Are Banks Afraid to Lend?

Unfinished manuscript.

Back in 2008-2009 in the depths of the financial crisis in the US, there was widespread assertion that the large buildup in excess reserves at the Fed was the result of banks’ fear of lending their capital. Certainly this was the case for the inter-bank market. No bank knew how badly impaired another bank’s balance sheet was. Their only information was on how badly their own balance sheet was impaired and a suspicion that their neighbour would likely not be in better shape.

The accusation however was leveled at the banks’ failure to lend to the public. At the time we considered this consensus view and felt not only was it unsupported by evidence but alternative explanations were more likely, namely:

  1. That their balance sheets were so bad that they needed to keep the excess reserves to maintain an adequate capital ratio.
  2. There simply were no credit-worthy borrowers – no demand.

We attempted to raise the issue with others at the time without any response. In the last year, however, our views have been vindicated by others.

Below is a history of our thinking and associated commentary to capture the issue.

Our Original Premise

On March 28, 2009, we sent the following note to Paul Kasriel of Northern Trust:

I just read the March 23 edition [of the Econtrarian] and have a question or two.

I am mystified by the money center banks’ excess reserves (
Firstly, I interpret your statement, “Just as the non-bank public’s demand for money to hold has increased in the past year, banks’ demand for “money” or reserves to hold also has increased.”, to mean personal savings. The actual percentage of these savings that would impact reserve requirements I would expect to a smallish fraction of the total amount saved (shown below, I think). Further, going back to “The Paradox of Thrift”, I thought you debunked it. That is, there is no reason from the public’s point of view, to suggest that money is not free to flow.
If I look at the period August 1, 2008 to February 1, 2009, Required Reserves ( have increased by about $16 B, while Personal Savings have increased by about $360 B (
In the same period, Excess Reserves – FRED above – have gone from 0 to about $640 B.
The standard economic dogma these days says credit markets are frozen – or at best starting to thaw – and banks are not lending. Another source that I cannot put my finger on (it might actually be something Asha Bangalore showed at one point) suggests that data shows credit is being accessed at normal rates. So the question I am looking for an answer for is why the massive excess reserves, or “Why are the banks not lending?”, apart from the too-obvious reason – that there is no demand.

Best Regards,

Here we enunciated the first part  of our premise that lack of public demand was a reason for banks’ not lending. Then on May 9, we sent the following note to Prieur du Plessis:

message lost

In 2010, we sent the following note to a friend:

Sent: Thursday, February 25, 2010 12:29 PM
Subject: Re: Deflation argument
I think most of the sources I follow side with deflation as opposed to the doomsday crowd such as Schiff that go for inflation or hyperinflation. The key here is to identify the amount of money the Fed has “printed” and where it is. The St. Louis Fed through its FRED ( data base, gives us a free tool that allows us to examine about 13,000 economic time series as I recall.
Most are uninteresting but a few are very insightful.
First of all, currency in circulation ( is increasing at a normal rate. No evidence of exceptional currency creation here. The only other place where currency can reside and not be counted by this measure is, as far as I know, deposits of
client banks – the primary dealers ( – with their Federal Reserve banks. Indeed, if we look at the measure of such deposits known as excess reserves (reserves over and above what banks are required to maintain with the Fed to satisfy banking regulations) (, we see these reserves have gone from practically 0 to $1.05 trillion in this crisis.
The adjusted monetary base (, as I understand it, consists of currency in circulation plus currency held in Fed accounts, and currently stands at $2.01 trillion. So it looks to me like the Fed has ‘printed’ a trillion dollars or so, but it it is all held in Federal Reserve accounts. Note that this money can either be paper currency but more likely electronic bookkeeping entries.
Now here are three question I posed to the St. Louis Fed that were answered by an anonymous economist:
1. How did the commercial banks acquire these reserves? Was it done through a repo arrangement or other form of asset-backed loan?
>>> The banking system had no voice in the origin of these reserves. Fed actions that increased Fed assets automatically increased the deposits held by banks at the Fed (see any money and banking textbook for the mechanism). Individual banks might try to sell or lend these reserves to another bank, but the banking system cannot change the quantity of aggregate reserves. This is a fundamental principle of central banking.
2. What form are these reserves in? Currency, Treasuries or other negotiable paper?
>>> Deposits at the Federal Reserve Banks
3. Assuming the reserves are in Treasuries, what is the average maturity?
>>> N/A
This says to me that the dealer-banks have this ‘money’ in their accounts but cannot spend it into circulation.
So here is what I think has gone on.
As an aside the New York Fed has the responsibility of conducting ‘open market operations’ ( I followed these a couple of years ago and they consist of repurchase agreements or repos. These are short term – most were overnight terms – loans to dealers in which the dealer places an asset – strictly Treasury instruments at that time – on deposit with their Federal Reserve bank and the ‘money’ is advanced to them. The assets on deposit were frozen and I believe the money stayed largely within the Fed. Since in most cases it had to be returned the next day, there wasn’t time to place it in circulation if they were able.
With this crisis, the primary dealers were stuck with ‘toxic’ assets either on their books or off their books but having the requirement that they would have to come back on. Marking these assets to market would cause such a capital loss that the banks would be recognized as insolvent. So the Fed, through various programs, bought these assets at some nominal value but at a value that allowed the dealers to remain solvent. However, the ‘money’ paid for the assets is not being allowed out of the dealers’ accounts so that when the repos’ come to term, the toxic assets can be either returned to the dealer at the rated value at the time of the deal, or rolled over.
The Fed thus retains both control of the money created and control of the repatriation process. It can unwind the situation when it wants to. Further, the Fed has no risk since it has both the asset and the ‘money’ paid for it under its control.
In any case, when the repo is terminated, the money goes from the dealer’s account back to the Fed which cancels it.
The puzzle is the Fed’s purchase of GSE mortgages (Fannie and Freddie). Where is that money?
Anyway this is my reasoning. The doomsday crowd make their hysterical claims without any analysis or documentation.
Finally, of interest are the measures of the broader money supply:
M1 is increasing on trend ( as is M2 ( The big argument for near term deflation is the M1 money multiplier ( My understanding is that any value below 1 indicates a contraction in the money supply and by extension, is a disinflationary indicator.
Best Regards,
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