The Crisis in the US Financial Markets, Bank Regulation ...



The Crisis in the US Financial Markets, Bank Regulation and the Liquidity Trap: Evidence from Individual Bank Behavior

Submitted by:

Patrick A. McGuire

Professor of Economics

Hobart and William Smith Colleges

Geneva, New York 14456

Post Keynesian Cross Border Conference

Financial Crisis and Reform

Buffalo State College, SUNY

Buffalo, New York 14222

October 9-10, 2009

The Crisis in the US Financial Markets, Bank Regulation and the Liquidity Trap: Evidence from Individual Bank Behavior

For this is the third time in history that a major economy has found itself in a liquidity trap, a situation in which interest rate cuts, the conventional way to perk up an economy, have reached their limit. When this happens, unconventional measures are the only way to fight recession.

Paul Krugman, “Stay the Course”, New York Times, June 15, 2009, Opinion Column.

Introduction

In September, 2008, as the financial crisis worsened each day, the Federal Reserve’s money supply data began to reveal a different side of the turmoil in the financial markets. Excess reserves for depository institutions leaped from $2 billion in August, 2008 to $60 billion in September. Excess reserves then increased again to $ 267.9 B in October, $559 B in November and to $767 B in December, 2008. Bank Reserves remained high through the first 8 months of 2009. The increases in bank reserves were a direct result of the Federal Reserve’s effort to add liquidity to the financial market. In addition, the short term interest rate (the US Treasury bill rate) fell from 1.79% in August, 2008 to .04% in December, 2008. It seemed that the liquidity trap was alive and thriving in the US economy. Total reserves remained high, interest rates remained low and the financial crisis continued into 2009. I wanted to take a closer look at the financial meltdown so I began to examine the behavior of individual banks in the US economy to understand the causes, sources and possible solutions to the financial markets collapse. I began to work with the individual bank data from the Statistics for Depository Institutions database (SDI) from the Federal Deposit Insurance Corporation (FDIC). The SDI database contains detailed reports of all the depository institutions in the United States [1].

As part of an overall study of the financial crisis, I first sought to determine how liquidity developed within individual banks. The basic hypothesis of the study is that as risk within the financial market increased, banks moved towards liquidity and hence liquid assets. Risk is difficult to measure and for this study it is the possibility of financial loses that threaten the financial viability of the depository institution. The liquidity trap did appear or reappear in the Federal Reserve excess reserve data during the Great Recession of 2007-09. How it also appear on the balance sheets of individual banks? If the liquidity trap did indeed appear, how did it differ, if at all, from any former reincarnation of the Keynesian liquidity trap? The results of the first part of the study of bank behavior are presented in this paper.

The paper is divided into 4 parts. Part 1 is a brief review of the re-emergence of the concept of the liquidity trap in macroeconomic policy discussions. Part 2 presents the liquidity increase in the bank reserves of the Federal Reserve System as well as some results of an analysis of the FDIC’s time series database for depository institutions variables from 1934-2008. Part 3 looks at the liquidity trap and individual bank behavior for the period 2007 (4) to 2008 (4), the epicenter of the financial crisis of 2007-2009. (The FDIC provides quarterly reports in detail as well as the Quarterly Banking Profile approximately 60 days from the close of the most recent quarter). Part 4 provides some final results and conclusions from the data analysis [2].

The Liquidity Trap.

There is the possibility… that, after the rate of interest has fallen to a certain level, the liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest.

John Maynard Keynes, The General Theory (1936), page 207.

In Keynes’ original formulation of the liquidity trap, he was trying to explain why, at certain times, banks did not lend and investors did not borrow at low interest rates. Investors did not borrow because of rates of return were low. Banks did not lend because the lending rates, hence potential profits, were also low. However, when the central bank attempted to increase reserves or the liquidity in the banking system, banks did not lend, but rather held the reserves as cash balances on their balance sheets and money supply did not increase. In effect, the reserves were trapped in liquidity and further increases in reserves would only increase liquid cash balances and would not result in an actual increase in money supply.

James Tobin (1958) referred to existence of liquid reserves as the asset demand for money and implied that the asset demand for money was inversely related to the interest rate similar to Keynes’ speculative demand for money. The differences between Tobin’s view of the asset demand for money and Milton Freidman’s transactions demand for money became the basis of the monetarist controversy. Hyman Minsky recognizes the liquidity trap as an important component of Keynes’ original description of the failure of classical economics to develop a model of the macroeconomy.

In particular, the view that the liquidity- preference function is a demand-for- money relation permits the introduction of the idea that in appropriate circumstances the demand for money may be infinitely elastic with respect to

variations in the interest rate…This liquidity trap presumably dominates in the

immediate aftermath of a great depression or a financial crisis.

Hyman P. Minsky, John Maynard Keynes, (1975 reissued in 2008), page 36.

However, the concept of the liquidity trap gradually disappeared from the development of macroeconomic theory and the implementation of monetary and fiscal policy. As noted by Robert Gordon:

In an extreme (and hypothetical) case of the “liquidity trap,” people are convinced

that the prices of bonds and other financial assets are high and likely to fall, so

they hold on to the extra money and refuse to buy any financial assets.

Robert J. Gordon, Macroeconomics, (2006), page 114 (footnote).

The liquidity trap became an extreme or hypothetical case in the major textbooks in macroeconomics, if it was mentioned at all.

Macroeconomics evolved throughout the postwar period and many theoretical and policy conflicts arose. Certainly Friedman, Tobin, Minsky, Krugman, Gordon and many others (including Robert Lucas and the New Classical School) all made major contributions to these discussions as four Nobel prizes can attest. However, the liquidity trap did not become an accepted explanation of the failure of monetary policy. The concept has a simple appeal, when banks and individuals lose confidence in the economic system currently in place, or in Keynes words are “uncertain…” of the course of events in the financial market, normal bank behavior is disrupted. In Minsky’s view, banks and individuals fall victim to the inherent instability of the financial markets, they move to hold their assets in the most liquid form as cash balances in bank accounts, in mattresses, in wallets or as reserves with the district Federal Reserve Banks.

Paul Krugman revived the concept of the liquidity trap in his analysis of the lost decade for Japan in the 1990’s.

Japan, say the economists, has fallen into the dread “liquidity trap”…

Paul Krugman, The Return of Depression Economics, (2008), page 71.

Krugman describes the situation in Japan as a “classic” case of the liquidity trap: 1) stagnation with low interest rates coupled with the refusal of the Japanese government to let some of its large banks to fail, 2) an aggressive attempt by the Japan Central Bank to pump reserves into the financial markets and 3) the refusal of investors to borrow [3]. The Japanese government responded to this liquidity trap by increasing government spending to offset the decline in private investment spending. The government efforts were somewhat successful as Japan avoided a major recession or depression, however, it experienced a long decade of stagnation, dimming the glow of the rising sun of the 1980’s.

In September, 2008, we began to see a dramatic increase in bank reserves. Total reserves and excess reserves rose from a level that changed little in 50 years to ten times the amount held in these previous periods. What was different about the growth in cash balances in general and excess reserves in particular from September to December, 2008? Does this run to liquidity help us understand the financial crisis of 2007-09? How does the growth in cash balances help us understand the financial structure of the 21st century in the US and in the world? There may not be answers to these broad aggregate questions, however, I want to use the behavior of individual banks as the vehicle to shed some light on these broad questions. Specifically, how does the liquidity trap show up in the balance sheets of depository institutions in the US? And can these patterns help us understand the causes and consequences of the current financial crisis?

The Liquidity Trap and the Current Financial Crisis in the United States

The tables and charts in this section look at the reserves position of depository institutions in the US at the Federal Reserve and then in the FDIC’s annual time series format. First, Table 1 provides short term monthly data on total reserves (TR), required reserves (RR) and excess reserves (ER), monthly from October, 2007 to the most recent period (TR = RR + ER). As mentioned earlier the increases in all but the RR from August to October of 2008 are dramatic. TR increased to $821 B in December, 2008 and it maintains that level through the most recent months of 2009. These reserves are held by banks on their balances sheets as currency and coin and reserves deposits at the Federal Reserve district banks. Banks are expected to lend all of their excess reserve position since individual bank profits are determined by their interest bearing assets e.g. loans and leases, securities etc. Traditionally banks keep a small portion of their excess reserves as cash balances over the amount required to back of their deposit liabilities (RR).

The excess reserve position of the banking system averaged between $1.6 B and $3.0 B from October 2007 to August, 2009. As indicated in Table 1, the excess reserve position changed dramatically for the last 4 months of 2008 and continued to be significantly high for all of 2009 up to the most recent month. Table A1 in the Appendix provides a comparison of the Federal Reserve Banks Statement of Condition annually from May, 2006 to May 2009 to demonstrate how the FRS used its balance sheet to impact the liquidity needs of the financial markets. The table demonstrates how the Federal Reserve, with very low short term interest rates, was able to respond to the crisis in liquidity in the financial market including institutions in the shadow banking system.

The financial crisis started many years ago as the regulatory constraints on banks and the financial markets were released in the name of deregulation. However, the reality of the crisis began to appear in the first quarter of 2007 and daily news accounts reported a rapidly changing financial market situation throughout 2007 and into 2008 (For an excellent summary of the financial market events over this period see Acharyu and Richardson, Restoring Financial Stability, Prologue, pp 1-56). On July 13, 2008, the US Treasury announced a rescue plan for Fannie Mae and Freddie Mac, major market players in the subprime housing market; and confidence in the banking system took a major hit with the bankruptcy of Lehman Brothers on September 15, 2008. These are but 2 of the many events that characterized a chaotic period in the financial markets. As the data from Table 1 indicate, liquidity problems demanded that banks hold cash or near cash assets and the Federal Reserve numbers show a dramatic increase in excess reserves beginning in September, 2008.

There are 3 specific data sets for individual banks from the Statistics for Depository Institutions (SDI) of the FDIC. First, we look at general trends for all banks over the long term, 1934-2008 from the FDIC’s historical data base. Then we look at annual data for 1992 to 2008 from the FDIC’s quarterly financial reports for more detail of the composition of cash balances, as a measure of liquidity. Finally, we examine data from the fourth quarter of 2007 and the fourth quarter of 2008 from the detailed financial

TABLE 1

TOTAL RESERVES, REQUIRED RESERVES AND EXCESS RESERVES FROM THE FEDERAL RESERVE SYSTEM, SEASONALLY ADJUSTED, OCTOBER 2007 TO SEPTEMBER, 2009 IN MILLIONS OF DOLLARA AND PERCENT CHANGE

|Millions of |  |Total |TR |Required |RR |Excess |ER |

|dollars | | | | | | | |

|year |month |Reserves |percent ch |Reserves |percent ch |Reserves |percent ch |

|2007 |October |42422 |  |40963 |  |1459 |  |

|  |November |42615 |0.45% |40922 |-0.10% |1693 |16.04% |

|  |December |42674 |0.14% |40905 |-0.04% |1769 |4.49% |

|2008 |January |42149 |-1.23% |40508 |-0.97% |1641 |-7.24% |

|  |February |42820 |1.59% |41094 |1.45% |1726 |5.18% |

|  |March |44297 |3.45% |41324 |0.56% |2973 |72.25% |

|  |April |43562 |-1.66% |41718 |0.95% |1844 |-37.98% |

|  |May |44130 |1.30% |42119 |0.96% |2011 |9.06% |

|  |June |43363 |-1.74% |41092 |-2.44% |2271 |12.93% |

|  |July |43333 |-0.07% |41360 |0.65% |1973 |-13.12% |

|  |August |44565 |2.84% |42571 |2.93% |1994 |1.06% |

|  |September |102784 |130.64% |42726 |0.36% |60058 |2911.94% |

|  |October |315512 |206.97% |47606 |11.42% |267906 |346.08% |

|  |November |609962 |93.32% |50920 |6.96% |559042 |108.67% |

|  |December |821055 |34.61% |53655 |5.37% |767400 |37.27% |

|2009 |January |858418 |4.55% |60173 |12.15% |798245 |4.02% |

|  |February |700967 |-18.34% |57459 |-4.51% |643508 |-19.38% |

|  |March |779955 |11.27% |55321 |-3.72% |724634 |12.61% |

|  |April |881556 |13.03% |57176 |3.35% |824380 |13.77% |

|  |May |901292 |2.24% |57191 |0.03% |844101 |2.39% |

|  |June |809021 |-10.24% |57644 |0.79% |751377 |-10.98% |

|  |July |795571 |-1.66% |62561 |8.53% |733010 |-2.44% |

|  |August |  |  |  |  |  |  |

|  |September |  |  |  |  |  |  |

|  |October |  |  |  |  |  |  |

|  |November |  |  |  |  |  |  |

|  |December |  |  |  |  |  |  |

reports of individual depository institutions that are part of the FDIC. For the annual time series data, we will look for general trends in liquidity and macroeconomic variables. For the fourth quarters of 2007 and 2008, we will examine cross sectional data for individual banks as reported in the SDI database of the FDIC.

For the FDIC annual data, the closest variable to measure liquidity was cash balances which included both interest bearing assets and non-interest bearing assets. We use this variable as our measure of changes in liquidity for the period 1934-2008. Figure 1 measures cash balances against the US Treasury bill rate. Cash balances move up slowly from 1934 until 1976 when it increased significantly and settled into a higher level for a number of years. The interest rate on US Treasury bills fluctuated starting in the late 1950s and then spiked to near 14 % in 1981. During this time the US Treasury bill rate declined from its peak in 1981 with considerable variability to a low of 1.37 % in 2004, it rose again to a high of 4.73 % in 2006 before falling to 1.37 % for 2008 (The UST bill rate for July, 2009 was .19%).

[pic]

Cash balances (liquidity) more than doubled between 1976 and 1982-84. This period was characterized by high unemployment and inflation. Cash balances continued stable rising slowly after a decline in 1994 until 2004 when it began to increase significantly in 2005 to 2007. The housing bubble and the subprime lending crisis began to show its contagion in the mid 2000s and liquidity increased. However, the behavior of cash balances from 2007 to 2008 surpassed all previous increases as cash balances doubled in one year. In other words, liquidity in the banking system increased dramatically from 2007 to 2008. Normal banking activity was disrupted in 2008 by the collapse of the housing bubble and the consequent body blow to bank balance sheets from the decline in all asset prices.

Figure 2 illustrates another measure of liquidity, average cash balances as a percent of transactions accounts at banks (demand deposits and checkable deposits) versus the average capital ratio of banks, total capital of the bank (assets minus liabilities) divided by total assets. The capital ratio is used as and a measure of financial viability since it measures how much of the financial institution’s own capital is available to back up its investment decisions (often called the “skin in the game”). There are many measures of the capital ratio and the one here is the crudest since it does not distinguish among the different types of net worth of the firm.

[pic]

After a decline from 1934 to 1947 the average capital ratio stayed between 6.0% and 7.0% until 1978. There was a credit crunch in the late 1970’s and early 1980’s and the rate declined below 7.0% and gradually increased over the period from 1980 to 2007 when it declined. The capital ratio has been subject of many attempts to introduce discipline and efficiency in the financial system especially as a result of Basel I and Basel II. (see Barth et al, Rethinking Bank Regulation: Till Angels Govern, 2008). Our measure of liquidity (cash balances as a percent of transaction accounts) remained close to 40% of transactions accounts until 1978 when it began to increase as banks began to hold reserves during the credit crunch and economic recession of the early 1980’s. However, liquidity declined from 1984 until 1994 when it began to rise again. It leveled off in the late 1990’s and early 2000 but began a sharp increase in 2006 and doubled from 2007 to 2008.

The liquidity measures from Figures 1 and 2 indicate that the financial institutions are sensitive to changes in the economy and begin to hold more or less liquidity dependent on changes in the economy, that is, as risk increases, liquidity increases. Other comparison with more explicit macro data would also indicate sensitivity to economic trends. However, our interest is identifying more refined measures of liquidity in individual bank behavior. We now look at the quarterly reports for individual banks and in particular the section on cash balances. The FDIC reports on two variables that are part of the definition of the required reserves, i.e. currency and coins in the banks possession and deposits of financial institutions at the Federal Reserve district banks. These two variables are combined to create a measure of bank reserves (TR). The data is collected from the FDIC’s fourth quarter financial reports for 1992 – 2008 and appear in Figure 3. The total reserves of the banks are compared to the US Treasury bill rate.

[pic]

As Figure 3 illustrates, total reserves are not sensitive to interest rate fluctuations over the period, however, total reserves increased from $70 billion to $700 billion from 2007 to 2008, a tenfold increase. Our second, and more refined, measure of liquidity also demonstrates that banks ran to liquidity during the financial crisis. Of course some of this liquidity came to the banks as a result of actions of the US Treasury, the US Congress and the Federal Reserve. Liquidity increased, but was it trapped? And if it was, then what trapped it?

The Liquidity Trap and Individual Bank Behavior.

The data set for individual bank behavior contains 55 sectors and 881 variables for 8305 banks for 2007(4) and 2008(4). The data used for the current study came from 7 sectors and contained 209 variables for 2 periods, the 4th quarter of 2007 and 2008. For this paper the focus was on the liquidity changes for all banks, some subsets of banks and for a random sample of all banks. This section will report on the behavior of banks as measured in 7 sectors with a focus on the variables related to liquidity [4]. The questions remain the same: Does the liquidity trap exist and can it be identified in the individual bank data? Do all banks portray characteristics that describe the liquidity trap? How has it affected individual bank performance? And finally, has it affected bank regulatory behavior and monetary policy?

Table 2 presents summary data for the liquidity variables compared to the standard definition of the liquidity trap and how these variables are used in the conduct of monetary policy and in the supervisory function of bank regulators. All banks must maintain required reserves to back deposit liabilities, specifically transactions accounts. The required reserve ratio is 3% for net transaction accounts (liabilities) of between $10.3 million to $44.4 million and 10 % for net transaction accounts over $44.4 million [5]. Required reserves must include currency at the bank and deposits with the Federal Reserve district Bank. These 2 items appear as part of the Cash Balances section of the database. Excess reserves equal total reserves minus the required reserves. The sum of currency and coin and cash balances due from the Federal Reserve is our measure of total reserves. If the RR ratio is 10% and transaction accounts are $100 million, the bank must hold $10 M of reserves to back the deposit liabilities. Total reserves divided by transaction accounts (including demand deposits and checkable deposits) give us a measure of liquidity. If we assume that the RR ratio is 10%, then banks with a reserve ratio of 10 % are “loaned out” i.e. no excess reserves. If our liquidity measure is 40% then we can assume the 30% (40% minus 10%) represents excess reserves and the liquidity remaining on the balance sheet.

Table 2 provides data for all banks from 2004 to 2008. Transactions balances are non-interest bearing deposit liabilities. Cash balances are assets and they measure the general liquidity in the banking system and includes cash and balances due from depository institutions. There are interesting bearing and non-interest bearing balances; money supply for the US economy measures non-interest bearing deposit liabilities. Total reserves for banks include non-interest bearing assets that can be lent out to borrowers. Banks are required to hold a certain percent of these liquid assets as reserve against specific deposit liabilities, non-interest bearing liabilities (transaction balances). Money supply includes transaction deposit liabilities (demand deposits and checkable deposits) and coin and currency held by the individual banks on the asset side of the balance sheet. Required Reserves include coin and currency and reserves held by banks at the Federal Reserve District banks. Banks cannot lend the required reserves and must keep as reserves an amount equal to 10% of non-interest bearing deposits liabilities to back up these bank liabilities. The difference between TR and RR equals excess reserves (ER). Banks can lend all of their ER positions. Table 1 above provided data on total reserves, required reserves and excess reserves as determined by the Federal Reserve System.

Table 2 answers the first question posed. That is, is there considerable excess reserves “trapped” on the balance sheets of individual banks in the US? Yes. The all bank data indicates that bank reserves or total reserves in Table 2 increased from $70.2 B in 2007 (4) to $569 B in 2008 (4). The majority of this increase, 91% came from deposits at the Federal Reserve district banks. There has been a shift towards liquidity during the worst stages of the financial crisis. If we assume the banks must hold approximately 10% as required reserves to back their deposit liabilities (.10 * $569 B= $56.9 B), we can estimate $510.2 B in 2008 (4) as excess reserves (ER) for all banks. The excess reserves indicate a significant potential increase in Money Supply if the ER were to be lent out. However, the ERs have remained on the balance sheets and banks continue to maintain liquidity. The large ER position for the first 6 months of 2009 in Table 1 clearly shows that the banking system is holding on to its liquidity. Table 2 also shows the large even massive increase in some other measures of liquidity. Total cash balances increased from $525.3 B to $1.1 Trillion over the period and interest bearing cash balances accounted for most of the increase. As risk increase in the financial crisis, banks hold more liquid assets.

The FDIC individual bank data set provides a number of categories for the banking sector. The breakdown by asset size for 2008(4) along with the number of depository institutions (the total number of depository institutions for 2008 is 8305) for each asset size is:

1. less than $100 million – 3,131 depository institutions.

2. $100 million to $1 billion – 4,498 depository institutions.

3. $1 to $10 billion – 561 depository institutions.

4. greater than $10 billion – 115 depository institutions.

Table 3 presents the values for some of the variables for the largest asset group compared to all depository institutions for 2007 (4) and 2008 (4). The data provided a comparative perspective of the impact of bank size and the change in the selected variables over one crucial year. The dominance of the largest banks is clear in almost all measurement variables. This group accounts for 78 % of assets of all banks, 74 % of all deposits and 99.9% of all derivative contracts. For our measures of liquidity, large banks controlled 76% of bank reserves in 2007 and 92 % in 2008 and this group increased their holding of bank reserves over 40 times compared to 28 times by the entire banking system. It is important to note that our measure of bank reserves increased from $693.2 B in 2007(4) to $6,023 B in 2008(4). Finally, the ratio of reserves to transaction account was 91.8% for the large banks in 2008(4) compared to a ratio of 65% for all banks.

So much data but is it important? YES! The liquidity that is trapped in the banking system is being held by the largest banks. Why? Loans and leases for large banks have decreased at double the rate for all banks, -3.0% compared to -1.24% for all banks. The markets are uncertain at best, many of the assets on the balance sheets of banks have dropped in market value but remain on the books, short term markets for sources of funds and long term markets for uses of funds remain uncertain and the large banks remain cautious. Hence they have rushed to liquidity and are staying there. Too Big To Fail (TBTF) has taken on a new meaning in current markets and these very large banks want to maintain liquidity to remain flexible and nimble despite their large and very dense market footprints.

Tables 4A and 4B provide more evidence of the important influence of the largest banks. The tables present data for the 25 largest banks in the US for 2007(4) and 2008(4). These banks controlled approximately 60% of all assets, over 60% of all bank reserves and between 45% and 50% of all transaction accounts. Transaction accounts represent 48% of M1 money supply, therefore 25 banks control half of all demand deposits and checkable deposits in the US. The position of these very large financial institutions within our financial markets presents a problem for long term bank stability. It is not just the size of these banks but it is their interconnectedness. Counterparty risk is created when the balance sheets of these very large banks are threatened. For our concern, liquidity is trapped in these large banks and more than likely, the liquidity is used to insure adequate reserves for all types of financial positions. In effect, for protection against risk, all types of risk, including default, counterparty, systemic and inflationary risk. While these risks remain, the large banks do not seem willing to use the reserves to contribute to the efficient operation of the banking system. In fact, they are inhibiting the efficient operation of the economy and are increasing the systemic risk for the economy. For 2008, 62.1% of all reserves for the banking system are held by these 25 banks, and that leaves 38.1% of all bank reserves held by the remaining 8,280 depository institutions in the US.

What do these changes in bank reserves say about the existence of the liquidity trap? Does it exist? Yes. Does it exist for the same reasons that Keynes described over 60 years ago and Minsky and Krugman discuss more recently? Yes, if we mean that uncertainty is the principal cause for financial institutions to hoard reserves at low interest rates and not lend them out. However, the financial system that exists today is very different than that whics existed that any time in our past, even our recent past. Bank regulations and lack of regulation have contributed but so has the innovation and globalization of the financial markets. Lending and borrowing still involve the basic problems of moral hazard and asymmetric information despite all the sophistication of the financial innovation of the past 20 years. It is this uncertainty that remains the same when crises arise and it is this uncertainty that results in the liquidity trap and its implications. We can no longer afford the luxury of considering the liquidity trap as a hypothetical concept in our macroeconomic theory and policy. The central bank must consider this liquidity as a restraint to effective easy money policy during recessions, and an expansionary threat for the excess reserves that remain within the banks with its potential negative impact on inflation and inflationary expectations. An efficient and effective financial market cannot function properly with over $700 billion of excess reserves (see Table 1) on the books of money creating institutions. The financial crisis of 2007-200? will not be over until the liquidity trap is resolved.

Some Preliminary Conclusions

Many questions have been raised in this paper and the purpose was to answer as many as possible. For summary and conclusions, the questions and the preliminary answers are provided below.

1. What was different about the growth in total bank reserves over the period September to December, 2008? The major difference in the growth of total bank reserves was the dramatic increase in excess reserves over a four month period. The increase was due to a liquidity crisis for the banks and the efforts by the US Treasury and the Federal Reserve to pump liquidity into the nation’s banks with short term interest approaching zero (see Table 1).

2. If liquidity increased, was it trapped and if so, what trapped it? Was cash balances also trapped? Bank reserves, our measure of liquidity, was trapped because banks experienced a drop in asset prices including loans and leases, public and private securities and other types of assets. They looked to sell off some of these assets but given the fall in price they wanted to avoid the loss from a sale at below original cost. The FRS and the US Treasury purchased some of these assets and provided banks with the liquidity they needed to conduct their business however the banks were not willing to resume the level of lending that existed prior to the crisis.

3. Does the run to liquidity help us understand the financial crisis of 2007-2009? The run to liquidity was a direct result or consequence of the financial crisis. Banks have remained in a liquid position through 2009 in order to put their respective houses in order and stabilize their balance sheets. In the meantime the US economy continued to worsen after the recession started in the fourth quarter of 2007.

4. How does the growth in cash balances and bank reserves help us understand the financial structure of the 21st century in the US and the world? The sophisticated global financial system was still vulnerable to an asset price bubble despite the very innovative and exotic financial instruments available. Current domestic regulation has fallen behind global financial integration leaving our domestic banks exposed to increasing level of risk. The behavior of banks before and during the current financial crisis demonstrates that US regulation did not prevent speculation and excessive leveraging by financial firms. They were unprepared for the sudden credit crunch and liquidity crisis, and the Fed and the US Treasury had to create innovative ways to supply liquidity in order to avoid a collapse of the financial markets. (see Table A1 in the Appendix).

5. How does the liquidity trap show up on the balance sheets of depository institutions in the US? The Statistics of Depository Institutions data set has 2 components of cash balances that were used to measure bank reserves, currency and coin at the individual bank and deposit balances at the Federal Reserve District bank. These components were combined for a total of $569 B in bank reserves at the end of 2008(4), an increase from bank reserves of $70.2 B in 2007(4). (see Table 2).

6. Can the patterns in cash balances, transactions accounts and bank reserves help us to understand the causes and consequences of the current financial crisis? Lack of regulation, the housing bubble, excessive speculation, leveraging and risk all contributed to the financial crisis. The resulting liquidity trap resulted from the policy response to the crisis and the banks unwillingness to return to normal operations in their desire to protect their balance sheets.

7. If the liquidity trap appeared in the balance sheet of depository institutions then how different was it from former reincarnations of the Keynesian Liquidity Trap? The liquidity trap of 2008-2009 resulted from the uncertainty in the financial markets in response to the collapse of business as usual after the housing bubble. However the business as usual in financial markets since 2000 was very different than during any previous economic downturn including the Great Depression. Furthermore the role of the largest banks, the large complex financial institutions (LCFI) in 2009 have become TBTF (too big to fail), required a “bailout” by the US government and the Federal Reserve System. (See Tables 3, 4A and 4B).

8. Do all banks portray the same characteristics identified as the liquidity trap? What are the differences, if any, among the individual banks? A review of the all bank data indicate that smaller banks did not take the risks that the largest banks and institutions in the shadow banking system undertook. However due to the integration of the banking system, the interconnectedness and counterparty risk, the smaller banks were also adversely affected by the financial crisis of 2007- 2009.

9. If the liquidity trap exists, how has it affected individual bank behavior, monetary policy and bank regulation? Banking regulation was not able to foresee and appropriately respond to the financial crisis of 2007-2009. There is perhaps universal agreement, except for the largest banks, that there must be reform in the current bank regulatory structure. The economic recession that officially began in the fourth quarter of 2007 is also a response to the collapse of the housing bubble and the decline in asset prices in general. Interest rates are at an all time low, yet the Federal Reserve found some innovative ways to inject reserves into the banking system to encourage lending, however this has not resulted to an increase in lending and borrowing despite the large amount of excess reserves available. (See Table 1). The Fed’s monetary policy has been successful in limiting the damage to the financial markets but it has not as yet been successful in stimulating private sector spending in the economy.

One of the objectives of the bank research project was to analyze the individual bank data. Towards this objective, a random sample of 500 banks was drawn for the individual bank data for 2007(4) and 2008(4). There were considerable data work done on the new data set and only preliminary analysis was undertaken. The data set proved more difficult to work with than originally thought and only preliminary data results were obtained. More analysis on the data set will be done and hopefully more results can be reported at the conference on October 10, 2009.

Footnotes

1. Federal Deposit Insurance Corporation, Statistics on Depository Institutions, Quarterly Reports, sdi.

2. Federal Deposit Insurance Corporation, Statistics on Depository Institutions, Quarterly Reports, sdi .

3. Krugman, Paul, The Return of Depression Economics and the Crisis of 2008, Chapter 3, pp 56-76.

4. Federal Deposit Insurance Corporation, Statistics on Depository Institutions, Quarterly Reports, sdi .The sectors included: Performance and Condition Ratios, Assets and Liabilities, Total Deposits, Securities, Loans and Leases, Income and Expenses and Cash Balances.

5. Required reserves must be in the form of vault cash and/or in the form of a deposit maintained with a Federal Reserve District Bank. See Board of Governors, Federal Reserve System, Reserve Requirement, monetarypolicy/reservereq.htm.

6. In the FDIC’s SDI database, for the sector Cash and Balances Due, the variables coin and currency (chcoin) and balances due from the Federal Reserve Banks (chfrb) are used to measure reserves held by each depository institution. As of March 2001, depository institutions with less than $ 300 million in assets (over 6000 in both periods) were no longer required to provide detailed line items for this sector. Therefore the held by banks will be underestimated by a relatively small amount.

Sources

1. Acharyu, V.V. and Richardson, M. (editors), Restoring Financial Stability: How to Repair a Failed System, Hoboken, NJ: John Wiley & Sons, 2009.

2. Barth, J. R., Caprio, G., Levine, R., Rethinking Bank Regulation: Till Angels Govern, New York: Cambridge University Press, 2008.

3. Board of Governors, Federal Reserve System, Principal Economics Indicators, Aggregate Reserves of Depository Institutions, August 20, 2009 and various dates, releases/h3.

4. Federal Deposit Insurance Corporation, Statistics on Depository Institutions (SDI) Database, Quarterly Reports, sdi .

5. Federal Deposit Insurance Corporation, Quarterly Banking Profile, 2008, Volume 2, number 1 and 2008, volume 2, number 1, 2007.

6. Gordon, Robert, Macroeconomics, New York: Pearson Education, Inc., 10th Edition, 2006.

7. Keynes, John Maynard, The General Theory of Employment, Interest and Money, New York: Harcourt, Brace, 1936.

8. Krugman, Paul, The Return of Depression Economics and the Crisis of 2008, New York:W.W. Norton, 2008.

9. Minsky, Hyman, P., John Maynard Keynes, New York: McGraw-Hill, 2008.

10. Tobin, James, “Liquidity Preference as Behavior Towards Risk”, Review of Economics Studies, Volume 25, pp 65-86, 1958.

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