Wednesday, January 14, 2009

You should care about the surge in non-borrowed reserves

Nonborrowed reserves surged and nobody seems to care; perhaps its is because the reasoning is just so obvious. But I find the following rather interesting: previous to January 2008, the sharp decline in non-borrowed reserves signaled that a problem was brewing in the banking system; but now, the surge in non-borrowed reserves indicates the Fed is assuming an increasing amount of risk, partly on the behalf the U.S. household.

Non-borrowed reserves before January 2008

In December 2007, the Fed introduced the Term Auction Facility (TAF), and loans totaled $40 billion that month. Non-borrowed reserves plunged by the amount of TAF lending, and there was a roar in the media. Markets took this as a signal that banks were having a tough time making their reserve obligations; possible bank runs? Here was Felix Salmon’s take on it in “Why Non-Borrowed Reserves Don't Matter”.

The Fed calls the TAF loans “borrowed bank reserves” – total reserves = borrowed reserves + non-borrowed reserves – since the program is mostly a substitute for the discount window. Therefore the pluge was simply a technical issue, rather than an immediate problem in the banking system.

The sharp decline in non-borrowed reserves didn't matter: there were plenty of reserves (excess reserves, actually) in the system, and some called it a false alarm.

Non-borrowed reserves since October 2008

Starting in early October 2008, the Fed has beefed up its lending programs to include the following: Term Securities Lending Facility (TSLF), the asset backed commercial paper money market mutual fund liquidity program (ABCP MMMF), the commercial paper funding facility (CPFF), the money market investor funding facility (MMIFF), the term-asset backed securities loan facility (TALF), and international currency swap lines. Reserves stemming from lending under these facilities are called “non-borrowed” reserves.

Since October 22, non-borrowed reserves have surged $587 billion, while contemporaneously, borrowed reserve lending (TAF and discount window) has been slowing, if not falling. But now we should care!

The collateral accepted under the TAF program and at the discount window is sometimes less risky than the collateral being accepted under the new lending programs, especially that of the TALF or the TSLF. Therefore, the surge in non-borrowed reserves indicates that the Fed's portfolio is rising in risk, including various foreign currencies, commercial paper, mortgage-backed assets, and assets backed by student loans, auto loans, and credit cards.

In conclusion, the Fed’s measures are growing in risk. First, it is assuming some collateral that the open market has shunned. And second, the Fed’s exit strategy becomes increasingly hazy with rising non-borrowed reserves; the risk of inflation is on the move.

Rebecca Wilder


  1. Question. Do you really think they have an exit strategy? I seem to remember you saying they needed to develop one or at least say they possessed one.

  2. Rebecca....much of the commentary on the state of the economy seems to center around the Fed's actions with regard to MBS, ABS, Subprime loans and their derivatives, alt A products and Money markets, in other words domestic housing linked products. In the back of my mind im thinking, are their any other problem assets waiting to fall, like commercial real estate, credit card derivatives and portfolios, auto loan and student loan portfolios. Then there is the issue of emerging market debt, which if most emerging markets were built on an export strategy to the US consumer, these loans probably are starting to lose some of their liquidity, considering if Brad Setser is right in his observation that hot money is starting to flee China. do you see any additional shoes to fall and or... are you concerned about any of the topics I just mentioned.

  3. AH! Inflation! But I like my Starbucks once in a while.

    Hello Dr. Rebecca,

    I really enjoyed the help of the graphs. I still have a lot to learn and catch up on.

    Keep up the good work.

    Your random Non-truths reader


  4. @dmd555:

    You want "Other Shoes" - Ahh - We have got such sights to show you ;-)

    How about when people finally realize how badly their pension plans have blown up?

    The pension funds have bought massive amounts of 'AAA' 'high yield bonds' that now turns out to be based mostly on mortgages that will never be repaid.

    Or ... How about the Middle East blowing up - literally - starting with revolution in one of the many countries of +5% p/a population growth combined with 0% economic growth and the only manufactured product being the suicide bomber? That would put a crimp in Oil supplies.

    Perhaps some decent riots in Europe and the USA because social security payment can no longer be met?

    The bulk of Alt-A and Prime mortgages will reset from 2009 to 2012 so more there is more fuel to the crisis available.

    Personally, I think that Pakistan or maybe Egypt will go titsup before 2015 sparking off WW3 in the Middle East.

    Wars are fractal things, casualties follow a power law so we are overdue for a decent size conflict. Better there than here eh??

  5. One dollar of borrowed reserves provides the same legal-economic base for the expansion of the money supply as one dollar of non-borrowed reserves.

    It's not the composition of legal reserves that is determines the "expansion coefficient", but historically, the volume of total reserves.

    Though since the introduction of the payment of interest on reserves the "money multiplier" is now represented by the Board of Governors figure for required reserves (adjusted for reserve requirements but not seasonally mal-adjusted).

    Anyway, whatever the Fed's portfolio risk, it seems that the Fed can offset any collateral default, by monetizing the collateral pledged?