Thursday, August 25, 2011

Banking and Excess Reserves

After yesterday's post, I received a question about cash.  More specifically, what does it mean to "sit on cash?"  The complete answer is more complex than you may realize.  One of the aspects of our economy that I intentionally excluded from yesterday's post is the role of banking.  Because the parable of the broken window does not consider a bank loan as an option, I too excluded banking in my analysis for simplicity sake.  The question I received, "what does it mean to sit on cash?" cannot ignore the role of banks in our economy.  Moreover, introducing banks into the parable of the broken window helps explain in greater detail what "hoarding cash" really means.

In yesterday's post, I said:

Because our economy is still emerging from a recession, some people and corporations are hoarding money.  This is what happens in a recession.  The demand for money increases while the demand for productive assets decreases.  For evidence, consider that Apple was sitting on $76.2 billion in cash as recently as July.
Is Apple sitting on giant mountains of $20 and $100 bills?  No.  To do so would mean that Apple is sitting on $76.2 billion in currency.  The term "cash" has several uses, but in a business setting we typically mean currency and extremely liquid assets such as money in a checking account.  It's important to make a distinction between currency and bank deposits because banks will take the deposit and then make a subsequent loan.  When the bank makes a loan, they are injecting money back into the economy.  Therefore, if a corporation hoards cash, it doesn't automatically mean that they are pulling money out of economic distribution. 

Banks, however, do not actually lend out 100% of the money they hold as deposits.  Banks are required to retain a specific percentage of deposits in reserve which are simply called "required reserves." Required reserves help ensure that the bank will be able to pay depositors when they withdraw funds from the bank.  In a normally functioning economy, the bank will lend out virtually all the deposits in excess of the required reserves in order to maximize their profit. 

Banks are not required to lend out all the money they hold above the required reserve level.  Additional reserves over the required reserve threshold are called excess reserves, and they are a strong indicator of a bank's demand for cash.  If a bank is concerned that withdrawals are going to be exceedingly high (meaning depositors want currency over deposits), they will keep a higher level of reserves than is required.  Additionally, if interest rates fall too low, then banks lose the incentive to lend as it is not profitable.  With no incentive to lend, banks accumulate excess reserves as well.

The Federal Reserve provides information on banks' excess reserves, and currently they are extremely high.  Our banks are holding almost $1.6 trillion dollars in excess reserves right now.  Compare this to pre-crisis levels that typical remained below $10 billion!  Are the banks hoarding cash?  Yes, but only to a point.  The large amounts of excess reserves are primarily a result of expansionary monetary policy by the Federal Reserve coupled with extremely low interest rates.  This means that the Federal Reserve is effectively pushing cash into the banking system, but the individual lenders have no reason to lend the money out.  The banks' demand for cash is greater than their demand for loans, and so the money is not reaching the general economy. 

What does this mean in terms of the parable of the broken window and our current economy?  Well, for starters, parables about broken windows probably shouldn't be used to explain banking.  However, we can still conclude that cash is being hoarded in our economy.  Businesses are hoarding cash primarily in the form of deposit instruments, which does not directly take money out of the economy.  Banks are hoarding cash in the form of excess reserves, though, which limits the amount of money moving throughout the economy. What isn't so obvious in this equation is that banks are primarily hoarding cash coming from the Federal Reserve, not from depositors.   Fiscal policy does not have the same limitations as monetary policy in low interest rate environments, but that topic will have to wait for another post.


  1. Great post. Worth noting also that the Fed is paying interest on those excess reserves, which is contractionary for the same reason increased reserves is. This seems awfully boneheaded to me; I'd advocate charging them interest a la Sweden. What say ye?

  2. I'm okay with the decision to pay interest on reserves, as it allows the Federal Reserve greater control on the federal funds rate. That's a long term view, though. For the immediate situation, it's probably wishful thinking to believe that paying or charging interest on reserves is going to be the magic bullet to put millions back to work. For that, we're looking at either waiting a really long time, or a large fiscal stimulus.

  3. well, i posted a nice thoughtful response, and then the interwobs ate it. boo.

    my points:
    a) current situation is basic game theory. borrow infinite amount of money at zero percent, buy t-bills at slightly more than zero percent, profit! nice deal if you can get it.

    b) the fed can't raise rates. if we paid a real interest rate on our debt, the payments would be painful. to pick a fairly low number, say 3%, times 15 trillion dollars, means we would be spending half a trillion on interest payments a year alone. repeating this calculation for the double digit numbers of the volker period keeps bernanke awake at night.

    c) _long agitprop screed removed_

    are you both in como?