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What Would the Fed Do if Banks Started Lending, En Masse?

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A scenario analysis that has more relevance than the promised "taper" dominating the news.

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The Fed is holding $3.7 trillion in assets under SOMA (System Open Market Account). The size of SOMA shows the impact of the quantitative easing that financial writers seem to mention each week. As seen in the below balance sheet, this year's increase in assets has been substantial, rising 34%. As with any bank, the Fed has to fund these purchases. And to a large extent, it has funded the expansion of the balance sheet with excess reserves from commercial banks. Note that the actual "cash notes in circulation" has expanded only slightly (7%) as compared to the deposit reserves balance. Most of these deposit reserves are not required reserves – and I have seen estimates that about $100 billion of the $2.3 trillion are "required." The Fed pays interest (albeit meager) on these deposits, and the result is that much of the increased liquidity in the expansion in QE is actually sitting on the balance sheet of the Fed, not in the economy. And while the interest the Fed pays is small (about .25%), it is a lot higher than the banks pay in savings accounts, so the banks aren't losing money on these customer deposits that are parked at the Fed.

Federal Reserve Balance Sheet


(Source. Note: I abbreviated and grouped figures to simplify the presentation.)

Risk management departments of commercial and investment banks are required to run liquidity risk analyses, where we plan for unexpected changes to assets and liabilities, and we use these scenarios to ensure that the bank has funding plans in place to meet any potential shortfalls that may arise . In the case of the Fed, it has many options. Let's look at a scenario that is arguably much more relevant than the "tapering" that seems to dominate the news.

Scenario: Banks Start Lending, En Masse

When a bank makes a loan, it needs to draw cash from somewhere to send it to the borrower. In this analysis, we will recognize that the bank can draw from its reserve balance at the Fed and lend those funds to a customer. Of course, the bank could also attract more deposits, borrow on the interbank market, issue a bond, etc. But the scenario here is that the global economic activity continues to pick up steam, that credit expansion increases, and that, on aggregate, banks are incented to remove their excess reserves and put them to better use.

In general, an increase in bank lending is good for the economy's growth, and it sends a signal of business confidence to consumers and producers. And yet, this "good news" could be challenging to the Fed. Why? Because the Fed needs to do something to raise cash to send to those banks who are removing their excess reserves. Here are some options open to the Fed:
  • Sell Assets – The Fed could sell some of its massive holdings in QE bonds.
  • Print Money – The Fed is the only bank that can literally "mint money" if it needs to.
  • Repo Assets – The Fed could borrow from the interbank market, pledging its bond assets as collateral.
Let's look into these one at a time.

Sell Assets

The Fed has such a major share of the government security market on its balance sheet now that it would immediately impact yields and prices if it were to sell assets in any size. The resulting increase in interest rates would send financial markets into a chill, and the lending that was causing the liquidity crunch would dry up. In short, the economy would have the brakes put back on. This is an unpalatable outcome, especially for a new bank chairperson. In addition, selling assets would mean that the Fed has moved from a tapering to a negative QE, and that seems to be a huge leap from where we are today. There are other assets to sell, like the Fed's gold, but this isn't a likely scenario, and its balance isn't large enough to cover these trillions of dollars of reserves.

Print Money

The Fed could increase the cash in circulation, and this would send another jolt of liquidity into markets which are already flush with cheap funds. Most economic analysis suggests that this action would be highly inflationary, but the Fed has reiterated that it would accept some temporary inflation in return for better employment. So, while this action couldn't fill the entire need, it is a reasonable assumption that some of the shortfall might be met with increased money supply. And since the US dollar has been on an uptrend recently, any dollar weakness that may occur might be tolerated.

Repo Assets

The Fed has been running repos as a test program for a while now, because it seems to be an option to cover the gap that could be created by dwindling reserve deposits. Unfortunately, the Fed and the markets have not really tested how this would work on a large scale – the most recent balance of $160 billion pales in comparison to the $2.3 trillion reserves balance. And if the repos were needed because of increased lending by banks, one may conclude that this newly created borrowing need by the Fed would serve to increase the general level of interest rates, and therefore compete with the customers who were looking for capital. In short, the repos might stem the credit expansion and result in higher rates, again applying the brakes to an economy that is starting to show some gusto. Playing devil's advocate, one could counter-argue that the financial markets are so flush with capital that this increased borrowing would have only a muted effect, and that the stronger economy would outweigh the strain on credit.

Conclusions

Tapering discussions will definitely rile up the markets for a while, but one should not ignore other issues that are residing in our bloated Federal Reserve balance sheet. The reader should be reminded that the balance sheet expansion that has taken place under Chairman Bernanke is unprecedented in modern times. The massive deficit spending that has accumulated over various presidential administrations is also unprecedented in our nation's history. Should credit expansion happen in a meaningful way, it seems logical that this could result in increased money printing and repo activity on behalf of the Fed. The result would be increasing rates, falling USD, and rising inflation – and it may be accompanied by strong GDP growth.

One should not be haughty and expect that there will be no lessons learned from this five-year experiment in using a helicopter of money to avoid an economic depression. Of course there will be unexpected consequences! All that we can do, as investors, is exercise our minds to identify various financial scenarios and the potential implications – that's what risk managers do. Planning and scenario analysis will help an investor react when the actual events unfold, even if they don't play out in the format that we have envisioned.

Don't fight the Fed, but don't be blind to the insidious risks to long-term bonds given the current economic climate. And don't singularly stress about tapering – another risk is that the Fed will have to scramble to accommodate a drawdown in bank reserves in the event that commercial banks actually start lending again!

Editor's note: Edward Hoofnagle, CFA, founded and sold a variety of companies in the technology and consulting industry, and currently manages an investment portfolio of private companies. Ed also provides business advisory services and offers interactive seminars for entrepreneurs and family offices related to financial literacy and charitable planning.
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