In A Case for the Inflation Camp Robert P. Murphy asks When Will the Inflation Genie Get Out of the Bottle? Murphy's concern is over "excess reserves".



My reason for expecting large-scale price inflation is fairly straightforward: I see no coherent strategy for Bernanke to remove the excess reserves from the banking system. ...



After reviewing the evidence and the theories offered by the two camps, I still believe that Bernanke's unprecedented infusions of new reserves will lead to rapid price increases. These increases may not show up in the price of US financial assets, but they will rear their ugly heads at the gas pump and grocery checkout. Moreover, I think the genie may already be slipping out of the bottle. His escape will only be hastened once the year-over-year CPI figures show moderate inflation.

Steve Saville's Concern Over Excess Reserve

The reason that bank reserves aren't added to the money supply is that they do not constitute money available to be spent within the economy; rather, they constitute money that could be loaned into the economy or used to support additional bank lending in the future.



Bank lending in the US has declined on a year-over-year basis, so we know that the spectacular increase in reserves has not YET contributed to monetary inflation.



If the private banks were to join the inflation party then the risk of hyperinflation would greatly increase, and hyperinflation -- leading to what Mises called a "crack-up boom" -- would be the worst of all possible outcomes. In particular, it would be an order of magnitude worse than the deflation that many people still seem to be worried about.



So, let's hope that the banks don't start lending out their excess reserves. The situation is bad enough already.

Gary North's Concern Over Excess Reserves

The Federal Reserve System faces a dilemma of its own creation: the doubling of the monetary base.



The only thing that is keeping this from creating mass inflation is the decision of commercial bankers to deposit the bulk of this increase with the Federal Reserve. The banks are not lending out this money. Neither is the FED. This money does not legally belong to the FED.



AN EASY SOLUTION WITH DISASTROUS CONSEQUENCES



There is an easy solution to this problem. The Federal Reserve knows exactly what the solution is. Nobody mentions it. The suggestion that the Federal Reserve would attempt it would probably bust the bond market. The Federal Reserve would announce that, from this point on, all money deposited by banks as excess reserves will be charged a storage fee. This fee could be 2%.



Not only would banks not make any interest on the money deposited with the Federal Reserve, they would begin suffering a loss of 2% per annum on the money held as excess reserves. ...



Lots of Concern Over Excess Reserves

Reserve Balances with Federal Reserve Banks

Money Multiplier Theory

Money Multiplier Theory Is Wrong

1: Lending Comes First, Reserves Second

Proposition #1

Proposition #2

The underlying premise of the first proposition is that bank reserves are needed for banks to make loans. An extreme version of this view is the text-book notion of a stable money multiplier.



In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.



The main exogenous constraint on the expansion of credit is minimum capital requirements.



A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006.



Japan's Quantitative Easing Experiment







click on chart for sharper image



Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly (Figure 4).



Is financing with bank reserves uniquely inflationary?



If bank reserves do not contribute to additional lending and are close substitutes for short-term government debt, it is hard to see what the origin of the additional inflationary effects could be.

after

2: There Are No Excess Reserves

Total Nonperforming Loans

Percentage of nonperforming loans equals total nonperforming loans divided by total loans. Nonperforming loans are those loans that bank managers classify as 90-days or more past due or nonaccrual in the call report.

Total Loans and Leases of Commercial Banks

that are admitted to

admitted to



Total Loans and Leases of Commercial Banks Percentage Change

Assets at Banks whose ALLL exceeds their Nonperforming Loans

3: Bank reserves are "Fictional", there are essentially no reserves at all.

Cumulative Debt

Base Money Supply

M2 Money Supply

4: Banks are capital constrained not reserve constrained

Capital requirements

The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord.

Risk Weightings

Fed Can Provide Liquidity Not Capital

Fed Governor William Poole on Moral Hazards:



I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector. According to the S&P Case-Shiller home value data released earlier this week, as of December 2007 average prices had declined by 15 percent or more over the past 12 months in Phoenix, San Diego, Miami and Las Vegas. We can add Detroit to the danger list as the home price index for that city is down by almost 19 percent over the 24 months ending December 2007. With house prices falling significantly in a number of large markets, many prime mortgages issued a few years ago with a loan-to-value ratio of 80 percent may now have relatively little homeowner equity, which increases the probability of default and amount of loss in event of default.



As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues. I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.

First Nationalized Bank Of Fannie

Bernanke Expects Bank Failures

"Among the largest banks, the capital ratios remain good and I don't anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system," he said in response to a question during semi-annual congressional testimony.



"They have already sought something of the order of $75 billion of capital in the last quarter. I would like to see them get more," Bernanke said.



"They have enough now certainly to remain solvent and remain ... well above their minimum capital levels. But I am concerned that banks will be pulling back and not making new loans and providing the credit which is the lifeblood of the economy. In order to be able to do that ... in some cases at least, they need to get more capital," Bernanke added.

In order to be able to [lend] ... in some cases at least, they need to get more capital

Capital Is The Problem At Virtually All Banks

I talked to a friend this morning who is retired from both the Federal Reserve of Kansas City and RSM McGladrey. He now does consulting work with the FDIC, due diligence and other regulatory work. He said the picture he is seeing is worse than at any time in his life and CAPITAL is the problem with virtually all banks.

Hiding The Losses



ABO Writes:

Take a look at how the FDIC is selling failed banks. It is a little different than in the past. The FDIC is using a loss sharing agreement that is usually around 80-20 and has certain guidelines on timing of the losses. I would guess that the losses on the failed banks are dragged into the future somewhat rather than being recognized at the time the bank is closed. This method would be less of an immediate hit to the fund and would probably create a contingent liability rather than a direct one. The banks that agree to this loss sharing plan are relying on the promise of the FDIC to make good on future guarantees for losses. The losses are not backed by the full faith of the government. The Fed and FDIC always want to delay addressing the problems, hoping they will go away. Such structural problems seldom do.



Amazingly Financial Group was considered "well capitalized" right up to the brink of failure. When the bank did fail, the hit to FDIC was not immediately taken but stretched into the future.



The WSJ article notes ' There are 1,400 banks that own mortgage-backed securities that aren't backed by government-related entities such as Fannie Mae and Freddie Mac. " What we don't know is how many of those banks are levered up enough in garbage mortgages to fail.



Note too that those garbage trust-preferred securities problems are on top of the widely expected fallout from commercial real estate problems affecting small to medium-sized regional banks. Thus, banking woes are much deeper in many areas than either the FDIC or Fed is admitting.



FDIC Allows Banks To Hide Insufficient Capital

The Federal Deposit Insurance Corp. gave banks including Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. a reprieve of at least six months from raising capital to support billions of dollars of securities the firms will be adding to their balance sheets.



Bank regulators including the FDIC and Federal Reserve want to permit a phase-in of capital requirements that rise starting next month under a change approved by the Financial Accounting Standards Board. The rule, passed in May, eliminates some off- balance-sheet trusts, forcing banks to put billions of dollars of assets and liabilities on their books.



Executives from Citigroup, JPMorgan, Bank of America, Wells Fargo & Co., Capital One Financial Corp. and the American Securitization Forum met FDIC officials Dec. 2 to discuss capital requirements related to the FASB measure.



The executives proposed that “the transition period should extend beyond 2010 to a point in the economy where unemployment is lower and issuers are less capital-restrained from growing their balance sheet and providing credit,” according to a paper the ASF presented the FDIC.



Citigroup suggested three years to offset assets and liabilities brought onto balance sheets, Chief Financial Officer John Gerspach said in an Oct. 15 letter to regulators. Requiring banks to “assume the risk-based capital effects immediately, or even over one year, is an undeniably severe penalty,” he wrote.

Fictional Capital



Global Implications Of

Stronger Capital Rules From Basel

Global regulators have been wrestling with plans to tighten bank supervision following the worst economic crisis since World War II. The Basel Committee said yesterday banks’ core capital should exclude stock or instruments that may require lenders to make payments to third parties, as these could reduce reserves needed for meeting losses.



“The tightening of Tier 1 quality standards is overall negative for the Japanese banks because they have weak Tier 1 quality,” said Stephen Church, a research partner at Japaninvest KK, an independent research firm, in Tokyo. “The stock market is differentiating between those banks which have stronger Tier 1 and those which are weaker.”



The committee also said banks should have an “appropriate” period of time to replace such instruments.

5: Banks aren't lending because there are few credit worthy borrowers worth the risk.

Backdrop Banks Face

Demand for C&I loans from small firms

Lending Standards For Small Firms

One Unaddressed Point

Excess Reserve Recap