Fixing the Small Banks

By Warren Mosler*

Fixing the Small Banks

The Obama administration has been preaching the importance of fixing the small banks and getting them lending again. This will review what I see as the critical issue and how to fix it.

First, the answer:

1. The Fed should loan fed funds (unsecured) in unlimited quantities to all member banks.

2. The regulators should then drop all requirements that a % of bank funding be ‘retail’ deposits.

Yes, it is that simple. This simple, easly to implement ‘fix’ will immediately work to restore small bank lending from the bottom up by removing unnecessary costs imposed by current government policy.

The current problem with small banks is their too high marginal cost of funds. The only reason the Fed hasn’t expressed an interest in ‘opening the spigot’ and supplying unlimited funding at its target interest rate to any member bank to bring down this elevated cost of funds has to be a lack of understanding of our banking system.

Currently the true marginal cost of funds to small banks is probably at least 2% over the fed funds rate. This is keeping their minimum lending rates at least that much higher, which also works to exclude borrowers who need that much more income to service their borrowings, all else equal.

The primary reason for the high cost of funds is the requirement for ‘retail deposits’ that causes the banks to compete for a finite amount of available deposits in this ‘category.’ While, operationally, loans create deposits, and there are always exactly enough deposits to fund all loans, there are some leakages. These include cash in circulation, the fact that some banks, particularly large, money center banks, have excess retail deposits, and a few other ‘operating factors.’ This causes small banks to bid up the price of retail deposits in the broker CD markets and raise the cost of funds for all of them, with any bank considered even remotely ‘weak’ paying even higher rates, even though its deposits are fully FDIC insured. Additionally, small banks are driven to open expensive branches that can add over 1% to a bank’s true marginal cost of funds, to attempt to attract retail deposits. So by driving small banks to compete for a limited and difficult to access source of funding the regulators have effectively raised the cost of funds for small banks.

It should be clear my solution would immediately lower the marginal cost of funds for small banks. I’ll now attempt to address the usual host of objections to my proposal.

There are always two fundamentals to keep in mind when contemplating banking with a non convertible currency and floating exchange rate:

1. The liability side of banking is not the place for market discipline.

2. The Fed and monetary policy in general is about prices (interest rates) and not quantities.

Disciplining banks on the liability side has been tried repeatedly and always and necessarily fails. First, it’s fundamentally impractical to the point of ridiculous to expect anyone looking to open a checking account or savings account, for example, to be responsible for analyzing the finances of competing banks for solvency, when even Wall Street analysts can’t reliably do this. The US leaned this the hard way when the banking system was closed in 1934, reopening with Federal deposit insurance for bank deposits for the sole purpose of removing this responsibility from the market place. Regulation and supervision on the asset side then became the imperative. And while we have seen periodic failures due to lax regulation and supervision of the asset side of the US banking system, and it’s a work in progress, the alternative of using the liability side of banking for market discipline exposes the real economy to far more disruptions and far more destructive systemic risk.

Those who understand reserve accounting and monetary operations, including those directly involved in monetary operations at the world’s central banks, have known for decades that in banking, causation runs from loans to deposits, with reserve requirements, if any, being merely a ‘residual overdraft’ at the central bank and not a control variable. This includes Professor Charles Goodhart at the Bank of England, who has written extensively on this subject for roughly half a century, endlessly debating the ‘monetarist’ academic economists who spew gold standard and fixed exchange rate rhetoric, and who are unaware of how monetary operations are altered when there is no legal convertibility of a currency. Recall the ‘500 billion euro day’ back in 2008 when the ECB added that many euro in reserves to its banking system, and a week later the monetarists pouring over the data ‘couldn’t find it.’ The fact that they even looked was evidence enough they had no actual knowledge of reserve accounting and monetary operations. And, more recently, the notion that ‘quantitative easing’ makes any difference at all apart from changes in interest rates (it’s always about price and not quantity) reinforces the point that there is very little understanding of monetary operations and reserve accounting. While Professor Goodhart did declare quantitative easing in the UK a ‘success’ he did so on the basis of how it restored ‘confidence,’ making it clear that there was no actual monetary channel of causation from excess reserves to lending. Banks do not ‘lend out’ reserves. Loans create their own deposits. Total reserves are not diminished by lending. This is operational and accounting fact, and not theory or philosophy.

What this means in relation to my proposal of unlimited lending by the Fed to small banks at its target rate, is that any lending by the Fed will not alter anything regarding lending and the ‘real economy’ in any other regard, apart from the resulting term structure of interests per se. (Also, and not that it matters in any event, total lending by the Fed won’t exceed funds ‘hoarded’ by some banks along with the usual operating factors that routinely ‘drain’ reserves.)

In other words, the notion that this policy will somehow result in some inflationary monetarist type expansion is entirely inapplicable with a non convertible currency and floating exchange rate policy.

The other common concern is the risk to the Fed of lending unsecured to its member banks. However, there is none, if you look at government from the macro level. All bank assets are already regulated and supervised, and the banks are continually subjected to solvency tests. This means government has already deemed to the banks ‘safe to lend to.’ Furthermore, functionally, the fact that banks can indeed fund themselves in unlimited size with FDIC insured deposits means the government already lends to banks in unlimited quantities, protecting itself by regulating and supervising the assets, including asset quality, capital requirements, etc. Therefore, the Fed asking for collateral from its member banks is entirely redundant, as well as disruptive and a cause of increased rates to borrowers.

Conclusion: If the Obama administration had the knowledge, they would immediately move to implement my proposals to support small banking.

*First published on

3 responses to “Fixing the Small Banks

  1. Banks create deposits when they make loans. In fact, they create all the money in existence either through lending or interaction with the government. No money in accounts comes from the Fed and outside of cash for customers the only need for the Fed is for liquidity to settle accounts between banks. The problem banks have with deposits are 2 fold. One, the bank is undercapitalized and thus under reserved. I contend that a bank can't have any more reserves than it has capital. I got some debate on this subject the other day, but if part of the reserve amount is already a portion of the deposit base in that assets minus reserves are less than deposits, then as an entity with insufficient assets other than reserves, the reserves can only be the net worth, which is that way whether the Fed steps in or not. The other problem with deposits is that because banks actually create deposits, the shortage of deposits could actually be a sign the bank is engaging in excessive lending. The problem with deposits only arises when doubts of the banks solvency arises. Citi was one that made excessive loans and failed to attract enough deposits. I understood, though I could be wrong that Citi's funds liability was $400 billion in mid 2007. I commented at that time it was a bomb ready to go off. I actually beat Whitney by several months on that one. That is what reserves are for. A bank should have roughly its net worth in something that would serve as collateral. It hasn't much use for reserves other than to pay other banks for its excessive lending. Most banks make more on loans they make than they would ever pay for reserves in the fed funds market. That is all the purpose they serve is to pay the liabilities of the bank due to lending or to refund money deposited by customers. To enact a system of pushing reserves into small banks would clearly become a moral hazard. Big banks make whopper mistakes, but small banks with an open door of lending make a whole bunch of them. The solution to our current problems is to deflate the debt bubble as soon as possible while attempting to maintain the survival of the population and the country. There are a lot of numbers on financial statements that cannot continue to exist there.

  2. Sorry Mannfm: In Canada, banks hold Zero reserves, but positive capital. I cannot follow your logic. Net worth = Assets less Liabilities. Period.Maybe you would like to propose that banks hold 5% or 10% of assets in "reserves" or "govt bonds" or something else. Fine. But there is no accounting that will automatically result in the conclusion that Reserves = Capital. LRWray

  3. I have done much research and the argument is shaky on two grounds. First over my lifetime the smallest of banks usually depend on networks of larger banks, wealthy individual partners or finance groups to secure thier stabilization funding. Was it not Marx that showed within the cycle of these crisises that large banks will seek to absorb small banks? This type of consolidation is evident, especially recently. My own family is involved with two different small regional banks, due to recent legislation and economic conditions, they are considering selling out to the larger banks in the area that are known to lend dramatically less. The second argument I have for your proposal is that your idea does not consider all of the facts. You relate the issue of lending as only a bank issue. My personal research has been a veritable boom lately. That is specifically, CREDIT UNIONS. At no other time in history have credit unions been filling this void. The amount of assets may not seem large by your standards, but the amount of accounts opened, show that this trend has the potential to balloon. Over the past 5 to 6 years, I have detailed studies that show over 120 out of 200 credit unions have grown by over 35% per year. The idea that banks are our source of monetary generation needs to be redefined. The spreading between rates is now growing significant, the availability to join is easy, and the locations, services, and ammenities are a real challenge hard to ignore.