Monetary policy effectiveness relies crucially on banks’ willingness to lend, which all agree is now sorely lacking. The important consideration, however, is why? The fact of the matter is that, without adequately transparent financial measures investors and banks alike will not allocate funds to any borrower. With over fifteen times “off-balance sheet” exposures as “on-balance sheet” exposures in US commercial banks and the demonstrated possibility for those “off-balance sheet” items to unexpectedly come back “on-balance sheet” in times of distress, investors and banks are loathe to lend and will remain so until the absurdity of “off-” and “on-balance sheet” distinctions is put to rest.
The credit channel of monetary policy transmission consists of banks lending the proceeds from Open Market sales of Treasury debt to customers who use the funds to purchase goods and services, the sellers of which redeposit the proceeds in their own banks who relend the money again and again. Mathematically, the money multiplier itself consists of one divided by the reserve ratio that banks hold back to cover liquidity needs created by the deposits. Hence, if banks hold a ten percent reserve ratio, the money multiplier would be ten. In that event, if Open Market Operations inject $1 billion of Treasury debt purchases, the lending and relending of those funds through the banking system will result in $10 billion of new deposits and therefore economic activity.
The problem is that the reserve ratio consists of several distinct elements. First and foremost, there is the legal reserve ratio required of banks, which amounts to, on average, about ten percent. On top of that, however, is a level of discretionary reserves that banks desire. When times are good, the discretionary reserves are low: when times are bad, the discretionary reserves are high. Of course, as the discretionary excess reserve increases, Open Market Operations have less and less economic effect. In today’s markets, therefore, banks desire high excess reserves to insulate their financial positions from continued economic shocks of the credit crisis and Fed Funds rate cuts have lost their effectiveness.
The problem is that policymakers have treated banks’ behavior of holding increased excess reserves as somehow irrational instead of trying to better understand banks’ motivations and disentangle the circumstances that have led to current desired levels of excess reserves. Policymakers, it seems, have resorted to Keynes’ “animal spirits” explanation without pursuing first other rational explanations of banks’ desire for reserves, and concomitant reluctance to lend.
One significant theme that runs through the credit crisis – though one that few want to talk about – is off-balance sheet financial arrangements. Before Basel I implementation in the US there was little in the way of off-balance sheet finance to speak of. But Basel I, implemented in recession at a time when raising additional capital – the numerator of the ratio – was hard, incentivized moving assets off-balance sheet to increase the ratio by reducing the denominator of the ratio in what we know to be a classic regulatory arbitrage. More importantly, it seems like regulators went along with the arrangements in order to bolster the apparent strength of US bank capital ratios and avoid what they felt at the time would be unnecessary regulatory enforcement that could potentially delay recovery from the 1991 recession.
Table 1: History of Commercial Bank Off-balance Sheet Exposures
In 1992, off-balance sheet items reported on Schedule M of commercial bank Reports of Condition and elsewhere (summarized in the Table below) and posted on the FDIC’s web site amounted to some 2.9 times reported on-balance sheet items. By 2007, the multiple was 15.9 times. During the period 1992-2007, on-balance sheet assets grew by $200 percent, while off-balance sheet asset grew by a whopping 1,518%! Furthermore, the off-balance sheet numbers cited below do not include structured finance arrangements. Securitizations reported on Schedule S add about $2 trillion in 2007 and $1 trillion in 2004, but the data was not gathered in earlier years. SIVs, CDOs, CLOs, ARSs, CPDOs, etc… are not reported to regulators and investors and therefore cannot be included in the comparison.
Policymakers, investors, and regulators have all learned recently that off-balance sheet isn’t really off-balance sheet because it can come back on-balance sheet in times of financial distress, at which point the bank will have to raise capital to fund the exposure at current regulatory capital requirements. Such absurdity has investors and banks alike wondering the full extent of off-balance sheet arrangements and the probability that additional significant exposures can come back to banks in the near term, similar to movements associated with SIVs last summer, ARMs this spring, and now potentially RMBS in the Countrywide settlement. Even more important, however, is the fundamental fact that the sheer magnitude of off-balance sheet exposures precludes their being recognized at even de minimus capital requirements, especially in today’s markets.
Hence, it is off-balance sheet shenanigans that maintain banks’ and investors’ reluctance to lend, but the widespread adoption of such arrangements in the years since Enron now makes it almost impossible for regulators and accountants to recognize the arrangements and appropriately capitalize commercial banks without tremendous economic disruption. Nonetheless, the longer we continue to deny the arrangements, resorting to “animal spirits” explanations of reduced confidence that continue to purportedly puzzle policymakers, the longer we perpetuate the downturn and threaten US financial markets preeminence as the most transparent and efficient in the world.