How to Restore Small Bank Lending

The Fed should lend unsecured and in unlimited quantities to all member banks at its target interest rate, while dropping all requirements that a percentage of bank funding be 'retail' deposits.
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The Obama administration has been preaching the importance of fixing the small banks and getting them lending again. Here is the critical issue at play followed by a proposed solution.

First, the answer:
  1. The Fed should lend unsecured and in unlimited quantities to all member banks at its target interest rate.
  2. The regulators should then drop all requirements that a percentage of bank funding be 'retail' deposits.

Yes, it is that simple. This simple, easy to implement 'fix' will immediately work to restore small bank lending from the bottom up by removing unnecessary costs imposed by current government policy.

The current problem with small banks is that their cost of funds is too high. Currently the true marginal cost of funds for small banks is probably at least 2% over the fed funds rate that large 'too big to fail' banks are paying for their funding. This is keeping the minimum lending rates of small banks at least that much higher, which also works to exclude borrowers because of the cost.

The primary reason for the high cost of funds is the requirement for funding to be a percentage of the 'retail deposits'. This causes all the banks to compete for these types of deposits. While, operationally, loans create deposits and there are always exactly enough deposits to fund all loans, there are some leakages. These leakages include cash in circulation, the fact that some banks, particularly large money center banks, have excess retail deposits, and a few other 'operating factors.' This causes small banks to bid up the price of retail deposits in the broker CD markets and raise the cost of funds for all of them, with any bank considered even remotely 'weak' paying even higher rates, even though its deposits are fully FDIC insured.

Additionally, small banks are driven to open expensive branches that can add over 1% to a bank's true marginal cost of funds, to attempt to attract retail deposits. So by driving small banks to compete for a relatively difficult to access source of funding, the regulators have effectively raised their cost of funds.

It should be clear to all the aforementioned solutions would immediately lower the cost of funds for all small banks. There will be the usual host of objections to these proposals. To understand why the usual host of objections are not significant, it is important to frame these objections with the two fundamentals that one must keep in mind when contemplating banking with today's 'non convertible' currency and floating exchange rate policy

  • The liability side of banking is not the place for market discipline.
  • The Fed and monetary policy in general is about prices (interest rates) and not about quantities.

Making banks compete for deposits has been tried repeatedly and always necessarily fails. First, it's fundamentally impractical to the point of ridiculous to expect anyone looking to open a checking account or savings account, for example, to be responsible for analyzing the finances of competing banks for solvency, when even Wall Street analysts can't reliably do this. The US learned this the hard way when the banking system was closed in 1934 and reopened with Federal deposit insurance for bank deposits for the sole purpose of removing this responsibility from the market place. Regulation and supervision of bank lending and investing then became the imperative. And while we have seen periodic failures due to lax regulation and supervision of the US banking system, it is a work in progress and far superior to the alternative of using the liability side of banking for market discipline which exposes the real economy to far more disruptions and far more destructive systemic risk.

Those who understand reserve accounting and monetary operations, including those directly involved in monetary operations at the world's central banks, have known for decades that in banking, causation runs from loans to deposits, with reserve requirements, if any, being merely a 'residual overdraft' at the central bank and not a control variable. This includes Professor Charles Goodhart at the Bank of England, who has written extensively on this subject for roughly half a century, endlessly debating the 'monetarist' academic economists who spew gold standard and fixed exchange rate rhetoric, and who are unaware of how monetary operations are altered when there is no legal convertibility of a currency.

Recall the '500 billion euro day' back in 2008 when the ECB added that many euro in reserves to its banking system, and a week later the monetarists pouring over the data 'couldn't find it.' The fact that they even looked was evidence enough that they had no actual knowledge of reserve accounting and monetary operations. And, more recently, the notion that 'quantitative easing' makes any difference at all apart from changes in interest rates (it's always about price and not quantity) reinforces the point that there is very little understanding of monetary operations and reserve accounting.

While Professor Goodhart did declare quantitative easing in the UK a 'success' he did so on the basis of how it restored 'confidence,' making it clear that there was no actual monetary channel of causation from excess reserves to lending. Banks do not 'lend out' reserves. Loans create their own deposits. Total reserves are not diminished by lending. This is operational and accounting fact, and not theory or philosophy.

What this means is that these proposals for unlimited lending to the banks by the Fed at its target interest rate will not alter anything of consequence apart from the resulting term structure of interests per se. (Also, and not that it matters in any event, total lending by the Fed won't exceed funds 'hoarded' by some banks along with the usual operating factors that routinely 'drain' reserves.) In other words, the notion that this policy will somehow result in some inflationary monetarist type 'money printing' expansion is entirely inapplicable.

The other common concern of unsecured Fed lending to its banks is the risk of losing 'tax payer money.' However, there is none, if you look at government as a whole. All bank assets (loans and other investments) are already intensely regulated and supervised, and the banks are continually subjected to strict solvency tests. This means that the government has already deemed to the banks 'safe to lend to.'

Furthermore, banks can already fund themselves in unlimited size with FDIC insured deposits, which means the government, for all practical purposes, already lends to banks in unlimited quantities as well as protecting itself by regulating and supervising all bank loans, investments, capital requirements, etc. Therefore, the Fed asking for collateral from its member banks is entirely redundant, as well as disruptive and a cause of increased rates to borrowers.

To restore the competitiveness of small banks to be able to service small businesses, the Obama Administration should immediately move to implement the above proposals.

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