Why aren’t banks lending to local businesses? The Fed’s decision to pay interest on $1.6 trillion in “excess” reserves is a chief suspect.

 Where did all the jobs go? Small and medium-sized businesses are the major source of new job creation, and they are not hiring. Startup businesses, which contribute a fifth of the nation’s new jobs, often can’t even get off the ground. Why?

 In a June 30 article in the Wall Street Journal titled “Smaller Businesses Seeking Loans Still Come Up Empty,” Emily Maltby reported that business owners rank access to capital as the most important issue facing them today; and only 17% of smaller businesses said they were able to land needed bank financing. Businesses have to pay for workers and materials before they can get paid for the products they produce, and for that they need bank credit; but they are reporting that their credit lines are being cut. They are being pushed instead into credit card accounts that average 16 percent interest, more than double the rate of the average business loan. It is one of many changes in banking trends that have been very lucrative for Wall Street banks but are killing local businesses.

 Why banks aren’t lending is a matter of debate, but the Fed’s decision to pay interest on bank reserves is high on the list of suspects. Bruce Bartlett, writing in the Fiscal Times in July 2010, observed:

Economists are divided on why banks are not lending, but increasingly are focusing on a Fed policy of paying interest on reserves — a policy that began, interestingly enough, on October 9, 2008, at almost exactly the moment when the financial crisis became acute. . .

Historically, the Fed paid banks nothing on required reserves. This was like a tax equivalent to the interest rate banks could have earned if they had been allowed to lend such funds. But in 2006, the Fed requested permission to pay interest on reserves because it believes that it would help control the money supply should inflation reappear.

. . . [M]any economists believe that the Fed has unwittingly encouraged banks to sit on their cash and not lend it by paying interest on reserves.

 At one time, banks collected deposits from their own customers and stored them for their own liquidity needs, using them to back loans and clear outgoing checks. But today banks typically borrow (or “buy”) liquidity, either from other banks, from the money market, or from the commercial paper market. The Fed’s payment of interest on reserves competes with all of these markets for ready-access short-term funds, creating a shortage of the liquidity that banks need to make loans.

 By inhibiting interbank lending, the Fed appears to be creating a silent “liquidity squeeze” — the same sort of thing that brought on the banking crisis of September 2008. According to Jeff Hummel, associate professor of economics at San Jose State University, it could happen again. He warns that paying interest on reserves “may eventually rank with the Fed’s doubling of reserve requirements in the 1930s and bringing on the recession of 1937 within the midst of the Great Depression.”

 The Travesty of the $1.6 Trillion in “Excess Reserves”

 The bank bailout and the Federal Reserve’s two “quantitative easing” programs were supposedly intended to keep credit flowing to the local economy; but despite trillions of dollars thrown at Wall Street banks, these programs have succeeded only in producing mountains of “excess reserves” that are now sitting idle in Federal Reserve bank accounts. A stunning $1.6 trillion in excess reserves have accumulated since the collapse of Lehman Brothers on September 15, 2008.

 The justification for TARP — the Trouble Asset Relief Program that subsidized the nation’s largest banks — was that it was necessary to unfreeze credit markets. The contention was that banks were refusing to lend to each other, cutting them off from the liquidity that was essential to the lending business. But an MIT study reported in September 2010 showed that immediately after the Lehman collapse, the interbank lending markets were actually working. They froze, not when Lehman died, but when the Fed started paying interest on excess reserves in October 2008. According to the study, as summarized in The Daily Bail:

. . . [T]he NY Fed’s own data show that interbank lending during the period from September to November did not “freeze,” collapse, melt down or anything else. In fact, every single day throughout this period, hundreds of billions were borrowed and paid back. The decline in daily interbank lending came only when the Fed ballooned its balance sheet and started paying interest on excess reserves.

 On October 9, 2008, the Fed began paying interest, not just on required bank reserves (amounting to 10% of deposits for larger banks), but on “excess” reserves. Reserve balances immediately shot up, and they have been going up almost vertically ever since.

 By March 2011, interbank loans outstanding were only one-third their level in May 2008, before the banking crisis hit. And on June 29, 2011, the Fed reported excess reserves of nearly $1.57 trillion – 20 times what the banks needed to satisfy their reserve requirements.

 Why Pay Interest on Reserves?

 Why the Fed decided to pay interest on reserves is a complicated question, but it was evidently a desperate attempt to keep control of “monetary policy.” The Fed theoretically controls the money supply by controlling the Fed funds rate. This hasn’t worked very well in practice, but neither has anything else, and the Fed is apparently determined to hang onto this last arrow in its regulatory quiver.

 In an effort to salvage a comatose credit market after the Lehman collapse, the Fed set the target rate for Fed funds – the funds that banks borrow from each other — at an extremely low 0.25%. Paying interest on reserves at that rate was intended to ensure that the Fed funds rate did not fall below the target. The reasoning was that banks would not lend their reserves to other banks for less, since they could get a guaranteed 0.25% from the Fed. The medicine worked, but it had the adverse side effect of killing the Fed funds market, on which local lenders rely for their liquidity needs.

 It has been argued that banks do not need to get funds from each other, since they are now awash in reserves; but these reserves are not equally distributed. The 25 largest U.S. banks account for over half of aggregate reserves, with 21% of reserves held by just 3 banks; and the largest banks have cut back on small business lending by over 50%. Large Wall Street banks have more lucrative things to do with the very cheap credit made available by the Fed that to lend it to businesses and consumers, which has become a risky and expensive business with the imposition of higher capital requirements and tighter regulations.

 In any case, as noted in an earlier article, the excess reserves from the QE2 funds have accumulated in foreign rather than domestic banks. John Mason, Professor of Finance at Penn State University and a former senior economist at the Federal Reserve, wrote in a June 27 blog that despite QE2:

 Cash assets at the smaller [U.S.] banks remained relatively flat . . . . Thus, the reserves the Fed was pumping into the banking system were not going into the smaller banks. . . . [B]usiness loans continue to “tank” at the smaller banking institutions.

 Local Business Lending Depends on Ready Access to Liquidity

 Without access to the interbank lending market, local banks are reluctant to extend business credit lines. The reason was explained by economist Ronald McKinnon in a Wall Street Journal article in May:

Banks with good retail lending opportunities typically lend by opening credit lines to nonbank customers. But these credit lines are open-ended in the sense that the commercial borrower can choose when—and by how much—he will actually draw on his credit line. This creates uncertainty for the bank in not knowing what its future cash positions will be. An illiquid bank could be in trouble if its customers simultaneously decided to draw down their credit lines.

If the retail bank has easy access to the wholesale interbank market, its liquidity is much improved. To cover unexpected liquidity shortfalls, it can borrow from banks with excess reserves with little or no credit checks. But if the prevailing interbank lending rate is close to zero (as it is now), then large banks with surplus reserves become loath to part with them for a derisory yield. And smaller banks, which collectively are the biggest lenders to SMEs [small and medium-sized enterprises], cannot easily bid for funds at an interest rate significantly above the prevailing interbank rate without inadvertently signaling that they might be in trouble. Indeed, counterparty risk in smaller banks remains substantial as almost 50 have failed so far this year.

The local banks could turn to the Fed’s discount window for loans, but that too could signal that the banks were in trouble; and for weak banks, the Fed’s discount window may be closed. Further, the discount rate is triple the Fed funds rate.

As Warren Mosler, author of The 7 Deadly Innocent Frauds of Economic Policy, points out, bank regulators have made matters worse by setting limits on the amount of “wholesale” funding small banks can do. That means they are limited in the amount of liquidity they can buy (e.g. in the form of CDs). A certain percentage of a bank’s deposits must be “retail” deposits – the deposits of their own customers. This forces small banks to compete in a tight market for depositors, driving up their cost of funds and making local lending unprofitable. Mosler maintains that the Fed could fix this problem by (a) lending Fed funds as needed to all member banks at the Fed funds rate, and (b) dropping the requirement that a percentage of bank funding be retail deposits.

Finding Alternatives to a Failed Banking Model

Paying interest on reserves was intended to prevent “inflation,” but it is having the opposite effect, contracting the money and credit that are the lifeblood of a functioning economy. The whole economic model is wrong. The fear of price inflation has prevented governments from using their sovereign power to create money and credit to serve the needs of their national economies. Instead, they must cater to the interests of a private banking industry that profits from its monopoly power over those essential economic tools.

Whether by accident or design, federal policymakers still have not got it right. While we are waiting for them to figure it out, states can nurture and protect their own local economies with publicly-owned banks, on the model of the Bank of North Dakota (BND). Currently the nation’s only state-owned bank, the BND services the liquidity needs of local banks and keeps credit flowing in the state. Other benefits to the local economy are detailed in a Demos report by Jason Judd and Heather McGhee titled “Banking on America: How Main Street Partnership Banks Can Improve Local Economies.” They write:

Alone among states, North Dakota had the wherewithal to keep credit moving to small businesses when they needed it most. BND’s business lending actually grew from 2007 to 2009 (the tightest months of the credit crisis) by 35 percent. . . . [L]oan amounts per capita for small banks in North Dakota are fully 175% higher than the U.S. average in the last five years, and its banks have stronger loan-to-asset ratios than comparable states like Wyoming, South Dakota and Montana.

Fourteen states have now initiated bills to establish state-owned banks or to study their feasibility. Besides serving local lending needs, state-owned banks can provide cash-strapped states with new revenues, obviating the need to raise taxes, slash services or sell off public assets.


Ellen Brown is an attorney and president of the Public Banking Institute, http://PublicBankingInstitute.org. In Web of Debt, her latest of eleven books, she shows how the power to create money has been usurped from the people, and how we can get it back. Her websites are http://webofdebt.com and http://ellenbrown.com.

21 Responses

  1. Sounds like the Fed needs to quit paying interest on the deposits, but the banks would probably find some other way to avoid lending regardless. All the more reason for states to set up alternative systems.

    • Looks like the Fed is purposely suppressing the real economy in the interests of its big bank clientele. The Fed has a dual mandate: to prevent inflation and to promote full employment. Why does it ignore the full employment part? It certainly shows that the Fed serves private interests only.

      If the Fed were to suddenly see the light, it could easily reverse its policies and force the banks to start lending again. It could, for instance, create negative interest on reserves, as someone suggested recently:

      “So now the Fed must find a way to drive the banks out of reserves and into loans. It can do this in several ways. One is to increase the creditworthiness of borrowers. But since all things are relative, one can adjust the other side of the equilibrium and make those borrowers look much better by creating negative rates on reserves . . .
      There will be great headwinds against this, from the recently enriched from the financial bubble who wish to keep what they have gained against all consequences. And so the push for austerity.”
      Of course this is wishing for something so unlikely that it’s as good as impossible, expecting a hardened criminal turn into a saint.
      The state bank idea — working from the bottom up to improve credit for small business and thus improve employment — is much more likely to work, as it is already working in North Dakota.

  2. Is there any way to determine what percentage of the government’s money is flowing through the Fed and what percentage of the money is bank money, or is it so tangled as to be an impossible task to separate the two accounts? i would love to see a flow chart and more charts and graphs describing this. Commentators are suggesting that Obama should follow Ross Perot’s lead and bring out the pie charts. Not a bad idea. The public hasn’t a clue as to what the Fed is doing and many in Congress could use a lesson as well. Requiring an annual report from the Fed would be a good start on the road to transparency.

  3. The REAL reason the banks aren’t lending is that Obama is standing up to Netanyahu and trying to settle the Israeli-Palestinian question.
    The Rothschilds don’t want to settle the question. Jimmy Carter tried it, so the Rothschilds raised the interest rate to 22% to embarass Carter. It worked and Carter lost. The Rothschilds want to keep the economy down so as to get rid of Obama. But Americans just are too
    ignorant of what is going on in the real world to do something about it.
    How can you throw off your chains if you don’t even know who your masters are?
    The only person who is even willing to stop the control of the Rothschilds over our country is RON PAUL.

  4. The insanity is this: we don’t have a stand alone money but instead are completely dependent on a banking system which creates credit out of nothing at interest rates determined by a central committee of so-called experts.

    Divide the total amount of U.S. fiat currency by the inventory of gold held by the Federal Reserve banking cartel to arrive at a fixed definition of the dollar as a unit of weight in gold, prohibit fractional-reserve lending of that dollar, and lend only from previous savings of that dollar at interest rates that are allowed to freely fluctuate in capital markets.

    They want you to believe monetary policy is rocket science because the present system rewards fraud and those that thrive by fraud. An honest money is simple to achieve: you start by being honest with yourself and your fellow man.

    • To do this we would need to follow Ron Paul’s call to audit the Fed and see if they really have the gold. Maybe they don’t. Read Ellen Brown’s Web of Debt to see why the gold-based system didn’t work and was predominantly fiat anyway because of the fractional reserve system. And, as Ellen Brown also tells us in Web of Debt, money is really only credit, an accounting system, and does not need to be based on a commodity to be honest. The tally stick system of old England and the govt. issued script of the American colonies of Ben Franklin’s time worked extremely well. If money is spent into the economy by government as needed for commerce rather than doled out by private bankers so they can produce booms and busts for their own gain, all is well.

  5. […] 6. Implement state banks like North Dakota. […]

  6. The real reason why we have no true economic growth in key inflationary markets like food and en……

    Its time for the USA to Isolate from the world let them Secure themselves feed themselves supply their own needs and we the people in the USA do the same . NO MORE FREE Markets END the WTO and all Trade . America can feed itself and supply all its own …

  7. Is the fear of worldwide Overpopulation by the global elite driving the collpase of the global ma……

    Is the fear of worldwide Overpopulation by the global elite driving the collpase of the global markets ability to expand and grow ? THIS looks like a financial district thats sure lost its will to Invest in economic growth policies , Obviously we are n…

  8. Is the fear of worldwide Overpopulation by the global elite driving the collpase of the global ma……

    Subject: here is what is really Driving the Islamic Movement in the USA , and How Obama will win the 2012 Election  here is what is really Driving the Islamic Movement in the USA , I think Obama has promised them this Fundamental transformation . And t…

  9. Is the fear of worldwide Overpopulation by the global elite driving the collpase of the global ma……

    An Idea to Boost the Economic Recovery faster right now and stop the trend towards SERFDOM in America . This will Increase Redistribution of the Retail markets Wealth and do it in a way that will Increase tax revenues and Give People a broader sense of…

  10. Is the fear of worldwide Overpopulation by the global elite driving the collpase of the global ma……

    When I look at this it looks like the Elite Globalists are Rat Holing to Cash of the worlds bailout and stimulus funds so what are they planning for ???  The Looting Of America: The Federal Reserve Made $16 Trillion In Secret Loans To Their Bankster Fr…

  11. Ms. Brown, I hope my webpage http://www.planmon.webs.com will prove valuable to your efforts. It is about money, banking, the fraccional reserve system and the value and logic of government issued, debt free money. Here are some exerpts.

    “So, here we are again hearing the banker think to himself: “If my monetary base is 1,000,000, and 10% is my fractional reserve, I divide 1,000,000 by 10% giving me 10,000,000. That means I can lend 10,000,000 if my fraction in my ‘fractional reserve’ is 10%. But, if I raise the fraction to 20% then I can only multiply by 5 because 1,000,000/.2 = 5,000,000. Ok. But I’ve seen what happens if I make the money supply shrink.”

    “People stop buying and get unemployed. Aha, but that benefits me too, because I have the mortgages. If they’re unemployed and can’t pay they’ll turn over their deeds, titles and all the other liens and I’ll get more than 5,000,000 worth of real values from the time, effort, and energy that they used to create real values from money I created out of thin air. And, to make sure that happens quickly, I can double the interest rate and still have the same interest income coming in to me. So, I get 5,000,000 worth of values out of the 1,000,000 of other peoples gold.”

    It is in Spanish and in English. On the upper left of the page is the link to the version in English.

  12. Ellen you wanted evidence? Confirmed:

    “Securities purchased (and sold) by the Fed, for example, could be absorbing assets that were held by the non-bank private sector or by the banking system itself.”

    But the Fed’s research staff missed the corollary – IOeR’s “could be absorbing assets that were held by the non-bank private sector or by the banking system itself.”

    Click to access ennis_wolman.pdf


    IOeR’s induce dis-intermediation where the financial intermediaries shrink in size — but the commercial banking system stays the same). But the Research Department at the Federal Reserve Bank of Richmond didn’t understand the implications of their comments.

  13. IOeRs (inter-bank reserve balances), are a credit control device. IOeRs’ are the functional equivalent of required reserves (by increasing the volume of un-used excess reserves outstanding [the ratio of reserves to deposits], the BOG reduces the CB system’s lending capacity).

    IOeRs are used to monetize debt, & to absorb CB deposit liabilities (offsetting any expansion of Reserve Bank credit on the asset side of its balance sheet, e.g., the expansion its liquidity funding facilities). An increase in Fed’s liabilities (IOeR’s), in effect sterilized (QE1’s & QE2’s) assets purchases (Treasury securities, agency debt, or agency MBS). I.e., IOeR’s sterilize open market operations of the buying type. IOeR’s are contractionary.

    SEE: Negating the Inflation Potential of the Fed’s Lending Programs

    Click to access ES0930.pdf

    According to FRBNY’s William Dudley, monetary policy seeks “an IOeR rate consistent with the amount of required reserves, money supply (bank credit proxy), and commercial bank credit outstanding”.

    A downward adjustment of the remuneration rate would “release” excess reserve balances. As IOeR’s are bank earning assets, changing the remuneration rate vis a’ vis other competitive ROIs, would necessitate changing the bank’s investment/loan portfolio. And when CBs loan or invest with the non-bank public, they acquire title to new earning assets by the creation of an equal volume of new money — somewhere in the banking system.

    As of May 2 excess reserve balances stood @ $1,457,763 trillion. If the remuneration rate was re-set to zero, the inherent alteration in the composition of bank earning assets would create a concomitant volume of new money. Even if the member banks exploited a small proportion of their excess reserve balances, the inflationary impact would be unacceptable.

    The BOG’s new policy tool, IOeRs, are not just a contractionary open market device for conducting monetary policy within the CB banking system; IOeRs exert a profoundly deflationary force (a cessation of the circuit income & transactions velocity of funds), in both the highly interdependent domestic, & global economies.

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