How Cash Makes the 'Bad Bank' Plan Work

There has been a massive increase since August in the amount of cash held by U.S. commercial banks, a product of injections of cash into the banking system via the TARP and the Federal Reserve's creation of money. These injections have occurred against a backdrop of cautiousness among bankers who are rationally worried about further downward marks against their assets. Banks would more likely use their cash to increase lending if they worried less about their marks, and that is why the idea of corralling the assets is appealing.

Lending has the potential to increase substantially, because cash balances have increased from $800 billion to $1.1 trillion since August, an amount that using the standard multiplier could be turned into $8 trillion of bank credit. Obviously, this won't happen, but the point is that current cash levels are substantial enough to, at the minimum, normalize growth in bank credit.

An added force is the Federal Reserve's interest rate policy, which has driven yields on Treasury, agency and mortgage-backed securities to levels that are below the net interest margins that banks could earn on new loans. This is certainly the case for cash holdings, which, because of the Fed's "curse on cash," are earning banks next to nothing.