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Banking System 101 – Part 1

Banking System 101 – Part 1

by evilMarch 19, 2013

This is the first 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 will start with a basic introduction and  then explore a chronological recap of what has transpired in the past few years.

Fed Monetary Policy and Quantitative Easing

Before the 2008 crisis, conventional monetary policy in the US boiled down to the Federal Reserve (the Fed) controlling interest rates. The way it achieved that was by manipulating what’s known as the Fed funds rate:

Commercial banks (banks in the US that accept deposits and make loans) have daily funding requirements. Let’s assume Bank A faces a withdrawal of deposits today totaling $1bn. Deposits are a liability of the bank, so to make that payment to its customers it needs to borrow money. It could do that in the interbank market with another commercial bank, so it negotiates an overnight rate and deals at that rate.

The weighted average rate of all such transactions in the banking system every day is known as the Fed funds effective rate.  That is essentially a proxy for an overnight interbank market rate. The Fed regularly meets via Federal Open Market Committee (FOMC) and sets what is known as the Fed funds target rate, which is the level of interest rates they consider appropriate for the economy based on macroeconomic factors and so on. Their job as part of conducting monetary policy is to ensure that the market rate (ie the Fed funds effective rate) accurately mimics the benchmark Fed funds target rate.

The Fed uses Open Market Operations (OMOs) to achieve this, by directly altering the supply of money in the economy. In simple terms, think of it as two worlds: the Fed and the Monetary System (ie banks, lending institutions, and then the real economy).  The way money reaches the economy is via banks’ lending money to firms and businesses. All the money that is sitting at the Fed does not affect the economy in any way since it is not available for lending to businesses. BUT if the Fed chooses to inject money into the economy, the quantity of money that banks have available to lend increases.

Interest rate is the price of money. And similar to a stock, if supply of money increases – its ‘price’ (ie the interest rate) goes down. During Open Market Operations, the Fed buys and sells government bonds to banks as a way of regulating money supply. Suppose the Fed funds effective rate (ie the actual market rate) is trading higher than the Fed’s target (the Fed funds target rate). To lower the market rate, the Fed can attempt to increase the supply of money. To achieve this, it buys government bonds from banks, and in exchange it credits their reserve accounts. That way the money now enters the monetary system as banks can lend that money to the economy.

During Temporary OMOs, Fed reverses its actions on money supply, i.e. if it initially bought bonds from banks it will reverse that after a period of time by selling an equivalent amount, thereby creating only a temporary change in money supply. In 2009 as response to the credit crisis, the Fed announced a longer-dated programme which became the main part of their Permanent OMOs (POMOs), as they started outright purchases of longer-dated bonds without immediate intention to sell them back. This has been labelled as QE (quantitative easing).

How Does QE Work?

To illustrate, consider two US commercial banks, ie institutions that take deposits and make loans. We have Bank A, which has been started with $10bn equity capital, and has accepted $100bn of deposits. These are liabilities on its balance sheet (BS), since it effectively “owes” that money to shareholders and depositors respectively. For simplicity, consider Bank B which has exactly the same liabilities. Let’s assume for simplicity that they are the only two commercial banks in the system.

By law a bank is obliged to maintain a certain level of reserves with the central bank, which it should hold at its reserve account. This is what is known as reserve requirements and they cover the bank’s assets and liabilities but the most basic form is that banks in the US should hold 10% of their deposits as reserves. These show up as assets, since they represent cash owned by the bank.

So total reserves in the system are $20bn and they are all required reserves, i.e. there are no excess reserves. Banks also make loans, which are assets on their balance sheet (since they are owed money by borrowers) and lets assume that they hold some securities on their balance sheet too (securities = stocks/bonds etc). Suppose Bank B has access to a larger pool of lending opportunities, and to be able to make more loans it has borrowed $40bn from Bank A. The full balance sheet of both banks is displayed in Figure 1.1 with the interbank loan in orange (Bank B owes money so it is a liability on its BS, and an asset on Bank A’s BS):

Note the importance of the interbank lending system in normal times, money has flown towards its most productive use (i.e. Bank B borrowed to service the need of its customers). In our example from Figure 1.1., suppose the financial system enters a period of turmoil like in 2008, which disrupted the normal pattern of lending and led to a “freeze”, which could be due to uncertainty about banks’ ability to pay back and also their ability to borrow for their own funding needs. Now Bank A does not want to continue lending to Bank B. This places a severe disruption on Bank B: if it is unable to quickly raise new deposits or borrow elsewhere to obtain the $40bn it owes, it could be forced to decrease its loans by $40bn. That in turn would force a contraction in deposits, as borrowers scramble to pay back loans to Bank B resulting in a sharp contraction in economic activity.

To prevent this, the Fed steps in with QE and suppose it buys $40bn of Treasuries from Bank B. Recall that in the original example the banking system, which consists of A and B, held no excess reserves. The resulting balance sheets after $40bn Fed QE are shown below (changes in red):

Fed credited Bank B’s reserve account with $40bn, which Bank B used to pay back the loan to Bank A (hence Bank A’s reserve account now holds extra 40bn). Bank B got the money by selling $40bn of its bonds (securities). Note that the total reserves in the system are now $60bn, but only $20bn are required – hence there are now $40bn of excess reserves. The chart below shows the actual US banking system total reserves (yellow) and excess reserves (red) that have resulted from QE, similar to the example above:

Numerous market observers and commentators such as ZeroHedge have used this to conclude that Fed has injected “dead money” that is sitting on banks’ balance sheets and hence its policies have been ineffective. But as our example shows, the job of the Fed here was to prevent an interbank market freeze and it was highly effective in this regard – it prevented Bank B from having to reduce its lending by $40bn!

In fact, lets assume that Fed does $50bn more QE, but this time the cash is released into the real economy, ie firms are sellers of the bonds to the Fed. The Fed can only deal with primary dealers which are banks, so suppose Bank B stands in as the intermediary and sells the bonds to the Fed on behalf of its clients:

Resulting Bank B’s balance sheet is now shown in Figure 1.3 (changes in red from Figure 1.2). I have split total reserves into required and excess reserves for clarity: the Fed deals with Bank B, which is representing the firms, so it credits Bank B’s reserve account with 50bn. Bank B is selling bonds on behalf of its clients to the Fed in return, so there is no drain to Bank B’s own stockpile of securities. To channel the proceeds of this sale to its clients, Bank B must credit the deposit accounts of its clients – hence its deposits increase by $50bn from Fig 1.2. So both reserves and deposits go up, BUT required reserves are only 10% * 150bn = $15bn, hence Bank B now gains $45bn in excess reserves (it previously held none).

Let’s further assume that Bank B directly increases lending by making a new loan of $20bn to a firm. Resulting balance sheet is shown in Figure 1.4: Bank B now has a new asset (the loan to the firm of 20bn) and an offsetting liability (it credits the firm’s deposit account at the bank by 20bn). Note that Bank B’s total reserves have not changed at all, and excess reserves have only narrowed slightly to ($60bn – 10%*170bn) = $43bn.

This is counter intuitive, as even though bank lending in the economy increased, total reserves and excess reserves still went up! Sure, the firm in our example can now withdraw that money from its deposit account and spend it, but since most of the money payments are nowadays electronic whatever they spend this money on (investment, research etc) will just end up at other firms’ accounts, which in turn would end up as another bank’s deposits.

This is the general principle: loans to banks and firms and direct purchases by the central bank all increase the TOTAL level of reserves in the banking system by the same amount. It doesn’t imply anything about the level of lending in the economy! Similarly, the level of excess reserves in the system does NOT imply that banks are not lending.  In the example above bank lending went UP by nearly 10% ( = $20bn / Total loans [$150bn + $60bn] ) But Bank B’s excess reserves also went UP by $43bn.


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  • Pervergence

    So on the platinum setup would you have taken the long on the breach of the inside candle………then reverse on the short breach??………or with the setup being in the lower section of the BB would you look to take the short only??

  • Pervergence

    On the range compression in Platinum today……..would the play have been long on the inside candle breach and then short on the bottom breach………or would you you be looking at short only……….

  • Darth_Gerb

    P. L. ?
    what? Did I miss the introduction?
    mystery author!

    ps. CS is posting replies on the previous post. it pays to backtrack.

  • molecool

    there was a little fake out – yes, but the SMA breach did the trick as it lead lower.

  • molecool

    @CS – if you see this please chime in.

  • Pervergence

    Would giving up a little of the move and using a breach of the candle previous to the IP be more cosistent?

  • Peter Levchenko

    P.L. is myself truly. Hope you enjoy it.

  • Darth_Gerb

    ah Peter! – yes I briefly remember now.. an interchange between you and MOle a few days ago.

    a chart worth noticing – cut lip is now a bleeding lip.

  • convictscott

    There are several ways to play this. The squeeze is well documented in John Bollinger’s Original Book which I have linked here

    Download it everyone 🙂

    Quite often there is a “head fake” move one way and then a big move in the opposite direction move. Typically the move is kicked off by the absolute lowest bollinger bandwidth, or Standard Deviation of the last 20 periods, which I have marked on the chart with a green vertical line.

    In this case after the Green Line we begin STALKING THE TRADE. What we are looking for is a SETUP IN EITHER DIRECTION, which, if entered will kick volatility (as approximated by bandwidth to a threshold level) The threshold is different for each timeframe and instrument, what I do is look back over a few screens of action for the volatility reading that indicates a threshold of tradeable action. Below a certain volatility threshold price action is choppy (especially close to a flat moving average) and virtually untradeable. In this case I have marked the volatilty threshold I think is valid with a blue line. I chose it by looking at what worked in the previous volatility squeeze around 3/16.

    We can work out mathematically whether a setup would kick volatility off by taking the readings for the last 20 closes, putting them in excel and applying the formula =STDEV(range) to them. All you have to do is enter in a hypothetical close and see if it would kick it off. Or you can eyeball it, after a while you don’t need the spreadsheet.

    OK so we look for

    1) Volatility reducing to the lowest level in a while with a nearly flat or flat moving average or mean – check

    2) Volatility giving an uptick to the verge of a tradeable threshold – check. Note if we had volatility expansion already we would just begin trading patterns as normal, as the win rate and expectancy goes up during increasing volatility.

    3) Each Bar we EXAMINE to see if a breakout would have set off a volatility expansion. The setup here is a FAKEOUT SHOOTING STAR.

    a) A spike high

    b) A shooting star candle which breaks that spike high

    c) Go short on break of the low

    Note in this case immediately before the shooting star candle was an inside bar. A breach of this to the DOWNSIDE would have had a similar effect, I would have been prepared to takr this trade.

    Also in this case I would have taken a breach of the TOP of the shooting star as a buy setup, a low probability outcome which could have kicked off a major move.

    This is highly reliable stuff I am currently building systems around. It is demonstrably provably that volatility squeezes are unsustainable and breakouts happen from this. Interestingly this price action would look like a HIGHER TIMEFRAME inside period. You can see how and why the inside day setup works from this 🙂

  • i Bergamot

    Very nice piece, Peter
    Good job

    If you don’t’ mind me asking,
    is it a kind of stuff they teach in college, or is it your own practical knowledge?

  • convictscott

    See my reply above. In this case I most likely would have jumped the gun and taken the inside candle long since that is an equally likely scenario. Then raised my stop to the low of the subsequent shooting star for a roughly .5R loss and a 5 R win to the downside.

    In this situation for exits I have stolen a system from Ken Long (youtube him his stuff is great) which I don’t use for entries but do for exits. Google “Ken Long RLCO”. Long story cut short, where price, linearregression(10) and linearregression(30) are all outside the 1SD bollinger this is trending action. In that case I exit the short position on a regression line crossover, which would have taken me out at the first green close at the bottom

  • Darth_Gerb

    Yesss!!! something to read on the plane tomorrow.
    I don’t think my traveling will come close to Mole’s Omen. ha!

  • convictscott

    With the comments I made on the platimum setup below. I am accustomed to taking setups off the physical spot price and overlaying them onto the futures price. That is a complication which is probably unneccesary for intraday trading.

    Here we have the unsustainable volatility squeeze and the inside day which I would have taken long, then raised my stop to the low of the subsequent Retest Variation Sell.

    An alternate method would be to wait for a breach of bollinger band, exiting if it didnt close outside the band

  • molecool

    Thanks for the book mate – very cool.

  • momac

    If I’m understand correctly, live cattle was a similar setup today, but it had advanced notice with an ID candle yesterday.

  • momac

    excellent article explaining the banking system

  • badflightrisk

    VIXX, VIXY and TVIX ETF’s scored their second highest volume since inception today.
    UVXY volume was a record
    If you go back to August UVXY averaged around 2 million shares
    Today it did 58 million.

  • Rightside_ot_trade

    /SB NR4 ID at the Daily 25MA

  • momac

    I hope it waits for me, I don’t want to stay up all night. 🙂

  • molecool

    Really good work – I just announced it via my mailing list as well.

  • convictscott

    Very cool stuff Peter, thank you for this

  • newbfxtrader

    FOMC day folks. If you dont like the choppy ride stay away….

  • Peter Levchenko

    My degree was in Maths and Computing. So this knowledge comes from my own research and during my career as trader I have had regular opportunities to test it with my colleagues in Research and Strategy, who are mostly professional economists.

  • captainboom

    Great discussion, thank you. I have Bollinger’s book, and recommend it. One thing I note in your discussion: Your chart is of Palladium, PD, and the original question was about Platinum, PL. Charts are nearly identical, so I think the analysis still works.

  • i Bergamot

    Very good.
    Looking forward to reading more of your research.

    Also, I wondering:
    From stand point of traditional economics Bank B is a short of lifetime, if you have an unlimited time horizon that is. Or is it too much of variant perception?

    just playing devil’s advocate, and looking for practical applications

  • Ronebadger

    According to Scott…”wait for the retest”. Might even be today!

  • badflightrisk

    Prior low retest on HL

  • ridingwaves

    Coming up to make or break on weekly….180 gives its heading to 360 to settle….

  • Joe_Jones

    I would recommend against advertising here these widow-makers. There are better and safer ways to bank coin betting on increased volatility.

  • badflightrisk

    Not advertising. It might be showing to many looking for a top

  • momac

    ct ID working

  • ridingwaves

    late to party shorts getting a spanking in AFFY…

  • ridingwaves

    Note to self – never believe stress tests – as 1 1/2 years ago the 3 largest banks in Cyprus passed the European test with flying colors

  • Ronebadger

    that reminds me, I gotta get a stress test

  • Ronebadger

    Does today count as a retest of last weeks high? (We’ll see)

    Does this year count as a retest of the 2007 high? (Who knows?)

    Watching and waiting….

  • i Bergamot

    I am not a big fan of Elliott Wave Theory (EWT)

    This is from personal experience. I don’t think anybody disputing that
    EWT is very hard to properly analyze in real time. What really necessary
    is for pattern to be finished, reversal of some kind to already occur
    and only then you have a “confirmed” EW count. This whole business is
    really pretty and can blow your mind with benefit of hindsight.

    SPX went thru bunch of stages, some looking like major top, some like
    run-away long term bull market, until everybody left. Bulls are afraid
    to get caught again, bears can’t take anymore pain. Five big waives off
    2009 bottom, five well defined waves off Fall 2011, five off November
    2012 low. This last one has distribution happening thruout – not on
    averages, but on most of former market leading stocks. I am not an
    expert on Elliott Wave Theory, and I am not sure how to properly label
    all stages, but i am looking at a picture that is just too perfect.

    I am not bullish. My target was 1600+ on SPX, some 50 point away.
    Possible correction / bear market can take this market to 1000 SPX, some
    500 points away.

  • Ronebadger

    Uh oh… you said “wave” and “elliott” in the same post

    Good thing you mentioned “theory” as well

  • i Bergamot

    Already in hiding

  • BobbyLow

    Elliot Wave is a term that I’ve been trying to remove from my vocabulary forever. IMO The study of The Elliot Wave Principle is similar to the study of Macro Economics in that it is dependent upon using a correct set of criteria to always be correct in Hindsight.

    As a forward indicator, it is absolutely useless as far as I’m concerned. As a matter of fact, I wonder whatever happened to $%^&*ing PEE THREE that was supposed to occur about 3 Years ago? I guess it’s just a little tardy.

    In the mean time, we have yet another Happy Bernanke Day. 🙂

  • Darkthirty

    when you mention p3 you must also mention prechter, then you must mention that you’ve never learned the parameters of ewt and are a follower of prechter.

  • molecool

    ¨°º¤ø„¸F R E S H „ø¤º°¨ 
    ¸„ø¤º°¨ M E A T“°º¤ø„¸

  • Peter Levchenko

    Bank B is not neccessarily a short. It is just more leveraged to the functioning of the economy, because it makes more loans and it has more deposits than Bank A. So if the economy is growing and lending is growing, interest rates are going up etc, this makes Bank B more attractive to own, as it has a bigger portfolio of loans so it earns more interest than Bank A. Sure, it has more deposits too so it has to pay interest on those, but the positive spread between interest it lends at and interest it has to pay on deposits is magnified by the size of its portfolio so it ultimately has higher earnings than Bank A.

    Conversely, in the deflationary scenario, with economy slipping into recession, or in case of a 2008 style credit squeeze, Bank B would be much more severely affected as it will face a contraction in its loans and potential drop in deposits, so it might struggle to attract financing. In that case its stock would probably dump more than that of Bank A’s.

    To reiterate, Bank B simply has more leverage than A to its balance sheet. So in a boom, it outperforms – in a recession, it underperforms.