Download paper - Buffalo State College Faculty and Staff Web Server

The Crisis in the US Financial Markets, Bank Regulation and the
Liquidity Trap: Evidence from Individual Bank Behavior
Submitted by:
Patrick A. McGuire
Professor of Economics
Hobart and William Smith Colleges
Geneva, New York 14456
Post Keynesian Cross Border Conference
Financial Crisis and Reform
Buffalo State College, SUNY
Buffalo, New York 14222
October 9-10, 2009
2
The Crisis in the US Financial Markets, Bank Regulation and the Liquidity Trap:
Evidence from Individual Bank Behavior
For this is the third time in history that a major economy has found itself in a
liquidity trap, a situation in which interest rate cuts, the conventional way to perk
up an economy, have reached their limit. When this happens, unconventional
measures are the only way to fight recession.
Paul Krugman, “Stay the Course”, New York Times, June 15, 2009,
Opinion Column.
Introduction
In September, 2008, as the financial crisis worsened each day, the Federal
Reserve’s money supply data began to reveal a different side of the turmoil in the
financial markets. Excess reserves for depository institutions leaped from $2 billion in
August, 2008 to $60 billion in September. Excess reserves then increased again to
$ 267.9 B in October, $559 B in November and to $767 B in December, 2008. Bank
Reserves remained high through the first 8 months of 2009. The increases in bank
reserves were a direct result of the Federal Reserve’s effort to add liquidity to the
financial market. In addition, the short term interest rate (the US Treasury bill rate) fell
from 1.79% in August, 2008 to .04% in December, 2008. It seemed that the liquidity trap
was alive and thriving in the US economy. Total reserves remained high, interest rates
remained low and the financial crisis continued into 2009. I wanted to take a closer look
at the financial meltdown so I began to examine the behavior of individual banks in the
US economy to understand the causes, sources and possible solutions to the financial
markets collapse. I began to work with the individual bank data from the Statistics for
Depository Institutions database (SDI) from the Federal Deposit Insurance Corporation
(FDIC). The SDI database contains detailed reports of all the depository institutions in
the United States [1].
As part of an overall study of the financial crisis, I first sought to determine how
liquidity developed within individual banks. The basic hypothesis of the study is that as
risk within the financial market increased, banks moved towards liquidity and hence
liquid assets. Risk is difficult to measure and for this study it is the possibility of financial
loses that threaten the financial viability of the depository institution. The liquidity trap
did appear or reappear in the Federal Reserve excess reserve data during the Great
Recession of 2007-09. How it also appear on the balance sheets of individual banks? If
the liquidity trap did indeed appear, how did it differ, if at all, from any former
reincarnation of the Keynesian liquidity trap? The results of the first part of the study of
bank behavior are presented in this paper.
The paper is divided into 4 parts. Part 1 is a brief review of the re-emergence of
the concept of the liquidity trap in macroeconomic policy discussions. Part 2 presents the
liquidity increase in the bank reserves of the Federal Reserve System as well as some
results of an analysis of the FDIC’s time series database for depository institutions
variables from 1934-2008. Part 3 looks at the liquidity trap and individual bank behavior
for the period 2007 (4) to 2008 (4), the epicenter of the financial crisis of 2007-2009.
3
(The FDIC provides quarterly reports in detail as well as the Quarterly Banking Profile
approximately 60 days from the close of the most recent quarter). Part 4 provides some
final results and conclusions from the data analysis [2].
The Liquidity Trap.
There is the possibility… that, after the rate of interest has fallen to a certain level,
the liquidity-preference may become virtually absolute in the sense that almost
everyone prefers cash to holding a debt which yields so low a rate of interest.
John Maynard Keynes, The General Theory (1936), page 207.
In Keynes’ original formulation of the liquidity trap, he was trying to explain
why, at certain times, banks did not lend and investors did not borrow at low interest
rates. Investors did not borrow because of rates of return were low. Banks did not lend
because the lending rates, hence potential profits, were also low. However, when the
central bank attempted to increase reserves or the liquidity in the banking system, banks
did not lend, but rather held the reserves as cash balances on their balance sheets and
money supply did not increase. In effect, the reserves were trapped in liquidity and
further increases in reserves would only increase liquid cash balances and would not
result in an actual increase in money supply.
James Tobin (1958) referred to existence of liquid reserves as the asset demand for
money and implied that the asset demand for money was inversely related to the interest
rate similar to Keynes’ speculative demand for money. The differences between Tobin’s
view of the asset demand for money and Milton Freidman’s transactions demand for
money became the basis of the monetarist controversy. Hyman Minsky recognizes the
liquidity trap as an important component of Keynes’ original description of the failure of
classical economics to develop a model of the macroeconomy.
In particular, the view that the liquidity- preference function is a demand-formoney relation permits the introduction of the idea that in appropriate
circumstances the demand for money may be infinitely elastic with respect to
variations in the interest rate…This liquidity trap presumably dominates in the
immediate aftermath of a great depression or a financial crisis.
Hyman P. Minsky, John Maynard Keynes, (1975 reissued in 2008), page 36.
However, the concept of the liquidity trap gradually disappeared from the development of
macroeconomic theory and the implementation of monetary and fiscal policy. As noted
by Robert Gordon:
In an extreme (and hypothetical) case of the “liquidity trap,” people are convinced
that the prices of bonds and other financial assets are high and likely to fall, so
they hold on to the extra money and refuse to buy any financial assets.
Robert J. Gordon, Macroeconomics, (2006), page 114 (footnote).
4
The liquidity trap became an extreme or hypothetical case in the major textbooks in
macroeconomics, if it was mentioned at all.
Macroeconomics evolved throughout the postwar period and many theoretical and
policy conflicts arose. Certainly Friedman, Tobin, Minsky, Krugman, Gordon and many
others (including Robert Lucas and the New Classical School) all made major
contributions to these discussions as four Nobel prizes can attest. However, the liquidity
trap did not become an accepted explanation of the failure of monetary policy. The
concept has a simple appeal, when banks and individuals lose confidence in the economic
system currently in place, or in Keynes words are “uncertain…” of the course of events in
the financial market, normal bank behavior is disrupted. In Minsky’s view, banks and
individuals fall victim to the inherent instability of the financial markets, they move to
hold their assets in the most liquid form as cash balances in bank accounts, in mattresses,
in wallets or as reserves with the district Federal Reserve Banks.
Paul Krugman revived the concept of the liquidity trap in his analysis of the lost
decade for Japan in the 1990’s.
Japan, say the economists, has fallen into the dread “liquidity trap”…
Paul Krugman, The Return of Depression Economics, (2008), page 71.
Krugman describes the situation in Japan as a “classic” case of the liquidity trap: 1)
stagnation with low interest rates coupled with the refusal of the Japanese government to
let some of its large banks to fail, 2) an aggressive attempt by the Japan Central Bank to
pump reserves into the financial markets and 3) the refusal of investors to borrow [3].
The Japanese government responded to this liquidity trap by increasing government
spending to offset the decline in private investment spending. The government efforts
were somewhat successful as Japan avoided a major recession or depression, however, it
experienced a long decade of stagnation, dimming the glow of the rising sun of the
1980’s.
In September, 2008, we began to see a dramatic increase in bank reserves. Total
reserves and excess reserves rose from a level that changed little in 50 years to ten times
the amount held in these previous periods. What was different about the growth in cash
balances in general and excess reserves in particular from September to December, 2008?
Does this run to liquidity help us understand the financial crisis of 2007-09? How does
the growth in cash balances help us understand the financial structure of the 21st century
in the US and in the world? There may not be answers to these broad aggregate
questions, however, I want to use the behavior of individual banks as the vehicle to shed
some light on these broad questions. Specifically, how does the liquidity trap show up in
the balance sheets of depository institutions in the US? And can these patterns help us
understand the causes and consequences of the current financial crisis?
5
The Liquidity Trap and the Current Financial Crisis in the United States
The tables and charts in this section look at the reserves position of depository
institutions in the US at the Federal Reserve and then in the FDIC’s annual time series
format. First, Table 1 provides short term monthly data on total reserves (TR), required
reserves (RR) and excess reserves (ER), monthly from October, 2007 to the most recent
period (TR = RR + ER). As mentioned earlier the increases in all but the RR from August
to October of 2008 are dramatic. TR increased to $821 B in December, 2008 and it
maintains that level through the most recent months of 2009. These reserves are held by
banks on their balances sheets as currency and coin and reserves deposits at the Federal
Reserve district banks. Banks are expected to lend all of their excess reserve position
since individual bank profits are determined by their interest bearing assets e.g. loans and
leases, securities etc. Traditionally banks keep a small portion of their excess reserves as
cash balances over the amount required to back of their deposit liabilities (RR).
The excess reserve position of the banking system averaged between $1.6 B and
$3.0 B from October 2007 to August, 2009. As indicated in Table 1, the excess reserve
position changed dramatically for the last 4 months of 2008 and continued to be
significantly high for all of 2009 up to the most recent month. Table A1 in the Appendix
provides a comparison of the Federal Reserve Banks Statement of Condition annually
from May, 2006 to May 2009 to demonstrate how the FRS used its balance sheet to
impact the liquidity needs of the financial markets. The table demonstrates how the
Federal Reserve, with very low short term interest rates, was able to respond to the crisis
in liquidity in the financial market including institutions in the shadow banking system.
The financial crisis started many years ago as the regulatory constraints on banks
and the financial markets were released in the name of deregulation. However, the reality
of the crisis began to appear in the first quarter of 2007 and daily news accounts reported
a rapidly changing financial market situation throughout 2007 and into 2008 (For an
excellent summary of the financial market events over this period see Acharyu and
Richardson, Restoring Financial Stability, Prologue, pp 1-56). On July 13, 2008, the US
Treasury announced a rescue plan for Fannie Mae and Freddie Mac, major market
players in the subprime housing market; and confidence in the banking system took a
major hit with the bankruptcy of Lehman Brothers on September 15, 2008. These are but
2 of the many events that characterized a chaotic period in the financial markets. As the
data from Table 1 indicate, liquidity problems demanded that banks hold cash or near
cash assets and the Federal Reserve numbers show a dramatic increase in excess reserves
beginning in September, 2008.
There are 3 specific data sets for individual banks from the Statistics for
Depository Institutions (SDI) of the FDIC. First, we look at general trends for all banks
over the long term, 1934-2008 from the FDIC’s historical data base. Then we look at
annual data for 1992 to 2008 from the FDIC’s quarterly financial reports for more detail
of the composition of cash balances, as a measure of liquidity. Finally, we examine data
from the fourth quarter of 2007 and the fourth quarter of 2008 from the detailed financial
6
TABLE 1
TOTAL RESERVES, REQUIRED RESERVES AND EXCESS RESERVES FROM THE
FEDERAL RESERVE SYSTEM, SEASONALLY ADJUSTED, OCTOBER 2007 TO SEPTEMBER,
2009 IN MILLIONS OF DOLLARA AND PERCENT CHANGE
Millions
of
dollars
year
2007
2008
2009
month
Total
TR
Required
Reserves
percent ch
Reserves
RR
percent
ch
40963
Excess
Reserves
ER
percent
ch
October
42422
1459
November
42615
0.45%
40922
-0.10%
1693
16.04%
December
42674
0.14%
40905
-0.04%
1769
4.49%
January
42149
-1.23%
40508
-0.97%
1641
-7.24%
February
42820
1.59%
41094
1.45%
1726
5.18%
March
44297
3.45%
41324
0.56%
2973
72.25%
April
43562
-1.66%
41718
0.95%
1844
-37.98%
May
44130
1.30%
42119
0.96%
2011
9.06%
June
43363
-1.74%
41092
-2.44%
2271
12.93%
July
43333
-0.07%
41360
0.65%
1973
-13.12%
August
44565
2.84%
42571
2.93%
1994
1.06%
September
102784
130.64%
42726
0.36%
60058
2911.94%
October
315512
206.97%
47606
11.42%
267906
346.08%
November
609962
93.32%
50920
6.96%
559042
108.67%
December
821055
34.61%
53655
5.37%
767400
37.27%
January
858418
4.55%
60173
12.15%
798245
4.02%
February
700967
-18.34%
57459
-4.51%
643508
-19.38%
March
779955
11.27%
55321
-3.72%
724634
12.61%
April
881556
13.03%
57176
3.35%
824380
13.77%
May
901292
2.24%
57191
0.03%
844101
2.39%
June
809021
-10.24%
57644
0.79%
751377
-10.98%
July
795571
-1.66%
62561
8.53%
733010
-2.44%
August
September
October
November
December
reports of individual depository institutions that are part of the FDIC. For the annual time
series data, we will look for general trends in liquidity and macroeconomic variables. For
the fourth quarters of 2007 and 2008, we will examine cross sectional data for individual
banks as reported in the SDI database of the FDIC.
7
For the FDIC annual data, the closest variable to measure liquidity was cash
balances which included both interest bearing assets and non-interest bearing assets. We
use this variable as our measure of changes in liquidity for the period 1934-2008. Figure
1 measures cash balances against the US Treasury bill rate. Cash balances move up
slowly from 1934 until 1976 when it increased significantly and settled into a higher level
for a number of years. The interest rate on US Treasury bills fluctuated starting in the late
1950s and then spiked to near 14 % in 1981. During this time the US Treasury bill rate
declined from its peak in 1981 with considerable variability to a low of 1.37 % in 2004, it
rose again to a high of 4.73 % in 2006 before falling to 1.37 % for 2008 (The UST bill
rate for July, 2009 was .19%).
FIGURE 1
CASH BALANCES (LIQUIDITY) WITH ESTIMATES FOR 1934 TO 1965 AND THE RATE ON US
TREASURY 3 MONTH BILLS, SECONDARY MARKET YIELDS, COMMERICAL BANKS 19342008
1200000000
16
14
1000000000
12
800000000
600000000
8
percent %
$(000)
10
6
400000000
4
200000000
2
0
19
3
19 4
3
19 6
3
19 8
4
19 0
4
19 2
4
19 4
4
19 6
4
19 8
5
19 0
5
19 2
5
19 4
5
19 6
5
19 8
6
19 0
6
19 2
6
19 4
6
19 6
6
19 8
7
19 0
7
19 2
7
19 4
7
19 6
7
19 8
8
19 0
8
19 2
8
19 4
8
19 6
8
19 8
9
19 0
9
19 2
9
19 4
9
19 6
9
20 8
0
20 0
0
20 2
0
20 4
0
20 6
08
0
years
chbal
ust3mon
Cash balances (liquidity) more than doubled between 1976 and 1982-84. This
period was characterized by high unemployment and inflation. Cash balances continued
stable rising slowly after a decline in 1994 until 2004 when it began to increase
significantly in 2005 to 2007. The housing bubble and the subprime lending crisis began
to show its contagion in the mid 2000s and liquidity increased. However, the behavior of
cash balances from 2007 to 2008 surpassed all previous increases as cash balances
doubled in one year. In other words, liquidity in the banking system increased
dramatically from 2007 to 2008. Normal banking activity was disrupted in 2008 by the
collapse of the housing bubble and the consequent body blow to bank balance sheets
from the decline in all asset prices.
Figure 2 illustrates another measure of liquidity, average cash balances as a
percent of transactions accounts at banks (demand deposits and checkable deposits)
versus the average capital ratio of banks, total capital of the bank (assets minus liabilities)
8
divided by total assets. The capital ratio is used as and a measure of financial viability
since it measures how much of the financial institution’s own capital is available to back
up its investment decisions (often called the “skin in the game”). There are many
measures of the capital ratio and the one here is the crudest since it does not distinguish
among the different types of net worth of the firm.
FIGURE 2
CAPITAL RATIO (TOTAL CAPITAL AS A PERCENT OF TOTAL ASSETS) AND LIQUIDITY (CASH
BALANCES AS A PERCENT OF TRANSACTION), COMMERICAL BANKS, 1934-2009
0.14
1.4
0.12
1.2
1
0.08
0.8
0.06
0.6
0.04
0.4
0.02
0.2
0
19
3
19 4
3
19 6
3
19 8
4
19 0
4
19 2
4
19 4
4
19 6
4
19 8
5
19 0
5
19 2
5
19 4
5
19 6
5
19 8
6
19 0
6
19 2
6
19 4
6
19 6
6
19 8
7
19 0
7
19 2
7
19 4
7
19 6
7
19 8
8
19 0
8
19 2
8
19 4
8
19 6
8
19 8
9
19 0
9
19 2
9
19 4
9
19 6
9
20 8
0
20 0
0
20 2
0
20 4
0
20 6
08
0
percent %
percent %
0.1
years
tecap_a
chb_trn
After a decline from 1934 to 1947 the average capital ratio stayed between 6.0% and
7.0% until 1978. There was a credit crunch in the late 1970’s and early 1980’s and the
rate declined below 7.0% and gradually increased over the period from 1980 to 2007
when it declined. The capital ratio has been subject of many attempts to introduce
discipline and efficiency in the financial system especially as a result of Basel I and Basel
II. (see Barth et al, Rethinking Bank Regulation: Till Angels Govern, 2008). Our measure
of liquidity (cash balances as a percent of transaction accounts) remained close to 40% of
transactions accounts until 1978 when it began to increase as banks began to hold
reserves during the credit crunch and economic recession of the early 1980’s. However,
liquidity declined from 1984 until 1994 when it began to rise again. It leveled off in the
late 1990’s and early 2000 but began a sharp increase in 2006 and doubled from 2007 to
2008.
The liquidity measures from Figures 1 and 2 indicate that the financial
institutions are sensitive to changes in the economy and begin to hold more or less
liquidity dependent on changes in the economy, that is, as risk increases, liquidity
increases. Other comparison with more explicit macro data would also indicate sensitivity
to economic trends. However, our interest is identifying more refined measures of
liquidity in individual bank behavior. We now look at the quarterly reports for individual
banks and in particular the section on cash balances. The FDIC reports on two variables
9
that are part of the definition of the required reserves, i.e. currency and coins in the banks
possession and deposits of financial institutions at the Federal Reserve district banks.
These two variables are combined to create a measure of bank reserves (TR). The data is
collected from the FDIC’s fourth quarter financial reports for 1992 – 2008 and appear in
Figure 3. The total reserves of the banks are compared to the US Treasury bill rate.
FIGURE 3
TOTAL RESERVES OF ALL BANKS AND THE US TREASURY BILL RATE FOR 3 MONTH
NOTES, ANNUAL, 1992-2008 and THE UST BILL RATE FOR JULY, 2009
600000000
7.00
6.00
500000000
5.00
(000) $
4.00
300000000
3.00
percent %
400000000
200000000
2.00
100000000
1.00
0
0.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
years
res
ust3mon
As Figure 3 illustrates, total reserves are not sensitive to interest rate fluctuations over
the period, however, total reserves increased from $70 billion to $700 billion from 2007
to 2008, a tenfold increase. Our second, and more refined, measure of liquidity also
demonstrates that banks ran to liquidity during the financial crisis. Of course some of this
liquidity came to the banks as a result of actions of the US Treasury, the US Congress
and the Federal Reserve. Liquidity increased, but was it trapped? And if it was, then what
trapped it?
The Liquidity Trap and Individual Bank Behavior.
The data set for individual bank behavior contains 55 sectors and 881 variables
for 8305 banks for 2007(4) and 2008(4). The data used for the current study came from 7
sectors and contained 209 variables for 2 periods, the 4th quarter of 2007 and 2008. For
this paper the focus was on the liquidity changes for all banks, some subsets of banks and
for a random sample of all banks. This section will report on the behavior of banks as
measured in 7 sectors with a focus on the variables related to liquidity [4]. The questions
remain the same: Does the liquidity trap exist and can it be identified in the individual
bank data? Do all banks portray characteristics that describe the liquidity trap? How has it
10
affected individual bank performance?
behavior and monetary policy?
And finally, has it affected bank regulatory
Table 2 presents summary data for the liquidity variables compared to the
standard definition of the liquidity trap and how these variables are used in the conduct of
monetary policy and in the supervisory function of bank regulators. All banks must
maintain required reserves to back deposit liabilities, specifically transactions accounts.
The required reserve ratio is 3% for net transaction accounts (liabilities) of between $10.3
million to $44.4 million and 10 % for net transaction accounts over $44.4 million [5].
Required reserves must include currency at the bank and deposits with the Federal
Reserve district Bank. These 2 items appear as part of the Cash Balances section of the
database. Excess reserves equal total reserves minus the required reserves. The sum of
currency and coin and cash balances due from the Federal Reserve is our measure of total
reserves. If the RR ratio is 10% and transaction accounts are $100 million, the bank must
hold $10 M of reserves to back the deposit liabilities. Total reserves divided by
transaction accounts (including demand deposits and checkable deposits) give us a
measure of liquidity. If we assume that the RR ratio is 10%, then banks with a reserve
ratio of 10 % are “loaned out” i.e. no excess reserves. If our liquidity measure is 40%
then we can assume the 30% (40% minus 10%) represents excess reserves and the
liquidity remaining on the balance sheet.
Table 2 provides data for all banks from 2004 to 2008. Transactions balances are
non-interest bearing deposit liabilities. Cash balances are assets and they measure the
general liquidity in the banking system and includes cash and balances due from
depository institutions. There are interesting bearing and non-interest bearing balances;
money supply for the US economy measures non-interest bearing deposit liabilities. Total
reserves for banks include non-interest bearing assets that can be lent out to borrowers.
Banks are required to hold a certain percent of these liquid assets as reserve against
specific deposit liabilities, non-interest bearing liabilities (transaction balances). Money
supply includes transaction deposit liabilities (demand deposits and checkable deposits)
and coin and currency held by the individual banks on the asset side of the balance sheet.
Required Reserves include coin and currency and reserves held by banks at the Federal
Reserve District banks. Banks cannot lend the required reserves and must keep as
reserves an amount equal to 10% of non-interest bearing deposits liabilities to back up
these bank liabilities. The difference between TR and RR equals excess reserves (ER).
Banks can lend all of their ER positions. Table 1 above provided data on total reserves,
required reserves and excess reserves as determined by the Federal Reserve System.
Table 2 answers the first question posed. That is, is there considerable excess
reserves “trapped” on the balance sheets of individual banks in the US? Yes. The all bank
data indicates that bank reserves or total reserves in Table 2 increased from $70.2 B in
2007 (4) to $569 B in 2008 (4). The majority of this increase, 91% came from deposits at
the Federal Reserve district banks. There has been a shift towards liquidity during the
worst stages of the financial crisis. If we assume the banks must hold approximately 10%
as required reserves to back their deposit liabilities (.10 * $569 B= $56.9 B), we can
estimate $510.2 B in 2008 (4) as excess reserves (ER) for all banks. The excess reserves
11
indicate a significant potential increase in Money Supply if the ER were to be lent out.
However, the ERs have remained on the balance sheets and banks continue to maintain
liquidity. The large ER position for the first 6 months of 2009 in Table 1 clearly shows
that the banking system is holding on to its liquidity. Table 2 also shows the large even
massive increase in some other measures of liquidity. Total cash balances increased from
$525.3 B to $1.1 Trillion over the period and interest bearing cash balances accounted for
most of the increase. As risk increase in the financial crisis, banks hold more liquid
assets.
The FDIC individual bank data set provides a number of categories for the
banking sector. The breakdown by asset size for 2008(4) along with the number of
depository institutions (the total number of depository institutions for 2008 is 8305) for
each asset size is:
1. less than $100 million – 3,131 depository institutions.
2. $100 million to $1 billion – 4,498 depository institutions.
3. $1 to $10 billion – 561 depository institutions.
4. greater than $10 billion – 115 depository institutions.
Table 3 presents the values for some of the variables for the largest asset group compared
to all depository institutions for 2007 (4) and 2008 (4). The data provided a comparative
perspective of the impact of bank size and the change in the selected variables over one
crucial year. The dominance of the largest banks is clear in almost all measurement
variables. This group accounts for 78 % of assets of all banks, 74 % of all deposits and
99.9% of all derivative contracts. For our measures of liquidity, large banks controlled
76% of bank reserves in 2007 and 92 % in 2008 and this group increased their holding of
bank reserves over 40 times compared to 28 times by the entire banking system. It is
important to note that our measure of bank reserves increased from $693.2 B in 2007(4)
to $6,023 B in 2008(4). Finally, the ratio of reserves to transaction account was 91.8%
for the large banks in 2008(4) compared to a ratio of 65% for all banks.
So much data but is it important? YES! The liquidity that is trapped in the
banking system is being held by the largest banks. Why? Loans and leases for large banks
have decreased at double the rate for all banks, -3.0% compared to -1.24% for all banks.
The markets are uncertain at best, many of the assets on the balance sheets of banks have
dropped in market value but remain on the books, short term markets for sources of funds
and long term markets for uses of funds remain uncertain and the large banks remain
cautious. Hence they have rushed to liquidity and are staying there. Too Big To Fail
(TBTF) has taken on a new meaning in current markets and these very large banks want
to maintain liquidity to remain flexible and nimble despite their large and very dense
market footprints.
Tables 4A and 4B provide more evidence of the important influence of the largest
banks. The tables present data for the 25 largest banks in the US for 2007(4) and 2008(4).
These banks controlled approximately 60% of all assets, over 60% of all bank reserves
and between 45% and 50% of all transaction accounts. Transaction accounts represent
48% of M1 money supply, therefore 25 banks control half of all demand deposits and
checkable deposits in the US. The position of these very large financial institutions within
12
our financial markets presents a problem for long term bank stability. It is not just the
size of these banks but it is their interconnectedness. Counterparty risk is created when
the balance sheets of these very large banks are threatened. For our concern, liquidity is
trapped in these large banks and more than likely, the liquidity is used to insure adequate
reserves for all types of financial positions. In effect, for protection against risk, all types
of risk, including default, counterparty, systemic and inflationary risk. While these risks
remain, the large banks do not seem willing to use the reserves to contribute to the
efficient operation of the banking system. In fact, they are inhibiting the efficient
operation of the economy and are increasing the systemic risk for the economy. For 2008,
62.1% of all reserves for the banking system are held by these 25 banks, and that leaves
38.1% of all bank reserves held by the remaining 8,280 depository institutions in the US.
What do these changes in bank reserves say about the existence of the liquidity
trap? Does it exist? Yes. Does it exist for the same reasons that Keynes described over 60
years ago and Minsky and Krugman discuss more recently? Yes, if we mean that
uncertainty is the principal cause for financial institutions to hoard reserves at low
interest rates and not lend them out. However, the financial system that exists today is
very different than that whics existed that any time in our past, even our recent past. Bank
regulations and lack of regulation have contributed but so has the innovation and
globalization of the financial markets. Lending and borrowing still involve the basic
problems of moral hazard and asymmetric information despite all the sophistication of
the financial innovation of the past 20 years. It is this uncertainty that remains the same
when crises arise and it is this uncertainty that results in the liquidity trap and its
implications. We can no longer afford the luxury of considering the liquidity trap as a
hypothetical concept in our macroeconomic theory and policy. The central bank must
consider this liquidity as a restraint to effective easy money policy during recessions, and
an expansionary threat for the excess reserves that remain within the banks with its
potential negative impact on inflation and inflationary expectations. An efficient and
effective financial market cannot function properly with over $700 billion of excess
reserves (see Table 1) on the books of money creating institutions. The financial crisis of
2007-200? will not be over until the liquidity trap is resolved.
Some Preliminary Conclusions
Many questions have been raised in this paper and the purpose was to answer as
many as possible. For summary and conclusions, the questions and the preliminary
answers are provided below.
1. What was different about the growth in total bank reserves over the period
September to December, 2008? The major difference in the growth of total bank
reserves was the dramatic increase in excess reserves over a four month period.
The increase was due to a liquidity crisis for the banks and the efforts by the US
Treasury and the Federal Reserve to pump liquidity into the nation’s banks with
short term interest approaching zero (see Table 1).
2. If liquidity increased, was it trapped and if so, what trapped it? Was cash balances
also trapped? Bank reserves, our measure of liquidity, was trapped because banks
13
experienced a drop in asset prices including loans and leases, public and private
securities and other types of assets. They looked to sell off some of these assets
but given the fall in price they wanted to avoid the loss from a sale at below
original cost. The FRS and the US Treasury purchased some of these assets and
provided banks with the liquidity they needed to conduct their business however
the banks were not willing to resume the level of lending that existed prior to the
crisis.
3. Does the run to liquidity help us understand the financial crisis of 2007-2009?
The run to liquidity was a direct result or consequence of the financial crisis.
Banks have remained in a liquid position through 2009 in order to put their
respective houses in order and stabilize their balance sheets. In the meantime the
US economy continued to worsen after the recession started in the fourth quarter
of 2007.
4. How does the growth in cash balances and bank reserves help us understand the
financial structure of the 21st century in the US and the world? The sophisticated
global financial system was still vulnerable to an asset price bubble despite the
very innovative and exotic financial instruments available. Current domestic
regulation has fallen behind global financial integration leaving our domestic
banks exposed to increasing level of risk. The behavior of banks before and
during the current financial crisis demonstrates that US regulation did not prevent
speculation and excessive leveraging by financial firms. They were unprepared
for the sudden credit crunch and liquidity crisis, and the Fed and the US Treasury
had to create innovative ways to supply liquidity in order to avoid a collapse of
the financial markets. (see Table A1 in the Appendix).
5. How does the liquidity trap show up on the balance sheets of depository
institutions in the US? The Statistics of Depository Institutions data set has 2
components of cash balances that were used to measure bank reserves, currency
and coin at the individual bank and deposit balances at the Federal Reserve
District bank. These components were combined for a total of $569 B in bank
reserves at the end of 2008(4), an increase from bank reserves of $70.2 B in
2007(4). (see Table 2).
6. Can the patterns in cash balances, transactions accounts and bank reserves help us
to understand the causes and consequences of the current financial crisis? Lack of
regulation, the housing bubble, excessive speculation, leveraging and risk all
contributed to the financial crisis. The resulting liquidity trap resulted from the
policy response to the crisis and the banks unwillingness to return to normal
operations in their desire to protect their balance sheets.
7. If the liquidity trap appeared in the balance sheet of depository institutions then
how different was it from former reincarnations of the Keynesian Liquidity Trap?
The liquidity trap of 2008-2009 resulted from the uncertainty in the financial
markets in response to the collapse of business as usual after the housing bubble.
14
However the business as usual in financial markets since 2000 was very different
than during any previous economic downturn including the Great Depression.
Furthermore the role of the largest banks, the large complex financial institutions
(LCFI) in 2009 have become TBTF (too big to fail), required a “bailout” by the
US government and the Federal Reserve System. (See Tables 3, 4A and 4B).
8. Do all banks portray the same characteristics identified as the liquidity trap? What
are the differences, if any, among the individual banks? A review of the all bank
data indicate that smaller banks did not take the risks that the largest banks and
institutions in the shadow banking system undertook. However due to the
integration of the banking system, the interconnectedness and counterparty risk,
the smaller banks were also adversely affected by the financial crisis of 20072009.
9. If the liquidity trap exists, how has it affected individual bank behavior, monetary
policy and bank regulation? Banking regulation was not able to foresee and
appropriately respond to the financial crisis of 2007-2009. There is perhaps
universal agreement, except for the largest banks, that there must be reform in the
current bank regulatory structure. The economic recession that officially began in
the fourth quarter of 2007 is also a response to the collapse of the housing bubble
and the decline in asset prices in general. Interest rates are at an all time low, yet
the Federal Reserve found some innovative ways to inject reserves into the
banking system to encourage lending, however this has not resulted to an increase
in lending and borrowing despite the large amount of excess reserves available.
(See Table 1). The Fed’s monetary policy has been successful in limiting the
damage to the financial markets but it has not as yet been successful in
stimulating private sector spending in the economy.
One of the objectives of the bank research project was to analyze the individual
bank data. Towards this objective, a random sample of 500 banks was drawn for the
individual bank data for 2007(4) and 2008(4). There were considerable data work done
on the new data set and only preliminary analysis was undertaken. The data set proved
more difficult to work with than originally thought and only preliminary data results were
obtained. More analysis on the data set will be done and hopefully more results can be
reported at the conference on October 10, 2009.
Footnotes
1. Federal Deposit Insurance Corporation, Statistics on Depository
Institutions, Quarterly Reports, www.fdic.gov/sdi.
2. Federal Deposit Insurance Corporation, Statistics on Depository
Institutions, Quarterly Reports, www.fdic.gov/sdi .
15
3. Krugman, Paul, The Return of Depression Economics and the Crisis of
2008, Chapter 3, pp 56-76.
4. Federal Deposit Insurance Corporation, Statistics on Depository
Institutions, Quarterly Reports, www.fdic.gov/sdi .The sectors included:
Performance and Condition Ratios, Assets and Liabilities, Total Deposits,
Securities, Loans and Leases, Income and Expenses and Cash Balances.
5. Required reserves must be in the form of vault cash and/or in the form of a
deposit maintained with a Federal Reserve District Bank. See Board of
Governors, Federal Reserve System, Reserve Requirement,
www.federalreserve.gov/monetarypolicy/reservereq.htm.
6. In the FDIC’s SDI database, for the sector Cash and Balances Due, the
variables coin and currency (chcoin) and balances due from the Federal
Reserve Banks (chfrb) are used to measure reserves held by each
depository institution. As of March 2001, depository institutions with less
than $ 300 million in assets (over 6000 in both periods) were no longer
required to provide detailed line items for this sector. Therefore the held
by banks will be underestimated by a relatively small amount.
Sources
1. Acharyu, V.V. and Richardson, M. (editors), Restoring Financial Stability:
How to Repair a Failed System, Hoboken, NJ: John Wiley & Sons, 2009.
2. Barth, J. R., Caprio, G., Levine, R., Rethinking Bank Regulation: Till
Angels Govern, New York: Cambridge University Press, 2008.
3. Board of Governors, Federal Reserve System, Principal Economics
Indicators, Aggregate Reserves of Depository Institutions, August 20,
2009 and various dates, www.federalreserve.gov/releases/h3.
4. Federal Deposit Insurance Corporation, Statistics on Depository
Institutions (SDI) Database, Quarterly Reports, www.fdic.gov/sdi .
5. Federal Deposit Insurance Corporation, Quarterly Banking Profile, 2008,
Volume 2, number 1 and 2008, volume 2, number 1, 2007.
6. Gordon, Robert, Macroeconomics, New York: Pearson Education, Inc.,
10th Edition, 2006.
7. Keynes, John Maynard, The General Theory of Employment, Interest and
Money, New York: Harcourt, Brace, 1936.
16
8. Krugman, Paul, The Return of Depression Economics and the Crisis of
2008, New York:W.W. Norton, 2008.
9. Minsky, Hyman, P., John Maynard Keynes, New York: McGraw-Hill,
2008.
10. Tobin, James, “Liquidity Preference as Behavior Towards Risk”, Review
of Economics Studies, Volume 25, pp 65-86, 1958.
17
18
TABLE 2
MEASURES OF LIQUIDITY FOR ALL BANKS FOR THE PERIOD 2004 T0 2008, MILLIONS OF DOLLARS
$ millions
year
cash balances non-interest interest bearing
currency
cash balances
chbal
chbal
and coin
due from FRB Reserves
chbalni
chbali
chcoin
chbal
chfrb
total
transactions as a percent of transactions
accounts
res
trn
res_trn
chbal_trn chbalni_trn
12/31/2004
421,696
247,270
174,426
36,394
23,001
59,395
756,888
7.85%
55.71%
32.67%
12/31/2005
435,357
301,480
133,877
45,533
19,975
65,508
748,027
8.76%
58.20%
40.30%
12/31/2006
469,913
300,890
169,023
47,274
19,309
66,583
715,868
9.30%
65.64%
42.03%
12/31/2007
524,168
311,059
213,109
51,911
18,299
70,210
707,418
9.92%
74.10%
43.97%
12/31/2008
1,104,808
286,608
818,200
51,468
517,527
568,995
850,200
66.92%
129.95%
33.71%
12/31/2009
percent change
chbal
rate
chbalni
chbali
chcoin
chfrb
res
trn
m1
m2
ust3mon
12/31/2004
-1.07
-13.53
24.32
-12.85
2.98
-7.33
3.37
5.57
4.64
1.37
12/31/2005
3.24
21.92
-23.25
25.11
-13.16
10.29
-1.17
2.03
4.22
3.15
12/31/2006
7.94
-0.20
26.25
3.82
-3.33
1.64
-4.30
0.19
5.02
4.73
12/31/2007
11.55
3.38
26.08
9.81
-5.23
5.45
-1.18
-0.08
5.76
4.35
12/31/2008
110.77
-7.86
283.94
-0.85
2,728.15
710.42
20.18
4.06
6.87
1.37
12/31/2009
19