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Seems everyone has this wrong? All reserve requirements do is raise the cost of funds for the banks, not the quantity of funds they can loan.

Stephen Green’s thoughts on China:

CHINA RAISES BANKS’ RESERVE REQUIREMENT RATIO 50bps: This is a significant move. Rrr hikes require state council to sign off so this signals that sc is on board with mild tightening earlier than most (incl us) had factored in. This move now is significant too as its a first shot across the banks bows in a very aggresive loan month, esp as excess reserves in the system are are at relatively low levels (around 2pc we believe). Banks need 1-2pc for settlement needs so that means this move will bite. Pboc also probably calculated that they had to move now before we get into second half jan, early feb, before the chinese new year, when pboc has to inject liquidity (since firms and households withdarw cash for presents etc). Markets will be in a bit of shock with this move. The next move is another rrr hike in march as they withdraw post hoiliday liqudity and then we believe 2 rates hikes.

Tina Zhang


35 Responses

  1. I think you are wrong here. If, for example, reserve requirements were raised to 100 percent, the banking system’s loanable funds would shrink to an amount equal to the industry’s capital ( debt plus equity). So it seems to me that , at the margin, an increase in reserve requirements increases the amount of funds banks must carry at the Fed and reduces the amount of funds available for other assets.

    1. You can have 100% RR and give banks overdrafts (i.e., the cb provides reserves at its stated rate, as it always does aside from a gold standard or currency board) and not have changed anything aside from the makeup of bank assets.

    1. That would do it.

      Although I think in China, “private” credit expansion through the state sponsored banking sector is closer to fiscal policy than private sector credit expansion is in the US. Remember — if you waive capital and reserve requirements, banks can operate at any level of insolvency and have no liquidity issues.

  2. China “manufactures” domestic (RMB) liabilities against FX reserve accumulation, in addition to requirements for any deficit it may run.

    Increased reserve requirements are an additional channel for such locked in RMB liabilities, while also acting as a domestic interest margin tax on the banking system.

    The liability effect also means PBOC has to issue fewer RMB “sterilization bills” due to FX intervention, other things equal.

    Scott, sounds like you think 100 per cent reserves is a separate structural issue from the fixed/floating question, which is consistent with what I posted at Bill’s. Agree that 100 per cent reserves have no necessary effect on lending capacity; just further downward pressure on interest margins and pricing pressure on loans.

    1. JKH: What I’m wondering about is, to what degree is state directed lending a “loan” vs a fiscal transfer, with the deficit spending being put in place afterwards as a bail-out of backstop.

      I can see telling a similar story with Fannie and Freddie in the US.

      To the extent the banking sector is just a fiscal vehicle, how much does profitability (and therefore margins) really matter?

      1. I suppose:

        loan =

        money out < money returned

        = profit

        roughly similar to expenditure < tax

        = surplus?

        e.g. taxing banks to make TARP “whole” at least

      2. I was thinking that a loan, where you *know* the money will not be returned, is really just a transfer.

      3. I’m think I’m confused on the point you’re making.

        Are you talking about commercial lending or government lending as per TARP?

        If commercial lending, I don’t see the banking sector being just a fiscal vehicle, so long as private capital remains at risk.

        If government lending, I’m not clear on the borderline between “known” to be lost, versus at very high risk, versus recoupable in any event. The Obama approach to TARP, narrowly defined, seems to be to tax back the actual losses. In a sense, again narrowly defined, this makes it “risk free”.

      4. Hi JKH:

        It’s a muddled idea, so I’m not being particularly articulate.

        In China, there are state owned banks, and the state tells them “you must lend X to such-and-such company” and they do. They know that the loans are not credit worthy, and they may get, say, 80 cents back on the dollar. But when they book the losses, they also know that the State will recapitalize them.

        My point is that this can be thought of as fiscal policy in disguise, where the State is effectively deficit spending, but it’s by directing and then backstopping nominally private sector credit extension. Private capital is not at risk (or at least, is significantly sheltered).

        The entities in the US that come closest to this would be the quasi-governmental housing agencies, Fannie, Freddie, and the FHA program. They are all being directly to lend, they are all writing down losses, and they are all being re-capitalized via deficit spending. Kind of.

      5. Makes sense, although both Chinese banks and the GSE’s are a bastardization of the private capital concept.

        Maybe think of it as lending backed by government coverage of losses, which by definition is a government deficit at the margin.

    1. Scott,

      Yes, I recall now, going back and looking at that post and your comments. In the interim, I got hung up on Bill’s subsequent post on the same topic. But I think the conclusion, for me anyway, is that 100 per cent is just another number. A 100 per cent reserve ratio within an integrated system that included both credit and deposits would be unwieldy, given the size of the reserve required and its effect on balance sheet management. But a bifurcated system that separated institutions for credit and deposits would introduce untenable payment systems risk for the credit piece, as you pointed out – unless backed by overdraft protection, which is a contradiction of intentions.

  3. India is another country where they play such games. The reserve ratio is called CRR. This is recommened in Samuelson’s textbook. After having descibed the reserve ratio, Samuelson goes on and says that the Fed Chairman is the second most powerful person on earth. The Indidan central Bank also changes the SLR – Statutory liquidity ratio – ratio of G-Secs to all deposits.

  4. even with a 100% capital requirement, which means you can only lend out equity, which is unspent income, the use of finance to purchase real goods and services would not necessarily be limited assuming govt had a policy to sustain demand with fiscal balance???

    1. Warren:

      Once we get 100% capital requirements, we are headed deep into the land of non-fiat currency, where Austrians actually make some sense.

      Most proposals around 100% capital requirements also make Govt just another currency user. They think that fixed monetary supply means no inflation.

  5. Winter, please explain. I must be missing something.

    reserve requirements aren’t a constraint with non convertible currency?

    if a bank makes a loan reserve requirements, in the first instance, are functionally an overdraft in it’s fed account, which is functionally a loan from the fed.

    1. Warren:

      I’m just pointing out that folks who recommend a 100% reserve requirement don’t understand what that means in a fiat monetary system (if they did they would not make the recommendation) and what they are arguing for is a return to some form of gold standard.

      One of the “benefits” of a gold standard is that it takes away the state’s power to devalue the currency through inflation and earn (steal) “seigniorage” profits. Read any Austrian literature and this is 90% of all they talk about.

      So the Fed would not be able to make loans either unless IT had the capital to loan out. When these guys talk about 100% reserve requirements, they actually mean 100% capital requirements (as you say) and extend this requirement to the State. So the State could not deficit spend either.

      1. What on earth is a 100 per cent capital requirement? Are you talking about banks? That means they can’t take deposits!

      2. The concept doesn’t translate well.

        Basically, the borrower would buy a CD, and that money would be lent out at the CD term. The bank would match borrowers and lenders, and keep track of those matches in some ledger. It would not take deposits (or make loans), it would match lenders and borrowers.

        I think these actually exist, or have existed.

      3. That’s 100 per cent reserves plus separate matched maturity risk credit/liabilities; it’s not 100 per cent capital requirements.

      4. Winterspeak,

        This is my take on the Austrians, which I posted at Billyblog:

        It’s fair to point out that The Austrians don’t have a monopoly on the subject of maturity transformation. Maturity matching is not an Austrian mystery per se. The Austrian prescription in fact is simply a pure case of a technique that is commonly employed by banks today in varying degrees. Because it’s presented as a pure case in the Austrian version, or pure principle, it’s fair to ask the question what the institutional implications are. Moreover, when the hard questions are asked about implementation of the pure case, it turns out that the response is one of compromise, because the pure case is not viable. It then becomes clear that the pure case as presented is irrelevant, because it is not viable, and because real world banks already implement maturity matching to varying degrees. The fact is that real world banks implement both maturity matching and maturity transformation in different parts of the asset liability portfolio.

        As I illustrated in an earlier example, the pure case of maturity matching is conceptually dangerous from a risk management perspective. If a bank were perfectly matched to maturity, it fails when the first bad loan matures. It simply has no cash to repay the corresponding maturity liability, unless it has an overdraft privilege. Bad loans are matched to equity losses. They are no longer matched to maturing liabilities, because they can no longer produce the cash flow that is required for a perfect match.

        This is a matter of cash flow observation, as well as accounting for balance sheet equity. Perhaps Austrians are not as familiar with double entry book keeping as they should be. In order to protect against this contingent mismatch risk in the pure model, it is necessary to deviate from it by constructing a deliberate “inverse maturity mismatch” at the margin. This means that term liabilities must be mismatched against short term risk free assets. As described earlier, this means that the credit bank must build up a cash reserve with the depository for 100 per cent reserved deposits in the other part of the model. In other words, the pure Austrian matching model fails, unless it is tweaked to become a mismatched model.

        And there is another critical area where the pure model of maturity matching fails. All banks that take risk, including the credit bank described in this thread, require equity capital. Like liabilities, equity capital is a source of funds. But unlike liabilities, equity capital has no nominal maturity date. Therefore, it is not possible to incorporate equity capital into a coherent maturity schedule for the entire bank, without deviating from the simply maturity matching formula of the Austrian prescription. Real world commercial and universal banks know this and allow for it.

        All this results from the portfolio effect of liquidity (the cash deposit with the 100 per cent reserved depository, plus other liquid assets) and capital (the equity that is intended to absorb losses in the credit risk bank). Commercial and universal banks are quite aware of such an interaction in their asset liability management. The functions of liquidity management (which includes the cash reserve and other liquid assets) and capital management (the cushion against losses) are quite separate (although partially intersecting) in these real world banks. The purpose of liquidity management is to protect the cash flow profile of the bank. The purpose of capital management is to protect the loss profile. The primary intersection of the two is that equity is a source of funding that doesn’t have to repaid with cash flow, unlike a liability. Therefore, in addition to providing loss protection, it improves the liquidity profile by alleviating cash flow pressures otherwise attributable to maturing liabilities.

        Commercial and universal banks are quite aware of these issues and typically have risk policies to deal with them. The fact is that no amount of maturity matching or other types of liquidity policies can protect against the ultimate risk of catastrophic capital loss. Catastrophic capital loss is not primarily related to liquidity; it is primarily a function of other types of risks taken – such as credit risk. There is no way that maturity matching can provide ultimate protection against such losses. Maturity matching can’t prevent the fact that some depositors won’t get their money back in the worst case for capital. It can only delay the day of reckoning in such a case. One gets the idea that the Austrians believe they’re the only ones that recognize the importance of the issue. I think it’s much closer to the truth that those who do recognize the issue reject the Austrian approach because their pure model is a naive treatment of a complex issue.

      5. JKH: You raise a very good point. There was a good conversation with another individual who managed a bank who stressed the same thing: that capital is critically important, and the degree to which banks maturity match (or do not) is to a certain degree a business decision. He also pointed out that a bank’s liability strategy (such as how much they plan to depends on the overnight market) is also determined by business model etc.

  6. also, a gold standard increases the relative value of gold by making it the object of taxation, and increasing the desire to save it.

  7. regarding maturity matching.

    As one way or another the cb sets the term structure of rates, it can lend term to member banks at its desired target rate for the term structure, and ‘eat’ the prepayment option by letting the bank pay it back any time in the case of default, or even in the case of prepayment of the borrower. And with my proposed permanent zero rate policy the options are meaningless for the CB, and in many ways make the entire duration matching exercise moot as well.

    1. Warren:

      You are correct, but most people (including the Academy) beleives the Fed sets short term rates but the market sets long term rates.

      The Austrians, with strict maturity matching, would let the “market” set rates up and down the term structure. Interestingly, they recommend interest rates be zero for demand deposits.

  8. The market sets term structure now; not the Fed. The term structure reflects market expectations for Fed policy. But expectations are volatile. So the Fed doesn’t set the term structure; not in the current regime. But Fed policy always ends up defeating erroneous expectations and correcting the yield curve at critical policy inflection points. In that sense, the market is always wrong on the forecasting accuracy of the term structure; the Fed is always right on the path of short rates and the realized term structure.

    Neoclassical theories like “savings glut” are as wrong about term structure as they are about the multiplier.

    I question whether the market completely loses its influence over term structure in a zero rate, zero government bonds regime. The market would still price a non-government term benchmark. And it would only lose its relevance in doing so if it were in a state of complete certainty about the permanence of a zero rate, zero bond regime. Otherwise, the market will price the risk of a reversion to a non-zero regime sometime in the future – just as it bets against a gold peg or a Yuan/dollar peg level (in the NDF market) from time to time.

  9. The Fed has the entire term structure under its immediate control but elects to only target the ff rate and let ‘market forces’ decide the term structure. as you well stated, all those market forces can do is guess what the fed is likely to do.

    Volcker didn’t even target ff for a while and thereby caused a lot of unnecessary disruption, interest rate chaos, and economic under performance.

    what i’m proposing is the fed go ahead and set what it feels is the optimal term structure of rates rather than let the market guess what it might do in the future.

    i’m also proposing a permanent 0 rate policy which means the longer term ff rates are all at 0 as well as the over night rate

    1. Understood, with one clarification requested:

      I assume you are proposing that the Fed intervenes at zero in the term rates as well, as necessary? That makes sense. Although it shouldn’t be necessary in theory, if the market believes in the durability of the zero rate regime.

      My point is that it may well be necessary for them to intervene at term in force, if the market ever bets that the Fed may back away from the zero regime at some point (e.g. a market bet against the ability of fiscal policy to do a tightening job on its own).

      In other words, intervention in force at term may still be required from time to time to overrule market expectations about the durability of the zero rate regime.

      1. Wouldn’t the net effect of a zero rate policy be a ceasing of the issue of treasuries? In effect, all govt. spending would be financed my direct money creation, and there would be no “risk free” rate of return.

      2. Right, although a term structure would still exist in non government markets. The short term risk free rate would be zero. If the Fed wanted to influence term structure in all markets, it could buy and sell term reserves held by the banks (instead of issuing treasuries). It intervene at zero throughout the yield curve.

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