Over many years of QE, the U.S. Fed has bought bonds to regulate interest rates, and in turn influence lending/borrowing conditions. More loans are meant to stimulate risk taking, investment and business growth.

But what happens when banks have had their fill of risky loans?

They park money with the Fed. They usually have to park a required level of reserve with the Fed, but it’s not a lot, so excesses above these required reserves are unsurprisingly called excess reserves.

In Europe, much the same occurred after the GFC. If judged too risky, loans were passed on in favour of parking the excess with the ECB.

But Mario Draghi did not like this and felt that banks should lend, not park. So, his response was to introduce a levy such that the actual deposit rate on those funds went negative. This created a negative interest rate and a deterrent for leaving money with the ECB. That said, as risk increased, many banks chose to pay the penalty, feeling they would still have more money left in the future than if they were to lend to risky businesses.

This should not be confused with negative bond yields, which also existed at the time, and still exist in Europe.

Back to the U.S., and the situation in March was that required reserves sat at ~$215 billion.

But as part of the overall COVID-19 stimulus, the Fed reduced the required reserve ratio for all banks, to zero.

Go out and lend!

You can see that in the chart below where the blue line hits the ‘x’ axis at zero, in April.

But even with those great intentions, excess reserves in respect of which the Fed pays interest at around the same rate that banks lend to other banks, shot up to $2.89 trillion.

Is there any wonder why?

And from there, excess reserves increased and have settled at ~$3.17 trillion, on last read.

But was Draghi’s method any better? That is, charge a levy and/or turn the deposit return negative to dissuade excess deposits and get more credit out into the real economy?

Or, on the other hand, are excess reserves a good thing as they can be seen as dry powder in the event of a crisis, and can be held back from creating more zombie corporations?

Hard to know which is better, but in any event this dry powder is not hitting the real economy.

It is low velocity money caught in a revolving door of low debt productivity.

Given the U.S. Fed is the bond buyer of first resort and the guarantor of last resort (including government and corporate paper), and because it seems like banks would prefer to park money than lend it, why have banks?

You could be forgiven for thinking that the banking system is about to be nationalised.

Stay safe, and stay tuned.

Mike.

NextLevelCorporate is a leading independent strategic corporate advisory firm with a multi-decade track record of delivering transformative corporate finance solutions, in and out of Australia.