Monday, March 30, 2009

Bank Cash Is Surging Again

The idea that commercial banks are letting sit on their books unusually high cash balances is by now well established. Banks for months have built up large amounts of cash, fearing further losses and marks against their assets. Modifications to the ridiculous m2m rules would help.

Cash balances, which consist largely of vault cash and balances held at the Fed, began moving sharply higher after Lehman fell, which was when the Federal Reserve opened its spigot and injected massive amounts of liquidity into the banking system.

Commercial banks held $300 billion of cash when Lehman fell, the same amount they had held for several years leading up to that point, before a surge took the tally to over $1 trillion, peaking at $1.038 trillion in early January. Cash levels fell to about $800 billion a few weeks ago amid a contraction in the Fed's balance sheet but increased a record $147 billion to $976 billion in the latest week, which was the week ended March 18, new data from the Fed show.

Further increases are likely, owing to the Fed's securities purchase programs--banks hold about 20% of their assets in securities, and the Fed will certainly be buying securities from banks. Cash holdings will increase also because of the term asset-backed securities loan facility, or TALF, and the public-private investment program, or PPIP.

The Fed will eventually find the right number with respect to the amount of money needed to compel banks to lend, but it is a massive amount, given the holes in the credit systemwide. The cash balances remind us that when banks are less fearful of losses, a very large amount of credit can be created - the so-called "multiplier" effect. The money supply will grow much more rapidly when this happens.

Success in removing illiquid assets will help free up some of the cash, but it will take time. Still, keep watching the cash tally, because as it becomes more mountainous, bankers will begin to notice, and the trade-off they are making for safety will slowly give way to a preference for earning the net interest margin on the loans they could be making but aren't out of fear of losses against legacy loans and securities.

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