Monday, December 28, 2009

>Why Are Banks Holding So Many Excess Reserves?

The buildup of reserves in the U.S. banking system during the financial crisis has fueled concerns that the Federal Reserve’s policies may have failed to stimulate the fl ow of credit in the economy: banks, it appears, are amassing funds rather than lending them out. However, a careful examination of the balance sheet effects of central bank actions shows that the high level of reserves is simply a by-product of the Fed’s new lending facilities and asset purchase programs. The total quantity of reserves in the banking system refl ects the scale of the Fed’s policy initiatives, but conveys no information about the initiatives’ effects on bank lending or on the economy more broadly.

The quantity of reserves in the U.S. banking system has grown dramatically over the course of the fi nancial crisis. Reserves are funds held by a bank, either as balances on deposit at the Federal Reserve or as cash in the bank’s vault or ATMs, that can be used to meet the bank’s legal reserve requirement. The level of reserves began to rise following the collapse of Lehman Brothers in mid- September 2008, climbing from roughly $45 billion to more than $900 billion by January 2009 (see the chart on page 2). While required reserves—funds that are actually used to fulfi ll a bank’s legal requirement—grew modestly over this period, this increase was dwarfed by the large and unprecedented rise in the additional balances held, or excess reserves.

Some commentators see the surge in excess reserves as a troubling development— evidence that banks are hoarding funds rather than lending them out to households, fi rms, and other banks. Edlin and Jaffee (2009, p. 2), for example, identify the high level of excess reserves as the “problem” behind the continuing credit crunch—or, “if not the problem, one heckuva symptom.” Other observers see the large increase in excess reserves as a sign that many of the steps taken by the Federal Reserve during the crisis have been ineffective. Instead of restoring the fl ow of credit to fi rms and households, they argue, the money the Fed has lent to banks and other fi nancial intermediaries since September 2008 is sitting idle in banks’ reserve accounts.

These views have led to proposals aimed at discouraging banks from holding excess reserves. The proposals include placing a tax on excess reserves (Sumner 2009) or setting a cap on the amount of excess reserves each bank is allowed to hold (Dasgupta 2009). Mankiw (2009) notes that economists in earlier eras also criticized the stockpiling of money during times of fi nancial stress and favored a tax on money holdings to encourage lending. Relating these past issues to the current situation, he remarks that “with banks now holding substantial excess reserves, [this historical] concern about cash hoarding suddenly seems very modern.”

In this edition of Current Issues, we argue that the concerns about high levels of reserves are largely unwarranted. Using a series of simple examples, we show how central bank liquidity
facilities and other credit programs create—essentially as a by-product—a large quantity of reserves. While the level of required reserves may change modestly with changes in bank lending behavior, the vast majority of the newly created reserves will end up being held as excess reserves regardless negligible. This process has clearly not taken place. After presenting our examples, we explain why the money multiplier is inoperative in the current environment, where reserves have increased to unprecedented levels and the Federal Reserve has begun paying interest on those reserves. We also argue that a large increase in the quantity of reserves in the banking system need not be infl ationary, since the central bank can adjust short-term interest rates independently of the level of reserves by changing the interest rate it pays on reserves.

Central Bank Lending: A Simple Example
To clarify how the types of policies implemented by the Federal Reserve over the course of the financial crisis affect individual banks’ balance sheets and the level of reserves in the banking system as a whole, we present a simple example. Consider the balance sheets of two banks, labeled A and B (Exhibit 1). Focus fi rst on the items in black. On the liabilities side of the balance sheet, each bank has started with $10 of capital and has taken in $100 in deposits. On the asset side of the balance sheet, both banks hold reserves and make loans. For simplicity, we assume that the banks are required to hold reserves equaling 10 percent of their deposits, and that each bank holds exactly $10 in reserves.

To read the full report: CURRENT ISSUES