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Banking System 101 – Part 2
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Banking System 101 – Part 2

by evilMarch 25, 2013

This is the second part in an ongoing series designed to guide you toward a basic understanding of Federal Reserve and ECB monetary policy as conducted in recent history, as well as what exactly constitutes and drives quantitative easing. Despite being on the forefront of the mainstream media since 2007 you will rarely run into anyone who has a thorough understanding of how all the pieces fit together. We are completing our basic introduction and then will explore a chronological recap of what has transpired in the past few years. If you missed part one then please make sure you read it first before continuing below.

MONEY SUPPLY AND THE MONEY MULTIPLIER

Recall our scenario from before, with two US commercial Banks, A and B. Reserve Requirements are 10%, and the balance sheet of Bank A that we ended up with is shown below:

As explained before, required reserves are simply 10% of deposits, and also recall the changes to Bank B’s balance sheet after it made a loan of 20bn USD to a firm:

Changes to its BS after making a loan are highlighted in red: most importantly, excess reserves decrease slightly, as deposits grow (Bank B credits Firm X’s deposit account with the loaned money, and the loan itself appears as an asset on the BS).  Clearly this could not occur if Bank B held no excess reserves in the first place. You can think of the loan as being a case of Bank B “using up” only 2bn of its excess reserves to “create” 20bn of money in the real economy. This will become important later, as this is known as the (money) multiplier effect.

To understand this effect we need to define Money supply – simply the total quantity of monetary assets available in the economy. There are different measures of money supply, of which the important ones are:

  1. Starting from the most narrow measure, we have M0 which is simply all the notes and coins in circulation. This does NOT include cash stored at the Federal Reserve Banks (ie. the central bank in the US) and cash stored at commercial banks’ vaults, as it is effectively dead money.
  2. The monetary base (MB) = M0 + bank vault cash + banks’ reserve accounts. This is a broader measure, that includes notes and coins but more importantly it includes a measure of central bank money, ie required and excess reserves, which commercial banks hold at their reserve accounts with the Fed. In our example from Figure 2.1, the monetary base would equal M0 + 0 + (10+40) bn + (17+43) bn = M0 + 110bn USD.
  3. M1 = M0 + demand deposits, and simply measures the money in circulation by also including the most common form of “electronic money”, which is easily accessible deposits (“on demand”), that one can use to withdraw money at any time without restrictions or delays. A common example of this is a debit (card) account.  Note that this measure does NOT include central bank money and vault cash! M1 therefore measures commercial bank money. For our example in Figure 2.1, M1 = M0 + (100bn) + (170bn) = M0 + 270bn USD [Assuming all deposits in our example are demand deposits].
  4. M2 = M1 + savings accounts + “time deposits” (money has to be locked in for a period for time to earn interest, and cannot be withdrawn – e.g. bonds, money-market deposit accounts for individuals etc). This is a broader measure of commercial bank money. In our example of Figure 2.1, M2 = M1 as we assume there are only demand deposits. [ There are other broader measures of money which I will not discuss here for simplicity ]

The multiplier effect, which we described for Bank B above, can be measured in general by the money multiplier (MM) , which is simply a statistic, that measures the ratio of “commercial bank” money to “central bank” money. Out of the 4 measures of money supply listed above, only the monetary base can qualify as central bank money. So we can choose either   MM = M1/MB  or  MM = M2/MB  to be the money multiplier. Let’s take money multiplier, ie MM =  M2 / MB  as a broader measure. Firstly, let’s measure the MM for our example in Figure 2.1, substituting in our calculations for M2 and MB above:

MM = M2/MB = M1/MB = (M0 + 270bn) / (M0 + 110bn). We do not know the notes/coins in circulation (M0), but given that in modern economy it is very small compared to electronic money (ie deposits), we can assume for our example to be negligible. Therefore as M0 à 0, mathematicians reading this will know that MM à 270bn / 110bn = 2.45.

DOESN’T THE BUILD OF EXCESS RESERVES, WHICH RESULTED FROM FED QE, PREVENT THE MULTIPLIER EFFECT???

Above we can see the money supply for the US economy, and the changes that resulted since 2008: As Fed started QE, the monetary base grew, but so did excess reserves – but M2 expanded at a lower pace than before, thereby reducing the MM to ALL-TIME lows.

According to the multiplier effect, an increase in bank reserves, which resulted from QE, should have been “multiplied” into a much larger increase in M2, as banks should have expanded their deposit and lending activities. The expansion of deposits, in turn, should have raised required reserves until there are no excess reserves in the system. Why has this NOT happened in our Figure 2.3 above?

To answer this, consider the situation from a commercial bank’s perspective. Once it gains excess reserves via QE, it has two options:

  1. deposit them with the Fed, in which case it would earn the Interest that the Fed pays On Excess Reserves (IOER); Since there were virtually no excess reserves until 2008, the Fed only started considering setting IOER after the 2008 crisis, and after briefly playing around with it, it was set to 0.25% and has remained that ever since.
  2. attempt to lend its excess reserves to earn an interest, which is higher than IOER (0.25%).

So the bank will attempt to lend out its excess reserves at any positive interest rate, greater than IOER. This additional lending in turn decreases short-term interest rates (Why? Interest is the price of money, and if more money is supplied via lending then this price goes down).  This lending also creates additional deposits in the banking system as in Figure 2.2 and thus leads to a small increase in required reserves.  Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself, with banks making more new loans and the short-term interest rate falling further.

This multiplier process continues until one of two things happens:

  1. there are no more excess reserves, i.e. the lending has expanded so much that all excess reserves turned into required . In this case, the money multiplier is fully operational.
  2. However, the process will stop before this happens if the short-term interest rate slips below what the bank can earn on its excess reserves with the Fed, i.e. IOER. At this point, there is no longer an incentive to lend and hence the multiplier process stops.

Above we add the Fed funds effective rate, currently 0.15%, (ie the actual short-term interbank lending rate), and the IOER, 0.25%, to our money supply picture from before.

Initially in 2008 the money multiplier shrunk as the credit squeeze kickstarted a massive contraction in lending (ie money supply fell), the Fed responded by aggressively cutting the Fed Funds target rate, which in turn anchored the effective rate lower. Once the FF effective rate fell below the interest Fed paid on reserves, the banks were no longer incentivised to lend and the multiplier process stopped, resulting in further collapse of the MM.

In the summer of 2012, the Fed considered cutting IOER to 0% or even negative to encourage lending but that never got much traction and another round of QE went ahead instead. I would argue on the basis of the diagram above that further rounds of QE will become increasingly less effective, and therefore cutting IOER is a much more effective next step in monetary policy.

Will excess reserves cause inflation?

The market consensus is that the large quantity of reserves will lead to an increase in the inflation rate unless the Federal Reserve acts to remove them quickly once the economy begins to recover. I would concur, as once grows picks up (IF IT PICKS UP), demand for lending will increase sharply, and the presence of such a huge amount of excess reserves, will encourage banks to lend them out aggressively – this can create an exponential surge in lending over a very short period of time, thereby resulting in runaway inflation.

However, the Fed has the power to control this via two ways:

  1. Under a traditional framework, ie Fed’s Open Market Operations (OMOs), it can remove nearly all excess reserves from the banking system. It can do so by selling back Treasuries it acquired via QE: recall our review of Fed ‘s OMOs in the previous article – the primary dealers (ie banks), would have to drain their reserve accounts to put up cash in exchange for Fed’s bonds. As their reserves shrink, but clearly required reserves have stayed the same, their excess reserves therefore also diminish.
  2. By raising the Interest on Excess Reserves (IOER), the Fed can manage the build-up of excess reserves more directly. As IOER is raised, it discourages banks from lending at the market rate, and instead simply park their excess reserves at the Fed. Of course, the IOER would have to be consistently set higher than the market lending rate.

The big problem here, which officials refuse to discuss, is that runaway inflation would quickly lift the market bond yields. Why? Well, imagine you are lending someone money at 5% a year, when inflation is 10%. You would be stupid, since you are effectively locking in a -5% annualized real return. Instead you could simply buy an asset, whose price grows with inflation (ie real estate) and earn 10%. Therefore, government bond yields (ie the rates at which the US Treasury borrows from the market) must also track inflation.

The chart above illustrates this relationship between 5yr and 10yr bond yields and CPI for the last 50 years.

So in an inflationary scenario above, the borrowing costs for the US Treasury would rise materially. If the Fed employs OMOs to combat inflation, it risks screwing with the Treasury even more, as its bond sales would also lift bond yields even further (yield is proportional to the inverse of the bond price). As the size US government debt is well publicised (including social security payments its over 500% of GDP), you can easily see that the costs of funding that debt will become unmanageable – tax receipts that the Treasury will earn from a growing economy will be nowhere near enough to pay its debt, but if it borrows more from the market it will have to commit to paying even higher interest rates in the future. This is a classic debt spiral that terminates in one of two ways:

  1. Formal default. That would be the last resort, as since the US government bond market is the most liquid asset market in the world, it would bring down the Financial system globally and this time no central bank alone will be able to patch it up.
  2. Pseudo-default. In this case, the Treasury would not default officially but it will effectively make the US consumer pay – by inflating away its debt. It will print an enormous quantity of USD, which will dilute the purchasing power of the consumer in real terms. This would be hugely negative for the US dollar – we are talking about a bear market of our lifetime. For historical reference, look up Weimar Germany.

Regards,

Peter Levchenko


About The Author
evil
  • http://evilspeculator.com molecool

    Hey Peter – I cleaned things up a little – please look it over and make sure it’s all hunky dory.

  • http://www.facebook.com/profile.php?id=222400168 Peter Levchenko

    all looks good!

  • convictscott

    Nice post Peter – Color yourself the smartest guy in the room :)

  • convictscott

    Hey Peter I have a couple of setups and commentary on the equities and currency moves to post, but I don’t want to post over your excellent work. Is it ok if I append to the bottom?

  • http://dartht.blogspot.com/ Darth_Gerb

    Peak Yield

  • newbfxtrader

    Peter Levchenko 10% reserves are theoretical right? Banks dont really have reserves when they lend money. In reality loans come first reserves comes later after a crash when the central banks prints. The money Bernanke prints now will be used to make up for reserves for the loans given out during the housing bubble. Its not for lending.

    http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

    http://globaleconomicanalysis.blogspot.com/2009/12/fictional-reserve-lending-and-myth-of.html

  • newbfxtrader

    The banks never had 10% as reserves. We would never have a 2008 crash with 10% reserves.

  • Joe_Jones

    very well written post. So when the economy does better, PMs should fly again. Makes sense. One question though: how are derivatives and off-exchange transactions such as credit default swaps changing your overall picture, especially when the big boys have over-extended themselves until 2007 and have been wanting to reduce since 2008 their risk exposure to non-performing loans and insurances against default issued in the boom years?

  • Joe_Jones

    Thursday’s POMO is significant

  • Talon_III

    Hello Scott, are you still up to posting some of your setups? I value your insight!

  • convictscott

    Essentially what happened yesterday was that we should have gone up on the “good” relief news. We broke the daily highs and should have triggered a short squeeze – and we did. However the short squeeze ran out of gas, leading me to believe that the bears have a very small window of opportunity to make something happen. SPX is still in limbo, but a break of todays lows is a valid short setup

  • Peter Levchenko

    They aren’t theoretical. As I said in my original post, banks are obliged to hold reserves against deposits by law. That prevents them from achieving infinite leverage. Deposits are a liability so think of reserves as money saved for a bad day in case a run on the bank happens. Of course they will only be able to support the bank only if the withdrawal is small….

    In the US the LAW requirement is as follows:

    A depository institution’s reserve requirements vary by the dollar amount of net transaction accounts held at that institution. With those accounts exceeding $79.5 million, the depositary institution must have a liquidity ratio of 10%.
    If you do not believe that this has been in effect for ages, check this out: http://www.federalreserve.gov/monetarypolicy/0693lead.pdf the appendix section has a table with history of reserve requirements and since 1990, it has been 10% of net transaction accounts which is almost equivalent to 10% of deposits.

  • Peter Levchenko

    Hey Scott. Feel free to post. To add to your spoos comment, FX was very interesting yesterday as EURUSD cratered very quickly as the market realised the details of the bailout are very negative for Cyprus and sets a landmark for the Eurozone. Its very bad. I can talk about it in detail but I wont waste time. So EURUSD produced a powerful selloff.

  • Peter Levchenko

    Well The CDS market has shrunk loads since 2008. It doesnt look a very attractive place to be in, and I have a few friends trading CDS at banks. The Off-balance sheet exposure is important as it potentially increases the true extent of leverage, which may not be apparent by looking at simple metrics such as household income/consumption etc…

    BUT since 2008 regulators have really cracked down on these markets, so the amount of leverage there has been reduced. and With Dodd Frank regulation coming in, it essentially kills any sort of dodgy leverage in the CDS market. though implementing this regulation will be a pain, I think asince 2008 already happened, you can now sleep safely and not worry too much about the CDS risk as most of it has already been shrunk.

  • Talon_III

    Thanks Scott. I completely agree. It may be that “jawboning” by the powers that be might not have the juice it once had. I will keep this in mind as I trade. As always, I will ignore the news and trade the tape!

  • convictscott

    I think about it more simply. A few days ago we had a retest of the lows, and a contraction in volatility which indicated the market was about to “choose” a direction for the next move.

    The euro tried to go up, and failed to do so. All the bottom picking Euro buyers were stopped out (thats me) and now we have volatility expanding from a low base, and the euro trying to hold critical support.

    At this juncture I advocate taking every setup, both long and short. After a month of sloppy choppy mess statistically (not my opinion) the odds are for a nice smooth easy to trade trending move.

  • convictscott

    I think about it more simply. A few days ago we had a retest of the lows, and a contraction in volatility which indicated the market was about to “choose” a direction for the next move.

    The euro tried to go up, and failed to do so. All the bottom picking Euro buyers were stopped out (thats me) and now we have volatility expanding from a low base, and the euro trying to hold critical support.

    At this juncture I advocate taking every setup, both long and short. After a month of sloppy choppy mess statistically (not my opinion) the odds are for a nice smooth easy to trade trending move.

  • convictscott

    But I don’t know the direction yet 😉

  • http://ibergamot.blogspot.com/ i Bergamot

    Excellent article, Petya!

    But why so much doom and gloom for such a young man? There is another resolution for debt spiral:

    #3. Inflation and technology mega-trend wins again. (Forget about Zimbabwe and Weimar Republic for a moment.) Because of implementation of new technologies – productivity goes thru the roof, incomes rise – leading to increase in revenues to Treasury. Because of rise of new industries – unemployment hits rock bottom, incomes rise – leading to increase in revenues to Treasury. Because of huge advancement in biotechnology – people live longer and with less medical expense, reducing pressure on Medicare/Medicaid – yep, you guess right, leading to increase in revenues to Treasury. I can go on and on…

    What I am saying is not outrageous at all, infact this is exactly how human history progressed for thousands of years with occasional hiccups ala Argentina, Zimbabwe etc. Weimar Republic’s inflation (that people like to quote so much) is really not so cut-n-dry if you try to research further than Wikipedia

    All is not lost!
    Progress can not be stopped!
    DOW 30000 (but not this week)

    Feel better now? :-)

  • Peter Levchenko

    There are several issues with your theory. Inflation can be “good” and “bad”. Bad inflation is where excessive lending fuels an explosion in money supply, which lifts prices but that does not represent an improvement in the economy – it does not mean incomes rise. You do not automatically get compensated for inflation by your employer. Incomes only rise if productivity increases. But if the GDP increase is fuelled purely by excessive lending, all you get is just inflation. The excess reserves are so huge, that if they get released quickly into the real economy, even if there are new industries US is a developed country, there simply isnt that much output potential/gap available to realise a return on all this lending. Good inflation is when GDP rises, and incomes go up, and therfore prices go up because purchasing power of consumers goes up. I was referring to the bad inflation that will be caused by excessive lending on its own. Sure no one has a crystal ball and maybe there will be industries that would have come about by that time that will create amazing growth opportunities. But I like to deal in facts, and the way things stand (OTHER THINGS BEING EQUAL) the excess reserves will be an issue once growth picks up further.

    Secondly, even if we get good inflation. US Treasury owes a MULTIPLE of its tax receipts. So even if tax receipts grow, they will have to grow over 100% (ie DOUBLE or more) for UST to become self-sufficient (ie for it to not have to borrow in the bond market at all). So thats unrealistic under any growth scenario. Also dont forget that as GDP goes up and tax receipts go up, US bond yields also go up and the Treasury has to tap the bond market to refund every year in billlions of USDs. And the yield it will have to borrow at will be significantly higher if GDP grows. So to sum up, as its tax receipts grow, its payments on debt and re-fudning will also grow, but since those are a MULTIPLE of tax revenues, the costs still go up.
    So this scenario doesnt really work either…
    I didnt say the world is going to end, I merely pointed out the undeniable truth that someone has got to pay eventually for the US debt…and that is going to have to be the US consumer.. it is going to lose ALOT of its real purchasing power in teh world, because the govt will pass on this debt to the consumer via inflating the debt, which will have a detrimental impact on teh currency.

  • Schwerepunkt

    Yeah, somehow I get the feeling Benny knows exactly what he’s doing and how to wind it all down without too many hitches. How? I have no idea . . .

  • http://ibergamot.blogspot.com/ i Bergamot

    So basically we are fucked regardless.
    Is this what you are saying?

  • http://evilspeculator.com molecool

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  • http://twitter.com/IslandLifeMiami Scott

    Peter:

    Great post.

    Could the government change the reserve requirement to say 15% (thus reducing the excess reserves) to reduce bank lending?

  • Peter Levchenko

    No. The US consumer is fked… What im saying is that overall the developed world that has been financing its growth via profligate spending, which is driven by excessive borrowing, is going to pay. As you said yourself evolution is constant, and there are business cycles – positive and recessionary. Its the way of life.. its natural.. sdo what must go up (borrowing) at some point must come down.

  • Peter Levchenko

    Hi Scott, the CENTRAL BANK (ie the Fed) could in principle change reserve requirements. But in western economies its not used because its too crude a measure. To understand what I mean imagine a bank which has 100bn deposits, and 12bn as total reserves – clearly 10bn are required reserves (assuming 10% RR), and 2bn are excess.

    If the central bank hikes reserve requirements to 15%, then the next day, the bank is going to find itself short 3bn of reserves. So imagine the impact on the interbank market when the central bank announces this change – everyoen will scramble to borrow more and this could create big swings in short-term rates.
    Instead the central bank in a developed world prefers to use Open Market Operations as I described. It is much smoother and can be fine tuned much easier simply by buying/selling required amount of bonds, instead of re-writing the official law each time a central bank wants to change reserve requirements.

  • http://twitter.com/IslandLifeMiami Scott

    Peter:

    Thanks for the clairification.

    Could a change in the reserve requirement be used in the run away inflation scenario?

  • Peter Levchenko

    Yes in principle it could, thoough I’d imagine it would be a measure of last resort. As explained above, Fed could combat inflation by intervening heavily via OMOs, also it could hike interest rate on excess reserves.

  • Peter Levchenko

    There have been a few question regarding the 500% of GDP figure I quoted for US debt. This has actually come about some time ago and flagged by one of the most well respected bond managers in the world, Bill Gross, who manages PIMCO – the largest bond fund in the world.

    The detailed analysis of the US debt, IF YOU INCLUDE social security payments, which are unfunded (this is not included in most official figures that simply cite federdal debt) is given in his April 2011 outlook, titled “Skunked”:

    http://www.pimco.com/EN/insights/pages/skunked.aspx
    The 500% of GDP figure is what one arrives after incorporating all the unfunded liabilities as part of public debt.

  • http://evilspeculator.com molecool

    Awesome – thanks for sharing that article.

  • http://www.facebook.com/tyrakis George Tyrakis

    InterestIng post PL, so what asset does one hold in your scenarios? A formal default scenario would shake the foundations of the financial system whilst negative real yields create bubbles elsewhere? Keep calm and buy gold? (physical gold that is…)