Bank Lending and Bank Reserves

by Dan Kervick, New Economic Perspectives

Frances Coppola has a very nice piece in Forbes that takes on some of the continuing confusion over commercial bank reserves, central bank payments of interest on reserves and the relationship of both to commercial bank lending.

Follow up:

She concludes with a ringing rejection of the frequently voiced claims that the Fed’s policy of paying interest on reserves inhibits bank lending, and that high excess reserve levels are an indicator of sluggish bank lending or bank hoarding:

The volume of excess reserves in the system is what it is, and banks cannot reduce it by lending. They could reduce excess reserves by converting them to physical cash, but that would simply exchange one safe asset (reserves) for another (cash). It would make no difference whatsoever to their ability to lend. Only the Fed can reduce the amount of base money (cash + reserves) in circulation. While it continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.

Banks cannot and do not “lend out” reserves – or deposits, for that matter. And excess reserves cannot and do not “crowd out” lending. We are not “paying banks not to lend”. Positive interest on excess reserves exists because the banking system is forced to hold those reserves and pay the insurance fee for the associated deposits. It seems only reasonable that it should be paid to do so.

I wholeheartedly agree with the bottom line moral Coppola draws from the operational mechanics of bank lending, but I do think some additional clarity can be had on the question of whether or not commercial banks lend their reserves. And I also have some reservations about the justification Coppola cites for the policy of paying interest on reserves in the first place.

First a clarification of terms: Commercial bank reserves come in two forms. One of these forms is the physical cash held by banks in their vaults (and their ATM machines, tellers’ drawers etc.) The second form of commercial bank reserves consists in the deposit balances held by commercial banks at the central bank. Physical cash reserves are held by banks to satisfy their depositors’ demand for cash withdrawals. Reserve balances at the central bank, on the other hand, are used to make payments to other businesses that have their own Fed accounts – primarily other banks.

The traditional terminology of “reserves” can be misleading, especially as applied to reserve balances at the central bank. That terminology suggests that these assets are held “in reserve” as some sort of backup against unforeseen contingencies. But the fact is that banks need their reserve balances to conduct routine, daily business. They need them because in the everyday course of business they must make payments to other banks in the commercial banking system. Whenever a depositor at one bank makes an electronic or check payment to someone who banks at a different bank, then in order for the payment to be completed, the first bank will have to settle with the second bank. Net daily interbank settlements are processed by flows into and out of reserve accounts. These reserve balances could thus more accurately be called “payment assets” or “clearing balances”.

Do banks lend their reserves? A compete answer requires being clear about which question we are asking. If the question is, “Does an individual commercial bank lend its reserves?” then the most accurate answer is “Sometimes.” If the question is “Does the commercial banking system in the aggregate lend its reserves?” then the most accurate answer is “No.”

Let’s consider the mechanics of a single bank loan. A bank loan is an exchange: The borrower receives some asset from the bank, and the bank gets some asset from the borrower. The asset the bank receives from the borrower is a promissory note specifying the amount to be paid by the borrower to the bank and the schedule on which the payments are to be made. At the time of the loan, the borrower may request the entire borrowed amount in cash. In that case the bank clearly does lend out part of its reserves. The asset the borrower receives is cash, and the bank has reduced its cash reserves by surrendering part of those cash reserves to the borrower. In exchange, the bank gets a promissory note. It has financed its purchase of the promissory note by paying cash.

But it is more likely that the borrower will not take cash on the spot. Instead the bank will credit a sum of money to the borrower’s demand deposit account at the bank. In that case the asset the borrower receives is not a cash asset that the bank surrenders to the borrower, but a liability of the bank. The bank has in this case financed its purchase of the promissory note with debt. Yet once the borrower begins to make use of that deposit balance by making payments to various other people and businesses, the bank will have to begin surrendering assets from its reserve account – assuming that many of those payees bank at other banks. And the bank will surrender cash reserves to the borrower if the borrower decides to makes cash subsequent withdrawals from the account. So when an individual bank makes a loan, a portion of its reserves do then leave the bank as a consequence, whether that consequence is immediate or takes place over time.

But the important thing to note is that whenever these reserve movements take place, the reserves don’t leave the banking system as a whole. An interbank payment results only in reserve balances moving from one bank’s reserve account to another bank’s reserve account. Similarly most cash withdrawals proceeding from a loan are used very quickly to make cash payments to a business, and as a result are quickly re-deposited back at some bank in the commercial banking system. Thus, an increase in bank lending only results in more rapid movement of reserves from bank to bank, but has negligible net effects on the total volume of reserves held. If an analyst is attempting to gauge changes in the pace of bank lending, and is looking for a fall in reserve balances as an indicator of such a change, then that analyst is looking in the wrong place.

In fact, in a more normal, pre-QE environment in which banks are not carrying excess reserves, an aggregate increase in bank lending would result in an aggregate increase in reserves. An expansion in the consolidated balance sheet of the commercial banking sector will almost certainly be accompanied by a corresponding expansion in the volume of interbank payments and an expansion in the velocity of cash withdrawals and re-deposits. If banks were previously carrying just enough reserves to manage their liquidity needs relative to the previous size of the consolidated banking system balance sheet, they will likely need to expand their reserve holdings to manage their newly increased liquidity needs. Banks will either borrow the additional reserves from the Fed directly or sell other assets to the Fed to get those reserves. There is no other way to get them. An individual bank can increase its reserve holdings by attracting deposits from other banks. But the commercial banking system as a whole cannot do this, since there is no significant source of deposits outside the banking system as a whole.

So now let’s turn to the question of interest on reserves. First, we should note that the Fed currently pays interest on all reserves balance, not just excess reserves. Currently the interest rates for these two types of balances are the same: 0.25%. The Fed has Congressional authorization, however, to pay different rates for excess reserves and required reserves, including a rate of 0% if it so chooses.

But why pay interest on reserves in the first place? Coppola suggests that it is to compensate banks for the insurance fees they must pay to guarantee their deposits:

Positive interest on excess reserves exists because the banking system is forced to hold those reserves and pay the insurance fee for the associated deposits. It seems only reasonable that it should be paid to do so.

But I don’t really understand that rationale. For one thing, there may be no “associated deposits”. Coppola’s article is about the recent divergence between bank deposits and bank loans, and in the course of the discussion Coppola ably explains that in the QE era, central bank asset purchases can lead to higher reserve balances that are not driven by any increases in bank lending. Also, banks have been paying insurance fees for insured deposits for many decades, but the payment of interest on reserves is a relatively new policy – only in effect since 2008. Did the Fed suddenly decide that it wasn’t being reasonable?

Banks exist to serve the public interest, and while there is a public interest in ensuring the overall health of the banking system, it is no part of public policy to make sure banks earn the maximum amount of possible profit. Banks do not need to be compensated for holding one portion of their assets in the form of reserves, a substantial portion of which they would probably choose to hold anyway to manage liquidity needs. The Fed requires banks to do a lot of things, many of which incur costs, but it doesn’t pay for all the things the banks are required to do. Also, holding cash reserves in bank vaults is another source of security and insurance costs for banks. But the Fed does not pay interest on physical cash reserves – only reserve account balances. If payment of interest on reserves was motivated by the desire to compensate banks for costs associated with reserves, why doesn’t it make payments on all reserves, and not just deposited reserves?

The fact is that the Fed has told us many times why they pay interest on reserves, and in this case there is no reason at all to be skeptical of the explanation. Part of modern central bank policy consists in targeting the interbank lending rate, which in the US is known as “Fed Funds rate”. Prior to the decision to pay interest on reserves, the interbank rate had shown more volatility than Fed policy makers were comfortable with. By paying interest on reserve balances, the Fed hoped to establish a floor to the Fed Funds rate, because – in principle – no bank will lend to other banks at a rate lower than the rate they can earn by holding the reserves in their Fed account.

However, there are non-depository institutions that possess Fed accounts and have access to the Fed Funds market, but which are not eligible for the interest payments the Fed is authorized to pay to depository institutions. So the decision to pay interest on reserves has not had the effect of creating the hard floor on interbank lending rates that the Fed might have initially hoped it would have. The Fed has recently attempted to address that issue by experimenting with a fixed rate overnight reverse repo facility that could – again in principle – re-establish a hard floor for short-term interest rates by offering these non-depository institutions reverse repo contracts at a fixed positive rate determined by Fed policy-makers.

However, in her confirmation hearings, new Fed chief Janet Yellen indicated that the Fed is considering reducing the payment of interest on excess reserves. Some have suggested that the Fed reduce interest payments on excess reserves as a kind of cosmetic “signal” to be sent in conjunction with the tapering of QE, so as to reassure markets and the public that despite the end of QE, the Fed is committed to a policy of easy monetary conditions. Some economists go as far as Alan Blinder in suggesting that eliminating the payment of interest on reserves is necessary to restore the phenomenon of “high-powered money” and allow the Fed to stimulate economic expansion via quantitative means. But for the reasons Coppola has ably adduced in her article, whether or not the Fed pays small amounts of interest on reserves has almost nothing to do with bank lending decisions. The theory of high-powered money, and the money multiplier and loanable funds models that go with them, are pieces of textbook economic lore that were always wrong, and should be disposed of for good.










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted.  As the internet is a "war zone" of trolls, hackers and spammers - Econintersect must balance its defences against ease of commenting.  We have joined with Livefyre to manage our comment streams.

To comment, just click the "Sign In" button at the top-left corner of the comment box below. You can create a commenting account using your favorite social network such as Twitter, Facebook, Google+, LinkedIn or Open ID - or open a Livefyre account using your email address.















 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2016 Econintersect LLC - all rights reserved