zaterdag 22 februari 2014

Deposits Over Loans: Excess Reserves

What happened in 2008 was a once in a lifetime event and this is illustrated in the following chart comparison. There was a historic correlation between deposits and loans, but that correlation has broken down since the 2008 financial crisis.

Since 2008, deposits have increased at the banks, but lending by banks has not gone up substantially. All of this money is parked at the Federal Reserve at ultra low interest rates. It is not flowing into the economy and as long as lending doesn't grow, the Fed can't raise interest rates. More so, the Fed can't stop QE until lending goes up substantially.

The difference between the deposits and the loans are the so called "excess reserves". Historically, a high amount of excess reserves will be quite inflationary, the question is when will we see all of this inflation come? When lending finally starts (red curve goes up), inflationary pressures will come. The Federal Reserve will have to sell its bonds and mortgages, reduce its balance sheet to counter this inflation. Or it can raise interest rates. The question is, will they see this coming or not? Will they act appropriately soon enough or be too late to counter inflation? I'm not counting on it, that's why I protect myself against inflation.

As mentioned before, the amount of excess reserves is the difference between deposits and loans and it is shown in the chart below:
As you can see, we had $2.4 trillion in excess reserves in January 2014, which almost matches the amount of money printing or QE from the Federal Reserve. When this trend reverses, it could mean that lending growth has started, that banks are finally using their excess reserves to buy things and that's the moment when we will see the inflation coming. So monitor this chart!

For more info read this article.

(If you're wondering why there is a bleep in 2010, that's the "Financial Accounting Statements No. 166". This new set of rules deals with the way U.S. banks must handle off-balance-sheet vehicles (OBSVs). They needed to bring these off-balance-sheet items back on their books.)

Since 2015: 

Excess reserves at the Fed have been going down as the Fed started to unwind its balance sheet (blue line). But oddly, deposits minus loans at commercial banks were steady flat (red line). Why is this?

Moreover, this means that there are a lot of deposits but not enough loans. Taking into account that the yield curve is approaching zero (green line), banks need to pay the same interest to depositors (short term maturity) as they receive in loan interest (higher maturity), but this needs to be done on more depositors than loans. The net interest margin will drop.

Which means bank profits will be going down while the Fed reduces its balance sheet and its excess reserves. Less excess reserves also means less money being paid by the Fed to the banks via IOER.

When the blue line approaches zero and the red line doesn't, something magical will happen.

You can already see that the net interest margin is going down due to the flattening yield curve.
That little spike higher in 2016 is because of the tax cuts and because of the rising interest on excess reserves (IOER).

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