banking system Archives - the patient investor

June 3, 2013

Impact of QE (or lack thereof) is reflected by excess reserves

JKH at Monetary Realism writes:

….there is a systematic tendency in the blogosphere and elsewhere to misrepresent the impact of QE in a particular way in terms of the related macroeconomic flow of funds…… Most descriptions will erroneously treat the macro flow as if banks were the original portfolio source of the bonds that are being sold to the Fed, obtaining reserves in exchange. This is not the case. A cursory scan of Fed flow of funds statistics will confirm that commercial banks are relatively small holders of bonds in their portfolios, especially Treasury bonds. The vast proportion of bonds that are sold to the Fed in QE originate from non-bank portfolios……. Many descriptions of QE instead erroneously suggest the strong presence of a bank principal function in which bonds from bank portfolios are simply exchanged for reserves. In fact, for the most part, while the banking system has received reserve credit for bonds sold to the Fed, it has also passed on credits to the accounts of non-bank customers who have sold their bonds to the banks. This is integral to the overall QE flow of bonds.

There is a simpler explanation of what happens when the Fed purchases bonds under QE. Bank balance sheets expand as sellers deposit the sale proceeds with their bank. In addition to the deposit liability the bank also receives an asset, being a credit to its account with the Fed. Unless the bank is able to make better use of its asset by making loans to credit-worthy borrowers, the funds are likely to remain on deposit at the Fed as excess reserves — earning interest at 0.25% per year. Excess reserves on deposit at the Fed currently stand at close to $1.8 trillion, reflecting the dearth of (reasonably secure) lending/investment opportunities in the broader economy.

April 11, 2013

Time to clean up the Banks

Gabriele Steinhauser at WSJ writes:

A group of key crisis managers believes cleaning up weak banks is the only way to get Europe’s economy to grow again, after superlow interest rates and large-scale liquidity injections from the ECB have failed to produce the desired results. These officials see continued doubts over the health of many lenders as the main reason banks are reluctant to lend to companies, especially in the continent’s weaker countries.

“We’ve been stuck in this rubbish for five years, because we’ve been doing everything to prevent the banks from being recapitalized properly and the stress tests from being stringent enough,” said a senior EU official. “If we don’t do this, we will stay in this trap until 2020.”

The time has come to clear up the mess from the GFC and strengthen bank balance sheets — not only in Europe — so that a similar financial crisis is unlikely to ever happen again. Moves are also afoot in the US where Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) are working on a bipartisan bill to end too-big-to-fail banks. The bill does not attempt to break up big banks but focuses on improving bank capital ratios. Risk-weighted capital ratios as suggested by Basel III disguise banks’ true leverage and encourage risk-taking. Australian banks are particularly exposed to low risk-weighting of residential mortgages. Eliminating risk-weighting would force banks to strengthen their underlying capital base and discourage risk concentration in low risk-weighted areas.

The biggest obstacle to change, however, is the banks who benefit from an implicit taxpayer-funded guarantee in the event of failure. Being able to rely on a bailout enables them them to take bigger bets than their balance sheets would otherwise allow. Columbia University’s Charles Calomiris points out that the banks are able to get away with this because they are supported by populist democratic governments who trade off banking instability in return for political (and financial) support.

April 10, 2013

Why Canada Can Avoid Banking Crises and U.S. Can’t | WSJ

Victoria McGrane at WSJ reports on a paper by Columbia University’s Charles Calomiris, presented at the Atlanta Fed’s 2013 Financial Markets Conference.

In populist democracies, such as the United States, the regulation of banking is used as a political tool to favor some parties over others. It is not that the dominant political coalition in charge of banking policy desires instability, per se, but rather, that it is willing to tolerate instability as the price for obtaining the benefits that it extracts from controlling banking regulation………..

Smart economists with their regulatory ideas are sort of dead on arrival. Political coalitions will decide — not whether you’ve got the right VAR model — [but] whether a banking system is going to be set up with rules that will lead it to be stable and have abundant credit or not.

Charles Calomiris has absolutely nailed it: Populist democracies are prone to financial instability. If you want a stable financial system, you first need to overhaul the political system.