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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


  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.

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