I have written frequently about the massive expansion of the adjusted monetary base that has occurred over the last 5 years.  I have also written about the corresponding increase in excess reserves held by banks.  But I have only touched on some of the reasons on why we have seen a huge increase in the excess reserves.

I recently wrote a post about the excess reserves and how these are deposits that are available to depositors.  The excess reserves are technically not “owned” by the banks in most cases.  I received the following comments/ questions to that post:

“Why are the banks not lending money out?  Fractional-reserve banking is the biggest scam ever and the banks make a ton of money off of it.  So, why no lending?  Too risky?  Rates are too low to make it worthwhile?  The Fed is pressuring them not to lend because it is worried that increased velocity will cause price inflation?”

I don’t have all of the answers to these questions, but I have some guesses about what is happening.  First, I would say that fractional reserve banking is only the biggest scam ever because it is fully backed by the government and the Fed.  If there was no FDIC and no expectations of bailouts, then fractional reserves would not be a major problem, or at least not compared to what it is now.

Second, the comment did not mention anything about the Fed paying interest on the excess reserves.  I only mention this because a lot of people think that this is a big factor in the buildup of reserves.  However, I think the commenter here is on target for ignoring this.  The Fed is only paying .25 percent interest on reserves.  This is practically nothing and is not much of a deterrent for banks to lend.

Third, the last sentence/ question may be on the mark, but we can’t know for sure.  “The Fed is pressuring them not to lend because it is worried that increased velocity will cause price inflation?”  I have thought for a while now that the Fed likes what the banks are doing.  The Fed can say things and pretend that they want to encourage more credit and lending, but having these massive excess reserves is what allows the Fed to keep creating massive amounts of money while keeping price inflation relatively low.

So it is impossible to say if the Fed is telling the banks not to lend behind closed doors.  The Fed is buying $40 billion per month in mortgage-backed securities, which is essentially a bank bailout.  It would not be surprising if the Fed were calling the shots, at least with the major banks.

With all of that said, it does make some sense why the banks have built up huge reserves, even if the Fed weren’t instructing them to do so.  While the recession ended officially, it is obvious that the economy has been under duress since at least 2008.  There is a lot of fear.  People are scared about unemployment and reduced wages.  People are trying to get out of debt and save some money.  In other words, the demand for money has increased.  Velocity has been slower since the fall of 2008.  This goes hand in hand with the banks not lending as much.

In addition, it is not just a decision by the banks not to lend.  There are two sides to this transaction.  People and businesses are also reluctant to borrow.  Again, this all ties to together with the higher demand for money.

When there is a loan, the interest rate serves as the price of that loan.  With these massive excess reserves, it means that the lenders and the borrowers are not meeting in the middle.  Lenders will only lend for so low of a rate.  Borrowers are not willing to borrow at the rates available, even though the rates are low.  This is a generalization.  Of course, there are some people who are borrowing money for 30 years to buy a house.

It is also important to know that some borrowers simply can’t qualify.  While lending standards are probably still below where they ought to be, the banks have become a little bit stricter since the housing bust.  People with really bad credit can’t just walk into a bank and borrow money for a house, unless they have a huge down payment as collateral.

Lastly, it was less than 5 years ago that the banks were on the verge of insolvency.  Or maybe you could say they are always insolvent, but it was becoming apparent back in 2008.  So the banks are building up reserves as a way to hedge against more trouble ahead.  It gives them more cushion for more defaults or a run on the banks.  We saw companies like Lehman go down so quickly.  It is understandable that banks would want more of a cushion in case something goes wrong.  They don’t want a direct bailout and all of the bad publicity that goes with it.  That is why the Fed is doing it in a controlled and more underhanded way now by buying mortgage debt.

I don’t know if this build up in excess reserves will last, but the Fed’s massive monetary inflation is still doing great harm to the economy, even if price inflation stays relatively tame.