Understanding where the banking system is right now

Economist Scott Grannis has a noteworthy discussion of the current state of the monetary policy in the US over at his Calafia Beach Pundit blog.

In it, he observes that "the Fed has dumped a ton of reserves into the banking system, but banks have been either unwilling to make new loans, or the economy has no desire to take on more debt, or both." He draws this conclusion based on his examination of the Fed's balance sheet, which has ballooned to unprecedented proportions, versus the M2 measure of the monetary supply, which has not expanded at any unusual rate.

To understand this discussion, it is important to understand how balance sheets work throughout the banking system, which is illustrated in the diagram above (click on diagram to see larger image). The primary concept being illustrated is that deposits made into a bank are an asset for the depositor (in this illustration, the couple at the lower right) and a liability for the bank (in the center of the diagram). The couple has earned some income, which they deposit in their bank account, creating an asset on their balance sheet and a liability on the bank's balance sheet. The couple's savings or checking account is a liability to the bank, because the couple can demand those funds back at any time from the bank.

The bank, of course, also receives an asset to correspond to the liability on their balance sheet. They can hold the cash from the couple in their vault, they can purchase some securities with it (most likely US government bonds), they can turn around and loan it out to someone else, or they can put it in a bank account themselves.

If the bank selects this last option, the balance sheet activity will be very similar to the balance sheet activity we discussed when the couple took their deposit to the bank: the bank will send its deposit to a Federal Reserve Bank (the Federal Reserve acts as the "banker's bank") and will have an account there, which will be a liability to the Federal Reserve Bank (known as "bank deposits") and an asset to the bank (known as "reserves"). This is illustrated in the diagram below:

In the illustration above, the bank is shown doing two things: banking some deposits at the Federal Reserve (green arrow and green circled lines on the balance sheets, which creates the corresponding asset on the bank's balance sheet under their "reserves," and also creates a liability for the Fed under "bank deposits") and making a loan to some other members of the public (in this case, some businessmen who are starting some kind of business). The loan (red arrow and red circled lines on the balance sheets) creates a liability for the businessmen on their balance sheet, but it is an asset for the bank and it is the primary way that the bank makes money, because it is going to pay them interest.

The reason the diagram above shows the bank putting some of the deposits into reserves (green arrow) and lending some of it out (red arrow) is that this is the typical activity of a bank. It is required to hold some percentage of deposits in reserves, and it will usually lend some or all of the rest out (since lending is the way that banks make money).

As an aside, this lending activity by banks creates more money in circulation. When the two businessmen receive their loan in the diagram above, they may put it into their bank (which can then put some into reserves and then loan the rest out again) or they may use it to buy capital goods or other items for their business (in which case the vendors of those goods will put the money into their own bank accounts, and their banks will then save some in reserves and loan the rest out). The measure of money M2 mentioned in the Calafia Beach Pundit article looks at the sum of all currency, checking deposits, savings deposits, time deposits (such as CDs) and money market funds.

As Scott Grannis explains, QE2 has "dumped a ton of reserves into the banking system." The way this has taken place is that the Federal Reserve has decided to purchase massive amounts of US Treasury bills and bonds. Where does the Federal Reserve go to purchase these US government securities? The answer is: banks and other depository institutions (such as savings banks and credit unions). Banks have US government securities on their balance sheets, as we discussed above when we noted that banks can hold deposits as cash, send them as deposits to the Fed to become reserves, loan them out, or invest them in securities -- if they invest them in securities, those are usually US government debt instruments.

When the Fed decides to purchase US Treasury securities, the balance sheet repercussions are shown in the diagram below:

In the diagram, the Fed has decided to buy some US government bonds from the bank. These will leave the asset side of the bank's balance sheet and show up on the asset side of the Fed's balance sheet. The Fed will pay for these by increasing that bank's reserves, which increases the asset side of the bank's balance sheet by the value of the bonds that it sold to the Fed.

On the Fed's balance sheet, the newly-purchased government bonds will increase the asset side of its balance sheet. To counter-balance this entry, the Fed will gain a corresponding liability in the "bank deposits" line on the liability side of its balance sheet. This liability also corresponds to the "reserves" asset on the bank's balance sheet, as discussed previously. This explains why the purchase of US Treasury securities by the Fed increases the bank reserves available to banks.

Because banks are required to have a certain amount of reserves to support a certain amount of lending (the reserve requirement), an increase in their reserves creates the potential for banks to increase their lending as well.

Scott Grannis is observing that although bank reserves have grown tremendously due to the Fed's purchase of treasury securities, the M2 measure of the money supply has not grown any faster than its rate for the past fifteen years, which indicates that banks are not lending out what their larger reserves enable them to lend out.

Thus, he concludes that the Fed's actions have so far not been extremely inflationary. Had banks been lending to the degree that their larger reserves would allow them to lend, inflation could have become a huge problem already (remember that bank lending actually creates more money in the money supply, and boosts the size of M2, as discussed above; inflation is a function of "too much money chasing too few goods").

The reason bank lending has been lower than it could have been (or, seen from the other side, borrowing demand has been lower than it could have been) primarily has to do with fear and uncertainty, some of it on the part of lenders and some of it on the part of borrowers. Some of it also has to do with the fact that the private sector is awash in cash, with businesses holding huge reserves of cash on their balance sheets, and households generally paying down debts and shoring up their own balance sheets during the past four years.

There are indications, however, that business profits are picking up in many parts of the economy, which will tend to increase the appetite for borrowing to pursue business opportunities. And, as Scott Grannis points out, there are plenty of inflationary indicators that have been ticking up strongly over the past several months. Both of these observations indicate that both lending activity and inflation may be on the verge of increasing very sharply very soon.

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