Banks Are Hoarding Their Excess Reserves From the Fed

Rodney Johnson | Friday, October 26, 2012 >>

I give a lot of speeches, as well as radio and TV interviews. One of the hardest parts about this is making sure that my comments are suited to the audience – not too wonky, but not simplistic either.

When the topic of the Federal Reserve and new money comes up, I always have to couch my comments in a certain way. I can’t simply say, “when the Fed prints money,” because someone, somewhere, will start jumping up and down like Arnold Horshack on “Welcome Back, Kotter,” desperate to call me out.

The Fed doesn’t really print money. Fine. Instead it boosts electronic balances.

That leads to a problem. Unless those ones and zeroes are converted into cash, the recovery goes nowhere, and the Fed fails.

Welcome to the game…

Here’s how it’s played…

The Fed doesn’t print money in any sense. The U.S. Treasury controls the U.S. Mint. The Fed controls the flow of funds, but it must do so through banks. That’s because the Fed is neither federal – it is not an agency of the national government – nor is it a reserve – it holds no balance of funds.

The Fed’s only way to reach the market is through its owners, which happen to be the private banks.

National U.S. banks, such as Bank of America, Citibank, Wells Fargo, etc., are required to be part of the Federal Reserve system. As such, they have an account at the Fed where they hold their excess reserves. It is through these accounts that the Fed changes the amount of “money” in the financial system.

If the Fed wants to take money out of the system, it sells bonds to one of its member banks. Through this transaction the member bank receives the bonds and hands over cash to the Fed, removing money from the pool that’s sloshing around the economy.

The reverse is also true. To inject money into the system, the Fed buys a security from a member bank, which takes the security (a bond, for example) out of circulation and puts more money into circulation… almost.

The Fed accomplishes the increase in money by simply adjusting the bank’s reserve account higher. It’s a keystroke. Nothing physical changes hands.

But after that, the Fed has no control. If the bank doesn’t put the new funds to use in some way, then nothing happens.

Yes, a security was removed from the financial sector, but the corresponding pop in useable funds is now simply an entry in the bank’s reserve account. Who really cares?

Before the financial crisis, the total balance of excess reserves – the amount above what banks are required to hold at the Fed – was around $60 billion. Now excess reserves are over $2 trillion.

It’s one of those things that make you go, “Hmmm.”

Inflationists point out that when these extra dollars are changed from dormant digits into real cash through lending, prices will explode. Well, that could happen. But what if it doesn’t? What if banks, those paragons of quality lending standards, hold onto the funds because (1) there aren’t enough strong lending opportunities to warrant risking capital, and (2) they are scared witless about their existing books of loans that still include millions of foreclosed homes and millions of worthless HELOCs? (Of course, this is what they’re doing… Bank of America is a great example as it just got sued for $1 billion because of its sloppy lending.)

Well, you get an explosion in excess reserves.

This started three and a half years ago. You would think that 40 months would be long enough to see some sort of boom in lending and prices… if it were going to happen.

Our view remains the same – banks are hoarding the cash… er, electronic entries… to guard against their own troubles. We have not deleveraged. We have not dealt with our solvency crisis.

Like some Japanese B-movie, so far the banks have simply eaten the Fed’s pet monster while no-one else had gotten a taste.


Rodney

P.S. For those on the East Coast this weekend, stay safe as Sandy storms by.

 

 

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Categories: Economy

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.