Prof. Higgs doesn’t quite solve the puzzle
Prof. Bob Higgs has a very interesting article that tries to unravel the puzzle of “Hyperinflation” or the lack thereof. Here is the most interesting part of the article.
The preceding combination of events poses a great challenge to economic analysts. How can we explain that the fantastically enormous explosion of bank reserves has not given rise to bank lending that would greatly expand the money stock and thereby drive up prices in general?
The most obvious answer, of course, is that the banks are simply sitting on the reserves, rather than lending them to customers. And why are they doing so? The usual answer is that since late 2008, the Fed has paid the banks a rate of interest on their reserves at the Fed. This interest rate has recently been in the range 0-0.25 percent. Although this is not nothing, it verges very closely on nothing. And if one notes that the purchasing power of money has fallen at least a bit, it is clear that the banks are realizing a negative real rate of return on their holdings of excess reserves at the Fed.
Moreover, they are doing so notwithstanding that they appear to have the option of lending at 3.25 percent to their best corporate customers and at higher rates to their less creditworthy customers. Why are they forgoing the opportunity to earn huge sums by switching out of excess reserves at the Fed into commercial loans and investments? The answer would seem to be that that are so frightened of the risk associated even with loans to their best customers that they are loath to lend. After some volatility up and down and then up again between the summer of 2008 and early 2010, total loans and investments of all commercial banks have settled for more than a year at a level only about 2 percent greater than their level at the beginning of 2008. This increase of about $200 billion amounts to only a small fraction, about 13 percent, of the increase in their excess-reserve balance at the Fed during the same period.
I think this analysis completely misses the point. Let’s take a look at the bank capital requirements for various types of loans.
Cash and equivalents weight = 0
Government securities weight = 0
Interbank loans weight = 0.20
Mortgage loans weight = 0.5
Ordinary loans: weight = 1.0
Standby letters of credit weight = 1.0
You will see that Cash and equivalents have a capital requirement of zero, whereas for ordinary loans and letters of credit requirement is 100%.
So for a Bank of Bailout that issues corporate loan at the rate of 3.25% to Too Big to Fail Inc. has to keep 100% of that loan as reserve capital. If BoB loans out $100,000 to TBF Inc, therefore earns $3250 in interest that year, ROE = 3250/100,000 = 3.25%. This is assuming, cost of capital is 0%, which I think is a reasonable assumption because they can borrow at 0% from the fed.
Now what happens if BoB lends this $100,000 borrowed from the Fed at 0% and lends it to another bank at 1 year LIBOR rate of 0.73%. Bank is required to keep 20% in reserves, or $20,000. What would be the ROE in this case? 730/20,000 = 3.65%. A better return than lending to ABC corporation.
What if the bank lends this $100,000 right back to the Fed? It earns $250 from the lending and it still has the $100,000 dollars that it would have had to keep in equity(reserves) if it had lent it to TBF Inc. Equity for this type of loan is 0%, therefore ROE is infinite. This is why Banks have no incentive to lend to TBF Inc.