Currently there are about $1.2 trillion in “excess reserves” in the banking system, an amount held by banks above and beyond their reserve requirements (needed to “back up” their existing customer checking account balances.) Commercial banks are free to lend it out to their customers however most banks keep their excess reserves parked at the Fed, and get paid by the Fed an annual percentage rate (APR) of 0.25 percent (25 “basis points.”) This means that the banks’ excess reserve balance grows annually by 25 basis points, a convenient way for banks to earn interest by incurring no risk. Whenever money is lent out there is a risk associated with it even if the underlying asset and the borrower are outstanding. If you’ve been wondering lately why banks are so picky with their lending guidelines you will find your answer in this article.
Few economists (mostly Austrian) pay attention to the Fed’s chairman fine print where Bernanke frequently mentions the Fed’s ability to offer higher interest rates on excess reserves. The question is why would Bernanke be prepared to entice commercial banks with higher rates to keep their money parked at the Fed?
To best answer this question we need to address the high probability of an increase in the prime rate (what commercial banks charge their best clients). So far the Fed has been able to keep this rate at extremely low levels however rising prices on commodities will most likely force the market to adjust and increase the cost of money. When rates go up the banks will want to start using their excess reserve to make new loans. The higher the rate the more eager the banks will be to earn profits from making new loans. Yet, Bernanke is prepared to do whatever it takes to stop those reserves from being used for lending.
The motive behind the Fed’s determination to keep banks from lending is hiding behind the complexity of the monetary base and its sinister expansion since the 2008 financial crises. There is a lot of talk today about the Fed’s creation of new money (out of thin air) but not enough is known – or talked – about its repercussions. Monetary expansion distorts the markets by pushing interest rates below their natural market level, it dilutes the value of currency, and it causes inflation or worse, hyperinflation.
As mentioned earlier there are $1.2 trillion in excess reserves currently parked at the Fed. The fractional-reserve banking system allows a bank to lend out $10 for each dollar it has in excess reserves. The problem is that the $10 being used for credit purpose is technically newly created money and is listed on the bank’s balance sheet. This action increases the monetary base when the credit issued in form of loans is being monetized. What Bernanke knows is that the $1.2 trillion in excess reserves could ultimately translate into an estimated $11 trillion in new money created by the banks, as they pyramid new loans on top of the base money he has injected.
Currently the money stock (M1) is at $1.9 trillion. If banks start lending out at their full potential the money stock can be increased by a factor of six. The effects of such an increase would be devastating to most Americans. If you think $4 per gallon at the pump is too much you’d rethink it if the price turns into six times $4. Can you imagine for a barrel of oil to jump from $100 to $600 in a relatively short period of time? I can and it’s not pretty! When oil prices rise the prices of all commodities usually follow. Keep in mind that salaries and wages would not follow such a huge increase in the cost of living.
So far, we haven’t seen a massive price inflation, because the banks are making very few loans. But the battle between the market and the Fed will soon show who the true winner is. The universe will prove that it is more powerful than the men at the Fed. And when the Central Bank loses its ability to suppress the rates, the commercial banks will begin using their excess reserves (currently parked at the Fed) by making new loans to their customers. When that happens, Bernanke will need to act fast to prevent banks from lending out their reserves.
History and the economic laws tell us that after long periods of discount rate suppression it is not surprising for the prime rate to escalate to 10%. In such a case banks will most likely not have a hard time deciding whether to keep their excess reserves at the Fed (for a safe .25%) or to draw them and make new loans at 10%. Substantially higher returns will be a great incentive. The Fed knows it and thus it will be willing to bribe the banks to keep them from drawing their reserves by increasing the yield it pays. Bernanke does not necessarily have to increase the yield to match the prime. If he offers a 7.25% to keep their reserves parked at the Fed, the banks would most likely accept the offer due to its ability to earn higher yields while taking no risk whatsoever.
For one thing, Bernanke and Geithner are praised for saving the financial system. Yet on the other hand, Bernanke admits that if banks started to lend out that money, he would offer them even more to stop. But by offering more money to banks the Fed’s income will substantially decrease and in this case it will remit less money to the Treasury. So, let’s do the math. On a balance of $1.2 trillion, if the Fed had to pay 7.5 percent interest, that would translate into $90 billion in annual payments to the banks. Last year the Federal reserve earned about $81 billion in net income. Out of this amount it remitted $78 billion to the Treasury. It is obvious that the $90 billion the Fed would pay the banks to not make loans would not be sufficient to cover the entire amount. What would happen in such an event not only the Treasury would stop receiving the billions from the Fed but will have to create more money to satisfy the bribe. This event would increase the federal deficit and the taxpayers would ultimately be the ones paying bankers to not give them loans.
This solution to “solve” the problem is one of the very few the Fed has at this time. Bernanke appears to be more inclined to go with this one versus the other two (pulling the reserves out of the system or change the fractional reserve banking system to a full reserve system.) Yet those “remedies” would cause the economy to fall into a depression much sooner. His approach does not necessarily mean that an economic depression could be avoided. All it does is to postpone the inevitable and defer it for a later time. With the elections being just around the corner the Fed (and the politicians) need to make us believe that everything is OK. Therefore the more subtle solution is to prevent banks from lending their excess reserves by paying them a yield. The yield is currently very low (.25%) but if needed, as always the taxpayers will come to the rescue. Ultimately people will pay the banks to not make them loans.