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Money Supply And Economic Data Weekly Watch - How the Fed is Making Banks Lend |
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Written by Mark Sunshine
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Monday, 22 December 2008 |
 The Federal Reserve is forcing banks to lend or face financial disaster. The Fed’s latest strategy gives banks
the stark choice of lending or losing a lot of money from operations. Everyone knows the Fed cut its target Federal Funds rate to the bone this week. In a less obvious move, the Fed is also forcing down rates on Treasury bonds and other securities. As a result, banks have the choice of buying bonds that yield less than their cost of funds or lending. Any bank that decides not to lend will suffer losses. Cash is trash and if banks don’t recycle it, they will slowly bleed to death.
The Federal Reserve is returning banks back to the lending business in two ways.
First, the Fed is providing banks with cash to lend by dramatically increasing money supply. Newly created money becomes new deposits in banks. For the last 3 months, money supply as measured by M1 increased by an astonishing annual rate of 37.6%. The largest components of M1 are cash deposits at banks and those components are growing very rapidly. The Fed is making sure that banks get A LOT of new cash to lend.
In normal times, banks gather cash by accepting deposits and then recycle their cash into loans. But, these aren’t normal times and banks aren’t reacting the way they have in the past. Instead of recycling cash into loans, banks have tried to avoid risk by recycling their cash into low risk bonds that are like cash equivalents. So, monetary easing didn’t really do anything for the economy because cash was recycled into cash look alike instruments rather than into loans. The banking sector’s huge demand for cash equivalent investments caused yields on short term Treasury and government securities to drop to almost 0% (and was even negative for brief periods of time).
This led the Fed to its second, less obvious, strategy. The Fed has starting purchasing the cash equivalent investments that banks are buying and in the process driving down yields. Banks are losing money on their formerly safe investments because their all-in cost of deposits is higher than the yield they are earning from cash equivalent investments. This is similar to a retailer buying inventory for $100 and then selling it for $95. It isn’t a good business strategy. To make a positive net interest spread between their all-in cost of deposits and their investments, banks are being forced to lend. Loans to businesses and consumers have high enough yields for banks to make a profit.
Even when banks pay 0% interest to depositors if they don’t lend money they will lose money. Banks have a marginal cost of holding deposits that is much higher than the interest cost of 0%. Bank deposit costs include: operating expenses, FDIC insurance, cost of equity and regulatory compliance costs. These costs are generally between 1% and 3%. And if banks accept deposits that are CD’s which have an interest rate of between 1.5% and 4.5%, their all-in cost of funds gets even higher.
The types of investments that the Fed is initially targeting to drive down yields include Treasury securities, Federal Funds, Agency bonds and Agency and government guaranteed mortgage backed securities. These investments have historically been considered low to no risk investments that are as good as cash. One by one, the Federal Reserve is going to take away the hiding places that banks have used to avoid lending.
While yields on low risk cash equivalent investments are around 0%, the rate of interest that “real” borrowers need to pay for new loans has remained high. Most real measures of loan availability for businesses and consumers indicate a continuing credit crisis, incredible risk aversion and a relatively high cost of borrowing. It is into this lending void that the Fed is driving banks.
However, if banks continue to avoid lending to businesses and consumers, the Fed is making sure that they will feel a lot of financial pain. The Federal Reserve has put banks between a rock and a hard place. Either they lend, or destroy their institution with a negative interest spread and risk regulatory discipline. The Federal Reserve has morphed the strategy of hoarding cash equivalent investments into a very risky decision.
The Fed’s innovative approach goes far beyond the “qualitative easing” that bankers and economists were expecting. Sometime in the next few weeks, after corporate planning staffs and consultants grind out models and analysis, it is going to dawn on bankers that they have to participate in the economic recovery by lending. The Fed’s two-pronged strategy will get banks lending again. And, with fiscal stimulus from the new Obama Administration, the economy will respond sooner than most people expect.
This post was written by Mark Sunshine on December 19, 2008
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Last Updated ( Monday, 22 December 2008 )
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