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Money Supply And Economic Data Weekly Watch — How the Fed is Making Banks Lend

The Fed­eral Reserve is forc­ing banks to lend or face finan­cial dis­as­ter. The Fed’s lat­est strat­egy gives banks the stark choice of lend­ing or los­ing a lot of money from oper­a­tions. Every­one knows the Fed cut its tar­get Fed­eral Funds rate to the bone this week. In a less obvi­ous move, the Fed is also forc­ing down rates on Trea­sury bonds and other secu­ri­ties. As a result, banks have the choice of buy­ing bonds that yield less than their cost of funds or lend­ing. Any bank that decides not to lend will suf­fer losses. Cash is trash and if banks don’t recy­cle it, they will slowly bleed to death.

The Fed­eral Reserve is return­ing banks back to the lend­ing busi­ness in two ways.

First, the Fed is pro­vid­ing banks with cash to lend by dra­mat­i­cally increas­ing money sup­ply. Newly cre­ated money becomes new deposits in banks. For the last 3 months, money sup­ply as mea­sured by M1 increased by an aston­ish­ing annual rate of 37.6%. The largest com­po­nents of M1 are cash deposits at banks and those com­po­nents are grow­ing very rapidly. The Fed is mak­ing sure that banks get A LOT of new cash to lend.

In nor­mal times, banks gather cash by accept­ing deposits and then recy­cle their cash into loans. But, these aren’t nor­mal times and banks aren’t react­ing the way they have in the past. Instead of recy­cling cash into loans, banks have tried to avoid risk by recy­cling their cash into low risk bonds that are like cash equiv­a­lents. So, mon­e­tary eas­ing didn’t really do any­thing for the econ­omy because cash was recy­cled into cash look alike instru­ments rather than into loans. The bank­ing sector’s huge demand for cash equiv­a­lent invest­ments caused yields on short term Trea­sury and gov­ern­ment secu­ri­ties to drop to almost 0% (and was even neg­a­tive for brief peri­ods of time).

This led the Fed to its sec­ond, less obvi­ous, strat­egy. The Fed has start­ing pur­chas­ing the cash equiv­a­lent invest­ments that banks are buy­ing and in the process dri­ving down yields. Banks are los­ing money on their for­merly safe invest­ments because their all-in cost of deposits is higher than the yield they are earn­ing from cash equiv­a­lent invest­ments. This is sim­i­lar to a retailer buy­ing inven­tory for $100 and then sell­ing it for $95. It isn’t a good busi­ness strat­egy. To make a pos­i­tive net inter­est spread between their all-in cost of deposits and their invest­ments, banks are being forced to lend. Loans to busi­nesses and con­sumers have high enough yields for banks to make a profit.

Even when banks pay 0% inter­est to depos­i­tors if they don’t lend money they will lose money. Banks have a mar­ginal cost of hold­ing deposits that is much higher than the inter­est cost of 0%. Bank deposit costs include: oper­at­ing expenses, FDIC insur­ance, cost of equity and reg­u­la­tory com­pli­ance costs. These costs are gen­er­ally between 1% and 3%. And if banks accept deposits that are CD’s which have an inter­est rate of between 1.5% and 4.5%, their all-in cost of funds gets even higher.

The types of invest­ments that the Fed is ini­tially tar­get­ing to drive down yields include Trea­sury secu­ri­ties, Fed­eral Funds, Agency bonds and Agency and gov­ern­ment guar­an­teed mort­gage backed secu­ri­ties. These invest­ments have his­tor­i­cally been con­sid­ered low to no risk invest­ments that are as good as cash. One by one, the Fed­eral Reserve is going to take away the hid­ing places that banks have used to avoid lending.

While yields on low risk cash equiv­a­lent invest­ments are around 0%, the rate of inter­est that “real” bor­row­ers need to pay for new loans has remained high. Most real mea­sures of loan avail­abil­ity for busi­nesses and con­sumers indi­cate a con­tin­u­ing credit cri­sis, incred­i­ble risk aver­sion and a rel­a­tively high cost of bor­row­ing. It is into this lend­ing void that the Fed is dri­ving banks.

How­ever, if banks con­tinue to avoid lend­ing to busi­nesses and con­sumers, the Fed is mak­ing sure that they will feel a lot of finan­cial pain. The Fed­eral Reserve has put banks between a rock and a hard place. Either they lend, or destroy their insti­tu­tion with a neg­a­tive inter­est spread and risk reg­u­la­tory dis­ci­pline. The Fed­eral Reserve has mor­phed the strat­egy of hoard­ing cash equiv­a­lent invest­ments into a very risky decision.

The Fed’s inno­v­a­tive approach goes far beyond the “qual­i­ta­tive eas­ing” that bankers and econ­o­mists were expect­ing. Some­time in the next few weeks, after cor­po­rate plan­ning staffs and con­sul­tants grind out mod­els and analy­sis, it is going to dawn on bankers that they have to par­tic­i­pate in the eco­nomic recov­ery by lend­ing. The Fed’s two-pronged strat­egy will get banks lend­ing again. And, with fis­cal stim­u­lus from the new Obama Admin­is­tra­tion, the econ­omy will respond sooner than most peo­ple expect.

Posted in: BANKS, Bernanke, Credit Crisis, Deflation, Economic Statistics, economy, Federal Funds Rate, Federal Reserve, Finance, M1, monetary policy, Money Supply, Politics

2 Comments

  1. Mitchell

    This is Mitch from SIREN (Staten Island Real Estate News) blog. I just received your com­ment on my blog and after read­ing this arti­cle it cer­tainly sub­stan­ti­ates your pre­dic­tions from the other arti­cle you wrote. I think your blog is very insight­ful and I will be back to read some more of your posts.

    http://www.SIRealEstateNews.com

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