Tuesday, March 25, 2008

Banks Raising Reserve Ratios

This article gets at the heart of the issue with a financial crisis - banks horde cash. So how does this work without our model of the money market and the IS/LM?

2 comments:

Anonymous said...

This article “Hoarding by banks strokes fears in credit crisis” tells the ongoing credit crisis where central banks are making all efforts to minimize the strains in the money market. Central bank’s efforts to ease strains in the money markets are failing to stop financial institutions from collecting cash, fuelling up fears that the recent relief in equity markets may not signal the end of the credit crisis. Bank’s borrowing costs, a sign of their willingness to lend to each other, in the US, Euro-zone and the UK have risen again, despite the Federal Reserve’s unprecedented activity in lending to retail and investment banks.

The banks’ borrowing costs reflect a sign of their willingness to lend to one another. The money markets are still on edge although they are showing new signs of optimism. The US housing prices are falling at the fastest rate ever recorded. This is the worst that it has been for thirty five years. Back in London, the Bank of England has faced criticism for not being as proactive as the other banks. In the UK, the 3-month LIBOR has reached a level above 6%, its’ highest of the year. This is the highest rate of the year and is almost .9 percentage points above the level the investors ask for risk-free money. In the past a spread this high led to central bank interventions in September and December.

The European Central bank had allocated €216bn ($337bn) in the seven-day funds for a regular weekly operation which is about €50bn higher than the projected amount estimated. The Term Auction Facility is the Fed’s latest way to lend to banks was rather heavy in demand and was receiving bids for $88.9bn compared to the $50bn on offer, an excess of demand prior to the previous auction two weeks ago before the collapse of Bear Stearns. In Europe the FTSE 100 gained 3.5%, closing 193.9 points higher at 5,689.1, while the FTSE Eurofirst 300 rose 3.1% to close at 1,266. In Asia, Japan’s Nikkei 225 closed up 2.1% while the Hang Seng in Hong Kong rose 6.4%.

The rises were followed by strong gains on Monday. The United States revised a JPMorgan offer for Bear Stearns. The ending close for the S&P index was also up .23% while earlier gains striped by further evidence of the credit crisis sending the US economy into a deep recession. The consumer confidence greatly decline to a five-year low in March while US home prices fell dramatically in January. The Conference Boards confidence index fell from 76.4 in February to 64.5 this March. Consumers have very little hope about the future business conditions and the job market. This suggests that the economic conditions will get much worse before it gets better. Those hopes were raised on Monday when data showed that sales of previously owned homes rose for the first time in seven months in February.

Banks are required to have a reserve ratio of cash to total deposits to meet customer cash needs and honour cheques deposited at other banks. In many countries, this reserve is fixed by law, typically 10 percent, and must be deposited by commercial banks at the Central Bank. These “reserves” deposited with the central bank together with the Central Bank’s “vault cash” form what is called the monetary base, often referred to as "high powered money" The Central Bank acts as banker for the commercial banking sector as well as for the Treasury, which also holds cash at the Central; Bank. So “high powered money” also includes any cash reserve held by the Treasury at the Central Bank. Reserves and cash reserves (and vault cash) held at the Central Bank. It should be apparent that for any value of the reserve ratio less than one, the money multiplier expression is greater than one; ie, an increase in high-powered money will change the total money supply by a multiple of that increase. Thus, if the Central Bank wants to affect the money supply, it can either alter the supply of high-powered money or change the value of the money multiplier by changing the legal minimum reserve ratio of the commercial banks.

Mz_Virtue said...

In the post "Banks Raising Reserve Ratios", it illustrates the balancing act of the Federal Reserve and how they must pursue a slow economic growth enough to prevent inflation without triggering a recession. Consumers have very little hope about the future business conditions and the job market. This suggests that the economic conditions will get much worse before it gets better. Banks in temporary distress can borrow short term funds directly from a Federal Reserve Bank discount window at the discount rate. While the Fed has the power to independently set the discount rate directly and keep the Fed funds rate on target indirectly through open market operations, the impact of short-term rates on monetary policy implementation has been diluted by long-term rates set separately by deregulated global market forces. When long-term rates fall below short-term rate, the inverted rate curve usually suggests future economic contraction. Concerns grew that the Federal Reserve may not be able to prevent the credit slump from worsening and that contagion was spreading into the safest pockets of the US credit universe, leading to further large-scale write-downs. The financial problems may be so vast that we are now in an era of high debt. But money can be and is created by all debt issuers, public and private, in the money markets, many of which are not strictly regulated by government. While a predominant amount of global debt is denominated in dollars, on which the Fed has monopolistic authority,
After months of denial to sooth a nervous market, the Federal Reserve, the US central bank, finally started to take increasingly desperate steps in a series of frantic attempts to try to inject more liquidity into distressed financial institutions to revive and stabilize credit markets that have been roiled by turmoil and to prevent the home mortgage credit crisis from infesting the whole economy. Yet more liquidity appears to be a counterproductive response to a credit crisis that has been caused by years of excess liquidity. A liquidity crisis is merely a symptom of the current financial malaise. The real disease is mounting insolvency resulting from excessive debt for which adding liquidity can only postpone the day of reckoning towards a bigger problem but cannot cure. Further, the market is stalled by a liquidity crunch, but the economy is plagued with excess liquidity. What the Fed appears to be doing is to try to save the market at the expense of the economy by adding more liquidity.