Al-Jazeerah: Cross-Cultural Understanding
Opinion Editorials, July 2011
Why Banks Aren't Lending:
The Silent Liquidity Squeeze
Al-Jazeerah, CCUN, July 19, 2011
Al-Jazeerah, CCUN, July 19, 2011
Why aren’t banks lending to local businesses? The Fed’s decision to pay interest on $1.6 trillion in “excess” reserves is a chief suspect.
Where did all the jobs go?
Small and medium-sized businesses are the major source of new job
creation, and they are not hiring.
Startup businesses, which contribute a fifth of the nation’s new
jobs, often can’t even get off the ground.
In a June 30
article in the Wall Street Journal titled “Smaller Businesses Seeking
Loans Still Come Up Empty,” Emily Maltby reported that business owners rank
access to capital as the most important issue facing them today; and only
17% of smaller businesses said they were able to land needed bank financing.
Businesses have to pay for workers and materials before they can get
paid for the products they produce, and for that they need bank credit; but
they are reporting that their credit lines are being cut.
They are being
into credit card accounts that average 16 percent interest, more than double
the rate of the average business loan.
It is one of many changes in banking trends that have
been very lucrative for Wall Street banks but are killing local businesses.
Why banks aren’t lending is a matter of debate, but the
Fed’s decision to pay interest on bank reserves is high on the list of
suspects. Bruce Bartlett,
writing in the Fiscal Times in July 2010, observed:
Economists are divided on why banks are not lending, but increasingly are focusing on a Fed policy of paying interest on reserves — a policy that began, interestingly enough, on October 9, 2008, at almost exactly the moment when the financial crisis became acute. . .
Historically, the Fed paid banks nothing on required reserves. This was like a tax equivalent to the interest rate banks could have earned if they had been allowed to lend such funds. But in 2006, the Fed requested permission to pay interest on reserves because it believes that it would help control the money supply should inflation reappear.
. . . [M]any economists believe that the Fed
has unwittingly encouraged banks to sit on their cash and not lend it by
paying interest on reserves.
At one time, banks collected deposits from their
own customers and stored them for their own liquidity needs, using them to
back loans and clear outgoing checks.
But today banks typically borrow (or “buy”) liquidity, either from
other banks, from the money market, or from the commercial paper market.
The Fed’s payment of interest on reserves competes with all of these
markets for ready-access short-term funds, creating a shortage of the
liquidity that banks need to make loans.
By inhibiting interbank lending, the Fed appears
to be creating a silent “liquidity squeeze” -- the same sort of thing that
brought on the banking crisis of September 2008.
According to Jeff Hummel, associate professor of economics at San
Jose State University, it could happen again.
that paying interest on reserves “may eventually rank with the Fed's
doubling of reserve requirements in the 1930s and bringing on the recession
of 1937 within the midst of the Great Depression.”
The Travesty of the $1.6 Trillion in “Excess Reserves”
The bank bailout and the Federal Reserve’s two “quantitative easing” programs were supposedly intended to keep credit flowing to the local economy; but despite trillions of dollars thrown at Wall Street banks, these programs have succeeded only in producing mountains of “excess reserves” that are now sitting idle in Federal Reserve bank accounts. A stunning $1.6 trillion in excess reserves have accumulated since the collapse of Lehman Brothers on September 15, 2008.
The justification for TARP -- the Trouble Asset Relief Program that subsidized the nation’s largest banks -- was that it was necessary to unfreeze credit markets. The contention was that banks were refusing to lend to each other, cutting them off from the liquidity that was essential to the lending business. But an MIT study reported in September 2010 showed that immediately after the Lehman collapse, the interbank lending markets were actually working. They froze, not when Lehman died, but when the Fed started paying interest on excess reserves in October 2008. According to the study, as summarized in The Daily Bail:
. . . [T]he NY Fed's own data show that
interbank lending during the period from September to November did not
"freeze," collapse, melt down or anything else. In fact, every single
day throughout this period, hundreds of billions were borrowed and paid
back. The decline in daily interbank lending came only when the Fed
ballooned its balance sheet and started paying interest on excess reserves.
On October 9, 2008, the Fed began paying interest, not just on required bank reserves (amounting to 10% of deposits for larger banks), but on “excess” reserves. Reserve balances immediately shot up, and they have been going up almost vertically ever since.
By March 2011,
interbank loans outstanding were only one-third their level in May 2008,
before the banking crisis hit.
And on June 29, 2011, the Fed reported
reserves of nearly $1.57 trillion – 20 times what the banks needed to
satisfy their reserve requirements.
Why Pay Interest on Reserves?
Fed decided to pay interest on reserves is a complicated question, but
it was evidently a desperate attempt to keep control of “monetary policy.”
The Fed theoretically controls the money supply by controlling the
Fed funds rate. This hasn’t
worked very well in practice, but neither has anything else, and the Fed is
apparently determined to hang onto this last arrow in its regulatory quiver.
In an effort to salvage a comatose credit market after
the Lehman collapse, the Fed set the target rate for Fed funds – the funds
that banks borrow from each other -- at an extremely low 0.25%.
Paying interest on reserves at that rate was intended to ensure that
the Fed funds rate did not fall below the target.
reasoning was that banks would not lend their reserves to other banks
for less, since they could get a guaranteed 0.25% from the Fed.
The medicine worked, but it had the adverse side effect of killing
the Fed funds market, on which local lenders rely for their liquidity needs.
It has been argued that banks do not need to get
funds from each other, since they are now awash in reserves; but these
not equally distributed.
The 25 largest U.S. banks account for over half of aggregate reserves, with
21% of reserves held by just 3 banks; and the largest banks have
on small business lending by over 50%. Large
Wall Street banks have more lucrative things to do with the very cheap
credit made available by the Fed that to lend it to businesses and
consumers, which has become a risky and expensive business with the
imposition of higher capital requirements and tighter regulations.
In any case, as noted in an
earlier article, the excess reserves from the QE2 funds have accumulated
in foreign rather than domestic banks.
John Mason, Professor of Finance at Penn State
University and a former senior economist at the Federal Reserve, wrote in a
June 27 blog that despite
Cash assets at the smaller [U.S.] banks remained relatively flat . . . . Thus, the reserves the Fed was pumping into the banking system were not going into the smaller banks. . . .
[B]usiness loans continue to “tank” at the
smaller banking institutions.
Business Lending Depends on Ready Access to Liquidity
Without access to the interbank lending market,
local banks are reluctant to extend business credit lines.
The reason was
explained by economist Ronald McKinnon in a Wall Street Journal article
Banks with good retail lending opportunities typically
lend by opening credit lines to nonbank customers. But these credit lines
are open-ended in the sense that the commercial borrower can choose when—and
by how much—he will actually draw on his credit line. This creates
uncertainty for the bank in not knowing what its future cash positions will
be. An illiquid bank could be in trouble if its customers simultaneously
decided to draw down their credit lines.
If the retail bank has easy access to the wholesale
interbank market, its liquidity is much improved. To cover unexpected
liquidity shortfalls, it can borrow from banks with excess reserves with
little or no credit checks. But if the prevailing interbank lending rate is
close to zero (as it is now), then large banks with surplus reserves become
loath to part with them for a derisory yield. And smaller banks, which
collectively are the biggest lenders to SMEs [small and medium-sized
enterprises], cannot easily bid for funds at an interest rate significantly
above the prevailing interbank rate without inadvertently signaling that
they might be in trouble. Indeed, counterparty risk in smaller banks remains
substantial as almost 50 have failed so far this year.
The local banks could turn to the Fed’s discount
window for loans, but that too could
signal that the banks were in trouble; and for weak banks, the Fed’s
discount window may be
closed. Further, the
discount rate is triple the Fed funds rate.
As Warren Mosler, author of The 7 Deadly Innocent Frauds of Economic Policy, points out, bank regulators have made matters worse by setting limits on the amount of “wholesale” funding small banks can do. That means they are limited in the amount of liquidity they can buy (e.g. in the form of CDs). A certain percentage of a bank’s deposits must be “retail” deposits – the deposits of their own customers. This forces small banks to compete in a tight market for depositors, driving up their cost of funds and making local lending unprofitable. Mosler maintains that the Fed could fix this problem by (a) lending Fed funds as needed to all member banks at the Fed funds rate, and (b) dropping the requirement that a percentage of bank funding be retail deposits.
Alternatives to a Failed Banking Model
Paying interest on reserves was intended to prevent “inflation,” but it is having the opposite effect, contracting the money and credit that are the lifeblood of a functioning economy. The whole economic model is wrong. The fear of price inflation has prevented governments from using their sovereign power to create money and credit to serve the needs of their national economies. Instead, they must cater to the interests of a private banking industry that profits from its monopoly power over those essential economic tools.
Whether by accident or design, federal policymakers
still have not got it right.
While we are waiting for them to figure it out, states can nurture and
protect their own local economies with publicly-owned banks, on the model of
the Bank of North Dakota (BND).
Currently the nation’s only state-owned bank, the BND services the liquidity
needs of local banks and keeps credit flowing in the state.
Other benefits to the local economy are detailed in a Demos report by
Jason Judd and Heather McGhee titled “Banking
on America: How Main Street Partnership Banks Can Improve Local Economies.”
Alone among states, North Dakota had the wherewithal to
keep credit moving to small businesses when they needed it most. BND’s
business lending actually grew from 2007 to 2009 (the tightest months of the
credit crisis) by 35 percent. . . . [L]oan amounts per capita for small
banks in North Dakota are fully 175% higher than the U.S. average in the
last five years, and its banks have stronger loan-to-asset ratios than
comparable states like Wyoming, South Dakota and Montana.
Fourteen states have now initiated bills to establish state-owned banks or to study their feasibility. Besides serving local lending needs, state-owned banks can provide cash-strapped states with new revenues, obviating the need to raise taxes, slash services or sell off public assets.
Ellen Brown is an attorney and president of the Public Banking Institute, http://PublicBankingInstitute.org. In Web of Debt, her latest of eleven books, she shows how the power to create money has been usurped from the people, and how we can get it back. Her websites are http://webofdebt.com and http://ellenbrown.com.
Opinions expressed in various sections are the sole responsibility of their authors and they may not represent Al-Jazeerah & ccun.org.
email@example.com & firstname.lastname@example.org