along with Bernanke's charade (And, I might add, are earning the interest spread during the charade). Getting this money back will be easier to do than finding women on South Beach, Miami.

Bernanke in his FOMC releases tells us he is going to have this whole thing drained by H2010, so we won't have long to see if Bernanke is clueless, or has thought this bluff thought out. I think he has thought it out. There are no public figures that tell us which banks are holding the excess reserves, so it is going to be a real time show for us.

Two notes:

1. Just because the excess reserve thing has pretty much been a charade, it doesn't mean that you shouldn't take your eye off of M2 money growth. As I have said right along, that's where the real game is that provides clues as to what direction the economy is headed in.

2. Many have raised the question as to how the Fed is going to drain the reserves if the collateral is junk. This confuses a number of things. What is being drained here is from loans the Fed has made. It is not entirely clear what the Fed has been loaning against of late, but it doesn't matter. The bank pays back its loans from the excess reserves and the banks get their collateral back.

Now the real toxic stuff the Fed is holding is not part of these credit facilities. It was bought, as opposed to being loaned against, and is in such entities as the Maiden Lane entities. These are real toxic, but have nothing to do with this particular drain.


  1. The Current Issues report is nonsensical; the idea that the fed reserves had an effect on the economy because they induced banks not to wind down existing loans is unfortunately irrelevant. Most outstanding paper was fixed term and rate. These banks could not have wound down the majority of their loans, whether or not the fed had boosted their reserves.

    I also point out that the authors ignore the fact that, in order to prevent the banks from using excess reserves for lending/investment, the Fed will have to pay interest on such reserves at an increasing, increasing rate (i.e., the first derivative is positive). Ultimately, they would have to pay an infinite interest rate on a fixed amount of outstanding reserves grown by the amount of prior interest payments.

    One way or another, these reserves are making their way into the monetary base

  2. @Anonymous

    The Fed would have to pay an infinite interest rate?

    Most outstanding paper was fixed term and rate. These banks could not have wound down the majority of their loans, whether or not the fed had boosted their reserves.

    They sure can if the are keeping the funds they receive as excess reserves.

    One way or another, these reserves are making their way into the monetary base.

    They have ALREADY made their way into the monetary base, just not the money supply.

  3. One thing to keep in mind with the excess reserves is that, before the Fed started paying interest on those reserves, banks were putting their excess reserves in the overnight Fed Funds market, Federal Home Loan Banks, and other similar areas, not at the Federal Reserve.

    This raises a question: How much of this Trillion is actual emergency money from Fed programs and what is just normal excess reserves from the course of business? How much of this money is truly spoken for? I don't know how anyone could determine this.

    You see, we became shocked when we saw the Fed chart spiking with excess reserves when, at the same time, we would probably see the inverse in the Federal Home Loan Bank system. I believe this is part of the monetary base, but not a part of the active money supply, although it is easily transformed. The price inflation threat is there, but how probable is left for debate.

    As I have mentioned before on Murphy's blog and here, I don't think Bernanke can be the master of the universe and drain the reserves, and offload the securities he bought, without causing serious disruptions, including re-injuring the banks. Dump the securities onto the market and mortgages rates spike and housing deflates (again). Or he could buy up more MBS indefinitely and hope for the best that inflation stays away.