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Why banks aren't lending
By Ellen Brown
Why aren't banks lending to local businesses? The Fed's decision to pay
interest on US$1.6 trillion in "excess" reserves is a chief suspect.
Where did all the jobs go? Small and medium-sized businesses are the major
source of new job creation, and they are not hiring. Startup businesses, which
contribute a fifth of the United States' new jobs, often can't even get off the
ground. Why?
In a June 30 article in the Wall Street Journal titled "Smaller Businesses
Seeking Loans Still Come Up Empty", Emily Maltby reported that business owners
rank access to capital as the most important issue facing them today; and only
17% of smaller businesses said they were able to land needed bank financing.
Businesses have to pay for workers and materials before they can
get paid for the products they produce, and for that they need bank credit; but
they are reporting that their credit lines are being cut. They are being pushed
instead into credit card accounts that average 16% interest, more than double
the rate of the average business loan. It is one of many changes in banking
trends that have been very lucrative for Wall Street banks but are killing
local businesses.
Why banks aren't lending is a matter of debate, but the Fed's decision to pay
interest on bank reserves is high on the list of suspects. Bruce Bartlett,
writing in the Fiscal Times in July 2010, observed: Economists are
divided on why banks are not lending, but increasingly are focusing on a Fed
policy of paying interest on reserves - a policy that began, interestingly
enough, on October 9, 2008, at almost exactly the moment when the financial
crisis became acute ...
Historically, the Fed paid banks nothing on required reserves. This was like a
tax equivalent to the interest rate banks could have earned if they had been
allowed to lend such funds. But in 2006, the Fed requested permission to pay
interest on reserves because it believes that it would help control the money
supply should inflation reappear.
... [M]any economists believe that the Fed has unwittingly encouraged banks to
sit on their cash and not lend it by paying interest on reserves.
At one time, banks collected deposits from their own customers and stored them
for their own liquidity needs, using them to back loans and clear outgoing
checks. But today banks typically borrow (or "buy") liquidity, either from
other banks, from the money market, or from the commercial paper market. The
Fed's payment of interest on reserves competes with all of these markets for
ready-access short-term funds, creating a shortage of the liquidity that banks
need to make loans.
By inhibiting interbank lending, the Fed appears to be creating a silent
"liquidity squeeze" - the same sort of thing that brought on the banking crisis
of September 2008. According to Jeff Hummel, associate professor of economics
at San Jose State University, it could happen again. He warns that paying
interest on reserves "may eventually rank with the Fed's doubling of reserve
requirements in the 1930s and bringing on the recession of 1937 within the
midst of the Great Depression."
The travesty of 'excess reserves'
The bank bailout and the Federal Reserve's two "quantitative easing" programs
were supposedly intended to keep credit flowing to the local economy; but
despite trillions of dollars thrown at Wall Street banks, these programs have
succeeded only in producing mountains of "excess reserves" that are now sitting
idle in Federal Reserve bank accounts. A stunning $1.6 trillion in excess
reserves have accumulated since the collapse of Lehman Brothers on September
15, 2008.
The justification for TARP - the Trouble Asset Relief Program that subsidized
the nation's largest banks - was that it was necessary to unfreeze credit
markets. The contention was that banks were refusing to lend to each other,
cutting them off from the liquidity that was essential to the lending business.
But an MIT study reported in September 2010 showed that immediately after the
Lehman collapse, the interbank lending markets were actually working. They
froze, not when Lehman died, but when the Fed started paying interest on excess
reserves in October 2008. According to the study, as summarized in The Daily
Bail: ... [T]he NY Fed's own data show that interbank lending during
the period from September to November did not "freeze", collapse, melt down or
anything else. In fact, every single day throughout this period, hundreds of
billions were borrowed and paid back. The decline in daily interbank lending
came only when the Fed ballooned its balance sheet and started paying interest
on excess reserves. On October 9, 2008, the Fed began paying
interest, not just on required bank reserves (amounting to 10% of deposits for
larger banks), but on "excess" reserves. Reserve balances immediately shot up,
and they have been going up almost vertically ever since.
By March 2011, interbank loans outstanding were only one-third their level in
May 2008, before the banking crisis hit. And on June 29, 2011, the Fed reported
excess reserves of nearly $1.57 trillion - 20 times what the banks needed to
satisfy their reserve requirements.
Why pay interest on reserves?
Why the Fed decided to pay interest on reserves is a complicated question, but
it was evidently a desperate attempt to keep control of "monetary policy". The
Fed theoretically controls the money supply by controlling the Fed funds rate.
This hasn't worked very well in practice, but neither has anything else, and
the Fed is apparently determined to hang onto this last arrow in its regulatory
quiver.
In an effort to salvage a comatose credit market after the Lehman collapse, the
Fed set the target rate for Fed funds - the funds that banks borrow from each
other - at an extremely low 0.25%. Paying interest on reserves at that rate was
intended to ensure that the Fed funds rate did not fall below the target. The
reasoning was that banks would not lend their reserves to other banks for less,
since they could get a guaranteed 0.25% from the Fed. The medicine worked, but
it had the adverse side effect of killing the Fed funds market, on which local
lenders rely for their liquidity needs.
It has been argued that banks do not need to get funds from each other, since
they are now awash in reserves; but these reserves are not equally distributed.
The 25 largest US banks account for over half of aggregate reserves, with 21%
of reserves held by just three banks; and the largest banks have cut back on
small business lending by over 50%. Large Wall Street banks have more lucrative
things to do with the very cheap credit made available by the Fed than to lend
it to businesses and consumers, which has become a risky and expensive business
with the imposition of higher capital requirements and tighter regulations.
In any case, as noted in an earlier article the excess reserves from the second
round of Fed quantitative easing (QE2) have accumulated in foreign rather than
domestic banks (see
QE2's disappearing act, Asia Times Online, July 14, 2011). John Mason,
Professor of Finance at Penn State University and a former senior economist at
the Federal Reserve, wrote in a June 27 blog that despite QE2: Cash
assets at the smaller [US] banks remained relatively flat . ... Thus, the
reserves the Fed was pumping into the banking system were not going into the
smaller banks. ...
[B]usiness loans continue to "tank" at the smaller banking institutions.
Local business lending depends on access to liquidity Without access to
the interbank lending market, local banks are reluctant to extend business
credit lines. The reason was explained by economist Ronald McKinnon in a Wall
Street Journal article in May: Banks with good retail lending
opportunities typically lend by opening credit lines to nonbank customers. But
these credit lines are open-ended in the sense that the commercial borrower can
choose when - and by how much - he will actually draw on his credit line. This
creates uncertainty for the bank in not knowing what its future cash positions
will be. An illiquid bank could be in trouble if its customers simultaneously
decided to draw down their credit lines.
If the retail bank has easy access to the wholesale interbank market, its
liquidity is much improved. To cover unexpected liquidity shortfalls, it can
borrow from banks with excess reserves with little or no credit checks. But if
the prevailing interbank lending rate is close to zero (as it is now), then
large banks with surplus reserves become loath to part with them for a derisory
yield. And smaller banks, which collectively are the biggest lenders to SMEs
[small and medium-sized enterprises], cannot easily bid for funds at an
interest rate significantly above the prevailing interbank rate without
inadvertently signaling that they might be in trouble. Indeed, counterparty
risk in smaller banks remains substantial as almost 50 have failed so far this
year. The local banks could turn to the Fed's discount window
for loans, but that too could signal that the banks were in trouble; and for
weak banks, the Fed's discount window may be closed. Further, the discount rate
is triple the Fed funds rate.
As Warren Mosler, author of The 7 Deadly Innocent Frauds of Economic Policy,
points out, bank regulators have made matters worse by setting limits on the
amount of "wholesale" funding small banks can do. That means they are limited
in the amount of liquidity they can buy (eg in the form of certificates of
deposit). A certain percentage of a bank's deposits must be "retail" deposits -
the deposits of their own customers. This forces small banks to compete in a
tight market for depositors, driving up their cost of funds and making local
lending unprofitable. Mosler maintains that the Fed could fix this problem by
(a) lending Fed funds as needed to all member banks at the Fed funds rate, and
(b) dropping the requirement that a percentage of bank funding be retail
deposits.
Alternatives to a failed banking model
Paying interest on reserves was intended to prevent "inflation", but it is
having the opposite effect, contracting the money and credit that are the
lifeblood of a functioning economy. The whole economic model is wrong. The fear
of price inflation has prevented governments from using their sovereign power
to create money and credit to serve the needs of their national economies.
Instead, they must cater to the interests of a private banking industry that
profits from its monopoly power over those essential economic tools.
Whether by accident or design, federal policymakers still have not got it
right. While we are waiting for them to figure it out, states can nurture and
protect their own local economies with publicly owned banks, on the model of
the Bank of North Dakota (BND). At present the nation's only state-owned bank,
the BND services the liquidity needs of local banks and keeps credit flowing in
the state. Other benefits to the local economy are detailed in a Demos report
by Jason Judd and Heather McGhee titled "Banking on America: How Main Street
Partnership Banks Can Improve Local Economies." They write: Alone among
states, North Dakota had the wherewithal to keep credit moving to small
businesses when they needed it most. BND's business lending actually grew from
2007 to 2009 (the tightest months of the credit crisis) by 35%. ... [L]oan
amounts per capita for small banks in North Dakota are fully 175% higher than
the US average in the last five years, and its banks have stronger
loan-to-asset ratios than comparable states like Wyoming, South Dakota and
Montana. Fourteen states have now initiated bills to establish
state-owned banks or to study their feasibility. Besides serving local lending
needs, state-owned banks can provide cash-strapped states with new revenues,
obviating the need to raise taxes, slash services or sell off public assets.
Ellen Brown is an attorney and president of the Public Banking Institute,
PublicBankingInstitute.org. In Web
of Debt, her latest of 11 books, she shows how the power to create
money has been usurped from the people, and how we can get it back. Her
websites are webofdebt.com and
ellenbrown.com.
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