Banks Still Growing Cash

New data released late Friday by the Federal Reserve indicate that banks continue to hoard cash and shrink their loan portfolios. Fed geeks will say that this shows that the velocity of money continues to fall.

Loans and leases at the nation's commercial banks decreased for a third week in a row in the week ended March 25, to $7.022, a drop of $23.5 billion, following a $91 billion decline the previous week. Loans have shrunk $264 billion from the peak set in the week ended Oct. 22, 2008. Loan growth had spiked in the weeks following Lehman's collapse, when the commercial paper market essentially shut, forcing issuers to tap their credit lines as a substitution.

The trend reversed when the Fed successfully launched its Commercial Paper Funding Facility, causing the loan tally to shrink. It nonetheless is running about $100 billion above where it was last summer. Moreover, of late there has been substantial issuance of corporate bonds, which means that credit formation exists, albeit too little to produce normal levels of economic growth.

U.S. commercial banks now hold $1.042 trillion of cash, or 8.6% of their $12.1 trillion in assets. That's about well above the roughly $300 billion in cash that banks held for several years leading up to last summer. Cash holdings are likely to increase more in the weeks and months ahead as a result of a further expansion of the Fed's balance sheet resulting from the Term Asset-Backed Securities Loan Facility, or TALF, and the Public-Private Investment Program, or PPIP.

Cash is of course not the same as capital, but if banks felt that the downside risks to their assets were reduced, banks would put the cash to work, expanding bank credit, the money supply and the economy. Remember the rule: Only banks can create money, so it is critically important for banks to remove illiquid assets from their books before they feel comfortable enough to lend. In other words, if the PPIP is successful in removing loans and securities from bank balance sheets, banks will deploy their cash; the velocity of money will increase.