Tuesday, November 4, 2008

The demographics of inter-bank lending

The Fed’s liquidity measures have become an obsession of mine; I am simply befuddled about the the massive liquidity injections that the Fed has undertaken to try and unclog a stopped-up banking system. Banks are sitting on the new funds and holding them as excess reserves; however, interbank lending has not come to a grinding halt because the Fed has injected $1 trillion into the banking system over the last year. But that's not the only reason: the re-distribution of funds across the regional Federal reserve banks indicates that there will always be a positive demand for interbank (overnight) funds.

Structurally, there will always be lending

Banks differ structurally in their reserve holdings. According to the Federal Reserve balance sheet H.4.1, Table 6, there is – and always has been – a shuffling of funds among the regional Federal Reserve banks. The October 30 statement indicates that some Fed banks (New York, Chicago, or St. Louis) have assets, credit extended to their regional depository institutions, that are less than their liabilities, and others (Boston, Philadelphia, or Richmond) have have liabilities that exceed their assets. This would imply that the underlying depository institutions have the same reserve holding at the Fed. If the Chicago Fed has a surplus of deposits, this would imply that the underlying institutions are holding excess reserve funding with the Fed. One can see the shortages/surpluses in Table 5 on the "interdistrict settlement account" line of the H.4.1 release on October 30 as a transfer of credit among the regional banks. For example:
  • Chicago Fed, $1.4 billion credit inflow - assets (credit) > liabilities (deposits)
  • St. Louis Fed, $3.8 billion credit inflow
  • Boston Fed, $79.5 billion credit outflow - assets > liabilities
  • Philadelphia Fed, $31.9 billion credit outflow
  • Richmond Fed, $114.2 billion credit outflow (to name a few)
There is an inherent mal-distribution of funds, where some banks are hold more reserves than others, and therefore, demand for overnight funds is always greater than zero.

Just eyeballing this statement compared to statements on January 31, 2008 and March 29, 2007, Boston usually has a surplus of credit (shortage of liabilities), Philadelphia a surplus, Cleveland a surplus, St. Louis a shortage, and Kansas City a shortage. New York had a surplus of credit (shortage of liabilities) in both earlier statements, but has a shortage of credit in this statement; it is holding the liabilities of the Treasury Supplemental Financing Account (TSFP), and so this statement is an anamoly compared to previous statements when the TSFP account did not exist.

The underlying structure of the regional Federal Reserve balance sheets is depository institutions that generally hold a surplus or shortage of reserves. Those regional banks - like the Boston Fed - that had a surplus of liabilities are likely backed by institutions that hold larger reserves (deposits with the Fed). As a result, there is always a structurally-defined demand for interbank funds.

Note: I will be investigating the Fed balance sheet further and will update you on Table 5.

Small banks and large banks are lending

The chart illustrates domestically chartered bank lending according to bank size. I thought that there may be a distribution problem of funding by bank size – perhaps large banks have easier access to Fed funding. However, it appears that all banks – large or small – are lending above their 2008 averages. Admittedly, the growth rate in bank lending was higher in 2007 than in 2008 in spite of the $1 trillion in new liquidity.

The Fed is smashed between a rock and a hard place; its massive liquidity injections still have not penetrated the brick wall of term lending. Overnight lending is flowing, but in order for the real economy to function, term lending must flow as well. Its various funding facilities for money market and commercial paper are a good start, but until these funds flow to the real economy, the credit crisis will continue. And each week that the credit crisis continues, the risks to the real economy grow.

I still see inflation as the bigger risk. Eventually the banking system will unclog, and the funds will flow. I believe that a signal that lending is clearing up again will be when markets price in the risk of inflation.

Rebecca Wilder

1 comment:

  1. I believe that a signal that lending is clearing up again will be when markets price in the risk of inflation.

    Exactly! Spot On!

    The big problem is that the markets are not 'allowed' to charge a higher interest than the negative rates the FED, ECB, e.t.c. are pushing.

    Rising interest rates would cause the deflation of asset bubbles around the world (In the longer run the funds will flow towards real investments again, the kind that creates jobs and manufacturing skills).

    Bernanke et. Al. will not allow that to happen and they will keep pouring money until it is picked up and inflates something.

    The endgame will be hyperinflation when the dam finally burst and we are buried in a flood of stupid money looking to buy anything before they loose their value.