Wednesday, October 8, 2008

Let's all bank directly with the Fed

The US Fed has now started paying interest on bank reserves. This is quite an innovation. It shows that the Fed is prepared to use all the tools necessary to jump-start liquidity and inter-bank lending.

The reserve requirement is supposed to be the Fed tool for controlling the growth of money supply. The reserve acts as sort of tax to banks, and a high reserve requirement impedes banks from lending out 100% of their deposits, thereby slowing down the velocity of money.

By paying interest on all bank reserves placed with the Fed, the Fed is now using the reserve as a way to mop up excess liquidity from the financial system. In normal times, this ensures that its policy rates will be uniformly followed throughout all lending channels. In today’s credit contraction environment, this allows the Fed to collect the excess liquidity that is otherwise not being lent out by banks, and use it to lend to those banks needing Fed loans. By using the liquidity that is already out there, but trapped within each bank, it minimizes the Fed’s need to increase money supply every time a bank uses the discount window. Voila, the Fed is now the conduit bringing back inter-bank lending. Well, that’s how I understand the implied objective

Now, the Fed is also said to already be buying commercial papers. It is jumping into the market because banks are now hoarding capital, and are reluctant to lend money out at any cost. It is also being asked to guarantee all inter-bank lending, also with the aim of jumpstarting a non-existent inter-bank credit market.

Well, well.

If only the Fed would start issuing credit cards and offering mortgage loans and commercial loans, it will start making sense for everybody to bank directly with the Fed. It seems much more efficient, given the reality we are seeing now. What do we need all these other banks for?

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