Federal Reserve and "excess reserves".

Excess reserves now total over $1.5 trillion.

Why would any bank leave such a large amount on reserve since the interest rate is so low (.025%)?

Is this Fed hardball? Does this mean the Fed distrusts the bank balance sheets?

Banks loan based on two major criteria: 1) The obvious question of whether they expect the loan will be repaid, with a profitable amount of interest, and 2) the less obvious question of whether the bank itself will have to pay high interest on its own borrowing.

We have to remember, banks are intermediaries. They are both borrowers and lenders simultaneously. If banks make a lot of loans today, but the Fed tightens unexpectedly tomorrow, then the banks will suffer both because tighter conditions decrease the chance of the loan being paid back, and also because tighter conditions increase the costs of the bank’s own borrowing. Those extra reserves were created at the push of some buttons, and they can be removed the same way. What matters is expectations.

It’s likely a consideration that the Fed wants to make sure there is plenty of liquidity in the system. But the bigger part of this, I would guess, is that the banks don’t necessarily trust the Fed.

There is ample reason for distrust of central bankers. The Bank of Japan did its own monetary easing to try to escape inflation, but what happened (at least two different times) when the deflation was starting to creep up to 0, and possibly back into very mild inflation? They raised interest rates. They pulled back on the chain. It’s hard to know how to make good investment decisions if the most powerful policy makers delight in opaque decisions. Thankfully, the Fed has been much more open than the Bank of Japan, and much more willing to reconsider the adequacy of its past decisions. Everyone makes mistakes. It’s a pleasant event to have that rare group of people who are willing to admit the error, and change course.

Those are all good points. I would just add that a lot of the paper on the fed’s balance sheet consists of derivatives, mainly MBS’s (mortgage backed securities) that are of questionable value. Many of these instruments are of the same ilk that were responsible for the financial crisis.

Back in 2008, it was a bit of gallows humor that the banks could go to the fed with an IOU written on toilet paper and they would give you face value. Obvious hyperbole but the point is well taken - somebody eventually will have to eat this shit and it won’t be Uncle Ben. I think a big chunk of those reserves are being held just for that purpose. But that’s purely speculation on my part. It’s possible the fed will take the loss and try to recoup in other ways, but I think that would generate the mother of all shit storms with more cries of the govt coddling the ‘to big to fails’ and now with HSBC getting away with serious felonies - the ‘to big to prosecutes.’

“banks are intermediaries”

Never are the commercial banks intermediaries in the savings-investment process. Every time a CB makes a loan to or buys securities from the non-bank public it creates new money - demand deposits, somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

I don’t think any of this makes sense. The Fed has infinite money, it doesn’t have to worry about “taking losses” or recouping the same.

they sorta do. What’s the alternative. This shit stays on their books for the next century? OK. But what does that mean.

Every trade has a buy and a sell. For every buy that put a tasty MBS shit sandwich on the fed’s books, the fed put out hard cash. Eventually that cash has to be called home. No one is just going to give it away, so the logical alternative is to sell back the shit that was bought in the first place. That’s why the balance sheet matters - because of what it represents.

If I want to buy a house, I don’t go the contractor and tell them I’ll be happy to pay a 30-year mortgage directly. The contractor is not in the business of knowing who is credit-worthy. Instead, I get into debt with the bank, and the bank gets into debt with the contractor. The bank’s asset is the debt owed to it, and its debt is the new deposit created. Exactly as I said: banks are both borrowers and lenders simultaneously. Between me and the contractor stands the commercial bank, facilitating the transaction between us.

There is a word we have in English for a party that stands between two other parties who wish to do business. That word is intermediary.

I don’t think MBS’s last a century, or anything close to that. Eventually the underlying mortgages will all be paid off or defaulted on. My understanding is that in a lot of cases this has already happened, with the Fed forwarding the profits to the Treasury Dept.

If the MBSs are “shit”, no one is going to buy them anyways.

I focused on that only because it’s the biggest chunk of the pie after treasuries, but those are supposed to be in there. Also, I was lazy and it was too much work to present the correct and more general view, so I apologize for that.

BTW, you can review the fed stats here. I was going to try to build you a custom graph just now showing the components, but I don’t use FRED that often and I’m pretty crispy from lack of sleep. Take a look though.

What I said is true, or at least I believe it to be, it’s just that the particular components don’t really matter so focusing on any one will give the wrong impression.

It is in fact the case however that there is a huge overhang of liquidity in the economy in the form of excess reserves. You can see that in a plot of the Monetary Base (MB), which is comprised of almost nothing else (at least since the crisis). I can’t say off hand by how much MB is inflated over what would be appropriate to current conditions, but just taking a stab, $1.5-2T is probably a pretty safe bet.

The banks got those reserves to some large extent by trading financial instruments to the fed for cash at a rate that was probably unduly favorable. I was waxing poetic before in some of my descriptions - if you’ll allow me to include Hunter S. Thompson as a poet (otherwise, go hate somewhere else, hater!). From what I recall, the worst “abuses”, if you can even call them that, occurred when credit markets seized after the Lehman debacle and even then, IIRC, the fed only gave full face value for the purpose of fairly short term loans.

I think that by the time they were buying securities outright, they has a reasonable review process in place. Although let’s not forget, these MBS’s are black boxes containing many tranches of thousands of loans each. So we could probably debate that “reasonable” part. Even so, not really relevant.

Ignore the last 2 paragraphs. The bottom line is that the fed created cash and traded for stuff in the form of financial instruments. The stuff is on their balance sheet. Therefore, their balance sheet has a strong positive correlation with excess reserves, ergo MB, ergo the money supply. As you noticed, it won’t be a perfect relationship but it’s going be very, very close, especially since that money coming back into the fed? It’s all being used to buy more stuff.

Yeah. Good times. :cool: