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Tuesday, May 10, 2016

Fed Worries About Deflation but Pays Banks Billions Not to Lend QE Proceeds!?!

In October of 2006, President Bush signed the Financial Services Regulatory Act (FSRA)...the culmination of a five year Congressional effort.  Significantly, the Federal Reserve was given authority to pay interest on reserve balances held by depository institutions in Federal Reserve Banks.  But not just reserve balances, which were required to be held, but also on excess reserves.  Interestingly, excess reserves at the Fed had never been held in significant quantities.  Banks saw relatively little reason to put working capital (beyond required levels) at the Fed.  Excess reserves (as a % of required reserves) had generally vacillated between 5% to 15% and typically under $2 billion dollars, at any given time.

However, all this changed upon the implementation of FSRA (which was implemented ahead of schedule in conjunction with Secretary Paulson's Emergency Economic Stabilization Act of 2008 or EESA).  The EESA was formally proposed Sept 21 of '08 and passed into law by Oct 3.  The impact was a shocking increase in excess reserves.  The FSRA law supposed intention was, according to the Fed's Oct. 6, 2008 press release..."The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability."

The implication I took from this very convoluted Fed speak was that absent the Interest on Excess Reserves or IOER...that the Fed was concerned that the banks (by banks I mean Primary Dealer banks that directly buy the Treasury's from the government with the intention of reselling the Treasury's into the market) would actually utilize this money?!?  The Fed's intent seems to have been to utilize QE to buy (remove) assets from the banks and then pay the banks not to lend this money, keeping it from entering the economy (chart below).  Still, why would banks go along for this mere pittance of a 0.25% (significantly less than the banks were earning) when the funds could earn so much more if allocated?  When the largest, most influential / connected banks in the land do something that looks dumb with $2.4 trillion dollars, it's pretty clear something has changed and we (I) simply haven't caught up yet.  Was this some fashion of quid pro quo, collusion, or have the rules of capitalism changed?

By September '08 (in expectation of the laws passage), excess reserves had already increased from a couple billion $'s to never seen before level of $59 billion...and up to $800 billion by years end 2008.  Of course, today $2.4 trillion in banking excess reserves are paid to sit and do nothing...while the Fed bemoans a lack of inflation?!?

Some Background:

In the US, bank reserves are held as FRB (Federal Reserve Bank) credit in FRB accounts, regardless whether the reserves are required or excess reserves beyond the Federal Reserve requirement.  The definition of reserves (and by extension excess reserves) are monies not lent out to customers to satisfy Federal Reserve set requirements.  One would think holding $2.4 trillion in excess reserves at 0.25% interest during one of the greatest bull market periods in history would be an opportunity cost as higher risk-adjusted interest could have been earned by putting these funds to use elsewhere.  Strange banks were seemingly disinterested in the misallocation of their funds?  Are there new or different requirements placed on the banks regarding reserves?

When the FSRA was passed in 2006, required reserves held at the Fed averaged about $8 billion and excess reserves under $2 billion.  As of August '08...little had changed and required and excess reserves still stood nearly as they had in 2006. 
  • Notably, required reserves held at the Fed had been declining from the high water mark of $37 billion in 1988 against then liabilities of about $3 trillion...a 12.5% ratio.  Obviously the leverage in '06 of $8 billion required reserves held against '06 liabilities of $8.5 trillion (less than 1% ratio) may have been a bit aggressive?  By Aug of '08, required reserves of $8 billion were held against liabilities of $10.9 trillion (a 0.7% ratio).
Against the Fed mandated declining required reserves, mortgage debt and total liabilities of all commercial banks had grown nearly 6-fold (below).
However, from September '08, the quantity of required reserves began steadily rising (below).
But excess reserves held at the Federal Reserve went ballistic.  The previously unutilized avenue of excess reserves at the Federal Reserve continuously rose, housing nearly 60% of all new banking liabilities from '08 onward.
Only 20% of the new liabilities were commercially lent and mortgage debt outstanding contracted, still to this day.

Was the FSRA and Fed's intent to create this massive holding of excess reserves?  The primary discussion prior to the law was around the required reserves and the payment of interest upon these.  And yet, now eight years subsequent to the laws implementation, required reserves are a tiny fraction of excess reserves.  As the chart below highlights, from 2000-->Aug, 2008 (pre-FSRA implementation) essentially none of the new deposits (net) had been placed with the Federal Reserve.  However, with immediate effect post FSRA, 57% of all new deposits from '08 through March, 2016 have (net) been held as excess reserves with the Fed.

Also interesting is that absent the utilization of this $2.4 trillion dollars (required and excess reserves combined), equities, RE, and most other asset classes (except the basis of all assets, commodities) have seemingly been unaffected and in fact have steadily risen 200% to 500% despite being starved of the new capital?!?

In order to see this phenomenon in it's fullness, the chart below highlights Fed Fund Rate % (FFR) vs. Excess Reserves.  The moment the FFR hit zero interest rate policy (ZIRP) in conjunction with implementation of IOER...this cheapening of credit theoretically should have been met with record new credit issuance but instead at ZIRP, credit began strongly contracting.  Banks stuffed the vast majority of new funds into a the Fed yielding 0.25% annually rather than lend?!?
The charts below are close ups of what happened with excess depository reserves during the past three recessions.

The chart below of the '91 recession shows the flash of reserves from just under a billion to $2.1 billion and the return of reserves to normal as interest rates were used to further heighten demand subsequent to the recessions conclusion.
Likewise, the chart below highlights the relationship in the '01 recession and safekeeping of assets associated with 9/11...
The chart below is the '08-'09 recession (vertical blue box with arrows top/bottom) and as rates hit zero, excess reserves ballooned from $2 billion to $1,200 billion.  And this is where during all previous recessions the Fed continued to push rates down and excess reserves went back to work.  But not this time.  Excess reserves continued to pile up "post recession" as rates did not decline as they had coming out of previous recessions...ZIRP did not turn into NIRP (negative interest rate policy).  The world was not ready for NIRP in '11.
Further, a massive implication of this quantity of reserves sitting at the Fed is the inability to effect interest rate policy as the Fed has since it's inception...via it's open market operations injecting or removing assets from bank reserves to impact overnight lending rates.  In order to effect rates as the Fed has done historically, the Fed would need to drain the excess $2.4 trillion in excess liquidity to effect an increasing tightness in overnight rates.  Clearly, the impact of draining this excess liquidity would likely be the equivalent of removing liquidity equal to 15% of US GDP.  The impact on equities, RE, bonds, etc. would not be pleasant.

So, lucky for us, the Fed in it's "wisdom" determined a means to raise rates without removing the excess reserves...or essentially rate hikes and QE simultaneously?!?  Pay the banks a higher interest rate to incent them not to lend the excess reserves!?!  The initial interest rate paid in '08 of 0.25% on a total of $10 billion was a relative rounding error.  Chump change by Federal .Gov standards.  But as the moonshot of excess reserves  headed toward infinity, a 0.25% turned into real money or about $6 billion paid to banks in 2015 not to lend.  But now with the Fed's rate hike cycle(?) underway, the Fed intends to continue hiking the interest paid corresponding to the Federal Funds Rate.  This means in 2016 (at the present 0.5% rate) banks will be owed $12.5 billion to not lend money!?!  Of course, if the rate cycle continues to say, 1% this year and 3% by 2018, and reserves don't decline substantially, banks will be paid about $75 billion annually by 2018 not to lend money (chart below).

As a final thought, a quick review of QE (charts below) shows that declining rates (based on 10yr treasury yields) were actually pushed upward during each QE period...and only once the completion date was announced did rates begin falling again.  Ultimately, rates were reduced by 100% from 5% to 0% but no net demand was spurred and instead outstanding mortgage debt has fallen by nearly $1 trillion.  Liabilities have increased by almost $3 trillion of which $2.4 trillion (80%) are excess reserves held with the Fed.

And a close-up of the Fed's QE and it's impact on the 10yr rate.  Likewise to the IOER's, the Treasury market yields are falling to century low rates on the absence of nearly all buyers since the abandonment of the BRICS (net) as of 2011 and all foreigners (net) plus the Fed since the completion of the Fed's taper.  These sources plus the fast waning intra-governmental buying via the SS surplus, had purchased 80%+ of all Treasury's since '00.  Now, in these sources absence of making any net new purchases, we are to believe the US public (pensions, insurers, institutions, and individuals) are buying around $50 billion of record low yielding treasury's...and again this has no negative impact on equity markets, RE, etc. etc. and instead all are near record valuations?!?
In a world in which growth is slowing, strange that the Fed (privately owned by the largest banks in the world) would institute a system of rising payments rewarding banks for not taking risk or lending money!  This all tends to make believe that manipulation is the order of the day and the explanation is far simpler than most would believe, detailed Here.

And just in case you were wondering what the relationship of excess reserves, the Fed's balance sheet, and equity valuations looks ya go.



    There were 3 reasons for the Federal Reserve version of QE.

    First, it was essentially a charade to make it look like the Federal Reserve was doing all it could to "stimulate" the economy and provide a "wealth effect" to try to life economic activity and asset prices.

    Second, and much more important in reality, the primary purpose of QE was TO CREATE A LARGE LIQUIDITY POOL OF EXCESS RESERVES OWNED BY THE BANKS AT THE FEDERAL RESERVE so that the banks would not have to sell off assets such as securities at fire sale prices in the next financial crises, panics, and shocks but rather could turn to that liquidity pool at the Federal Reserve to clear transactions, particularly from bad derivatives plays.

    Third, QE lowered the government interest on its massive then $17.5 trillion debt because the Federal Reserve increased its holdings of US Treasuries to over $2 trillion making the interest on those ESSENTIALLY FREE to the US government because the Federal Reserve operates as a NOT-FOR-PROFIT entity and rebates 100% of its annual profits each year to the US Treasury after paying a modest 6% annual dividend to its member bank shareholders.

    That mission has now been fully accomplished with a LIQUIDITY POOL OF $2.5+ TRILLION in the excess reserves of the banks at the Federal Reserve which will act as a cushion in the next series of crises. Which, I might add, are now HERE and rapidly worsening.

    1. Good post.

      You maybe missed the effect of ZIRP as well on the reduction of interest that the government has to pay.

      This has now paved the way for the Fed to meet all the obligations of the government into the future. This is not necessarily bad. The problem will be preventing the finance industry from leveraging this into private profits rather than putting money into the pensioners' bank accounts.

      Japan is also treading down this path.

      It is essentially the only way to meet the obligations of the state and keep the economies running.

      But the vultures of the finance industry will be scrutinizing every move to put money into their pockets and screw the rest of us.

      It is the way it has always been done.

  2. Wow! I muse say I have generally arrived at the same conclusion after a whole lot of reading and analysis. Great synopsis of the fundamental change in monetary policy post 2008. Looking at the ffr and assuming we have just started raising rates is so far off course it's almost laughable. Hence why I have generally placed more emphasis on the Atlanta fed shadow rate model.

    Side note - The emergency economic act of 2008 simply sped up the timeline to pay interestate onot reserves from 2011 to 2008. You have rightly dug down to the FSRA in 2006.

    Great work!

  3. Genuine lay person, non-college grad questions: So is it fair to say then, that we the taxpayers gave a huge gift to the banks, to cover past and future sins, gambles, and unpreparedness? Isn't it too generous to label/lump liquidity problems as external "shocks"? And likely in the process have we not massively expanded moral hazard for next time? Is it thus not the case that capitalism is at least severely injured as a result? Am I just too jaded?

  4. Reserves have absolutely no baring upon a bank's ability to generate credit, none, nada, zero zilch.

    Reserves are held on a fractional amount of existing demand deposits and are not used in the pseudo-lending process.

    The "Money Multiplier" theory, is pure fiction.

    The Bank of England Corrects a Widespread Myth

    Does the Money Multiplier Exist?

    “The role of reserves and money in macroeconomics has a long history. Simple textbook treatments of the money multiplier give the quantity of bank reserves a causal role in determining the quantity of money and bank lending and thus the transmission mechanism of monetary policy. This role results from the assumptions that reserve requirements generate a direct and tight linkage between money and reserves and that the central bank controls the money supply by adjusting the quantity of reserves through open market operations. Using data from recent decades, we have demonstrated that this simple textbook link is implausible in the United States for a number of reasons. First, when money is measured as M2, only a small portion of it is reservable and thus only a small portion is linked to the level of reserve balances the Fed provides through open market operations. Second, except for a brief period in the early 1980s, the Fed has traditionally aimed to control the federal funds rate rather than the quantity of reserves. Third, reserve balances are not identical to required reserves, and the federal funds rate is the interest rate in the market for all reserve balances, not just required reserves. Reserve balances are supplied elastically at the target funds rate. Finally, reservable liabilities fund only a small fraction of bank lending and the evidence suggests that they are not the marginal source data for the most liquid and well-capitalized banks. Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. Specifically, our results indicate that bank loan supply does not respond to changes in monetary policy through a bank lending channel, no matter how we group the banks."

    Here's a good explanation on how pseudo-loans are actually created.
    Basics of Banking: Loans Create a Lot More Than Deposits

    Banks are not intermediaries between borrowers and savers, they originate pseudo-loans as deposits, irrespective of credited savings accounts or current reserves held.
    Banks do not loan money.

    Working Paper No. 529: Banks are not intermediaries of loanable funds.

    Legal tender money (cash) is not borrowed or loaned into circulation.
    Banks do not loan money.

    How Currency Gets into Circulation

    Applicable Laws and Information.
    Federal Reserve Act, Section 16

    Legal Tender Status

    Legal tender Law

  5. Now, we can observe in the Treasury's Legal Tender Status, (a brief synopsis of the Federal Reserve Act) that the Fed must pay for the production of FRN notes, and post collateral of equal value to the notes it issues into circulation. (The Fed assets used as the collateral mentioned, have changed to Mortgage Backed Securities and Treasuries.) Also noteworthy is that member banks must buy the notes at face value from the Fed by drawing down their accounts with the Fed and that, Federal Reserve notes represent a first lien on all the assets of the Federal Reserve banks and on the collateral specifically held against them.

    Taking that into consideration along with congress's right to take possession of the notes and collateral upon the dissolution of the Fed, we can infer that, the Fed does not own the legal tender Federal Reserve notes. Combine that with the New York Fed's explanation of how FRNs get into circulation, we can also infer that FRNs are neither borrowed, loaned or spent into circulation.

    From this, we can objectively conclude that Federal Reserve notes are a debt free legal tender currency, issued into circulation through the Fed and the banking system, in compliance with their legal obligation to supply that money property, as represented by the credited deposit accounts, to the account holders upon their demand.
    As I cannot prove a negative, the next three assertions require a little bit of effort, they require disproving.

    1) There is no law anywhere that grants to the Federal Reserve or the banking system the authority to create money, and they don't.

    2) There is no law anywhere that designates or acknowledges the debt based credit generated by the Fed or the banking system as being a legal tender, or money, or currency, or even a medium of exchange.

    3) The only legal validity given to the debt based credit, is held by the debts incurred with its use.

    If the banking system collapsed tomorrow and all debt based credit !POOF!ed out of existence, all debts will still be valid and collectible even though the debt based credit used to create and service them, no longer exists. See: 1930's Great Depression. 2007-10 Credit Collapse.

    The takeaway from all of this should be the realization that, there are two Federal Reserve administered systems in operation and running concurrently within the U.S.:
    1) The legal tender monetary system.
    2) The Fed and Banks' asset backed, debt based credit system.

    Currently, there is only $1.45-Trillion in U.S. legal tender money in circulation around the globe, all the rest is Fed and bankster generated asset backed, debt based credit, not money.


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