Let loanable funds R.I.P.

The Global Economic Crisis brought about a questioning of economic orthodoxy, no meaningful introspection from the Ivory Tower establishment, and a catalyst to those interested in economic ideas to search the econ blogosphere. Economic blogs come in all shapes and sizes, the 200 most influential are listed here yet many take the unabashed position to posit ideas “as they should be” from the perspective of the bloggers beliefs and preferences rather than as they are.

A particular point of contention is the discussion of money, banking and money market operations. People who have actually worked in this sector, be they on the sell side as a broker or dealer in the capital markets function of an investment bank or on the buy side on a treasury desk for a bank or a major corporation understand the vagaries and nuances of origination, funding, loans and deposits. Some may view money from a metallist perspective while others from the chartalist perspective and all have their own innate beliefs as to whether the US Federal Reserve’s actions are for the greater good or for nought but in the end, most should not have time for drivel such as loanable funds theory or the fairy tale that is the money multiplier. Banking does not work that way.

If yours truly were a student today interested in the money markets then the indispensable text remains Marica Stigum’s Money Market, currently in its Fourth Edition and co-authored by Anthony Crescenzi. None of this stuff may be glamorous –after all MBA hot shots want to be Masters of the Universe and PhD Quants want to run the latest black box hi-frequency algorithm– but it is essential. The USD sits atop the hierarchy of money in the global financial system. If you understand the plumbing, you understand the connectedness thereafter when it seizes up as it would have done if the out of politicians in Washington had not reached a deal (however temporary).

What follows is a short explanation of the Fed Funds market “as it is” not as future and past winners of the Sveriges Riksbank Prize “believe it to be.”

(Emphasis in the passages below added by me]

The Federal Reserve requires that all commercial banks and depository institutions maintain reserves against their liabilities in the form of deposits at the Fed. Any vault cash such institutions hold also counts as reserves.

Prior to 1984, the reserves that a bank had to maintain during the current settlement week were based on the average daily deposits it held over a seven-day period two weeks earlier. Monetarists pushed for contemporaneous reserve accounting on the theory that it would reduce short-term fluctuations in money supply by forcing banks to adjust their reserves and thereby their lending to their current, not their previous, deposits. This was a naïve notion based on some Econ 101 text’s outmoded description of banking: a bank gets a deposit, and says, “Gee, I automatically make a loan.”

In real life, banks did not and do not operate that way. When loan demand was strong, money center banks adjusted their loans not to what deposits they received, but rather to the level of loans that their valued, creditworthy customers demanded of them; these banks then funded their loans, to the extent necessary, by buying money in the money market. This is a luxury that today’s bankers enjoy because both the supply and the demand for money have been strong for a few years. For example, the amount of commercial and industrial loans outstanding was at a record level in the middle of 2006, having increased by about 25% from two years prior before demand began to surge. Moreover, the banking system has been highly profitable, as evidenced by the FDIC’s Quarterly Banking Profile, which has shown that FDIC-insured banks earned record profits for five years straight through 2005, with earnings of $134.2 billion that year.

In any case, at the time of the switch to contemporaneous reserve accounting, banks objected on the grounds that the switch would be operationally expensive for them and, to boot, serve no useful purpose.

A second problem bankers saw with contemporaneous reserve accounting was that, while the Fed might get more current information, it might be less accurate because even a small error rate would amount to a large amount of money.

Despite bank protests, the Fed went ahead in 1984 with contemporaneous reserve accounting, some said as a sop that then Chairman Volcker felt he had to throw to the monetarists, who were at the time a vocal, in-fashion group.

Today, the reserves that a bank must maintain during the current settlement period are based on the average daily deposits it held before the settlement period began. This has been the case since July 1998 when the Fed adopted this lagged reserve accounting structure. Specifically, Federal Reserve rules state that a bank’s average reserves over the settlement period must equal the required percentage of its average deposits in the two-week period ending the Monday 16 days earlier. Banks receive credit (up to 4% of its required) in one two-week period for small amounts of excess reserves they held in the previous period; similarly, a small deficiency in one period may be made up with excess reserves in the following period. The carryover privilege is, however, limited to one period. A bank cannot go red (have a reserve deficiency) two periods in a row; and if it goes black (runs a reserve surplus) two periods in a row, the second period’s surplus becomes excess reserves for which it gets no credit. Thus, a bank’s settlements with the Fed tend over time to follow a pattern, alternating red and black settlement periods.2

For reserve calculation purposes, the reserve period begins on Thursday and ends on Wednesday. In settling with the Fed, a bank starts with a certain required average daily level of reserves. It need not hit its required level every day, but its average daily reserve balances over the reserve period must equal this figure. (Stigum et al. 2007)

Footnote

2 The 4% surplus or deficiency that a bank may carry forward equals 42% of the total reserves it must hold over the reserve period, which in turn equals the bank’s required reserves multiplied by 14; this is so because a bank’s “required” refers to the average balance it must maintain over a 14-day period. Thus, if a bank’s required were, for example, $1 billion, it could carry forward a reserve surplus or deficit equal to: $1 billion × 14 × 4% = $560 million.

Reference

Marcia Stigum, and Anthony Crescenzi, Stigum’s Money Market, (New York: McGraw-Hill, 2007), 492-493.

Stigum

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