Following the 2008 financial crisis, U.S. economic growth has been anemic compared to prior recessions. The average growth rate has been less than 3 percent. (1)
Follow the money
In the 1976 movie, All the President’s Men, the character Deep Throat whispered “Follow the money” to a Washington Post reporter and allow the reporter to see through the White House’s lies and deceptions and find out who was behind the Watergate burglary. To answer the economic question of why US GDP growth has been so low compared to prior recessions, we have to follow Federal Reserve money flow.
Since the financial crisis, American banks have increased their excess reserves or cash funds they hold over and above the Federal Reserve’s requirements. Excess reserves, as of January 2015 now stand at $2.6 trillion (3). Why are U.S. banks holding these excess cash reserves instead of making more loans and fulfilling the intentions of the Federal Reserve? The answer stems largely from the new Federal Reserve policies introduced after the 2008 financial crisis. Under normal economic conditions banks hold excess reserves for several reasons. First and foremost is to meet any unforeseen liquidity needs such as to make payments, service deposit withdrawals, or responding quickly to market opportunities or to make loans needing immediate action. Banks normally measure the cost of carrying reserves to the interest they would make in interest bearing accounts at another financial institution versus their cost incurred in last-minute borrowing from another banks to cover a reserve shortfall. It generally cost banks more to get cash from other banks than keep an “emergency stash of fund” that the bank could access when extra cash is needed.
What has changed since the 2008 financial crisis?
Since the financial crisis banks are required by the Federal Reserve’s Board of Governors to hold excess reserves (3). The Federal Reserve now mandates that net transactions greater than $14.5 million need to hold a 3% reserve ratio while ones over $103.6 million need to hold a 10% reserve ratio. A second reason (or incentive) in holding excess reserves is that now the Federal Reserve pays interests on all bank reserves (3). Before the 2008 crisis banks receive no interest payments on excess reserves but since December 2008, the Federal Reserve pays 25 basis points or 0.25% interest on all bank held reserves. This rate is substantially higher than what a bank could obtain in the market which is from 0.07% to 0.20%. For these reasons banks are calculating a zero risk and greater benefit to holding large reserves.
Carrot or the Stick: Banks move in the same direction
In 1936, as in today, US banks’ reserves accumulated to record levels. Federal Reserve at that time decided to reduce the flexibility of the banks’ options for using the cash by mandating an increased reserve requirement. Banks responded by dramatically reducing their loan portfolios. Today the Federal Reserve has mandate increased reserves but also used that powerful incentive of interest payments. With prime lending rates close to zero, banks easily sitting on large cash reserves and make money at zero risk.
Although for opposite reasons, the banks of 1936 and the banks of today have move in the same direction and reduced their loan portfolios. In 1937 the economy went in recession. We will have to wait, perhaps not long, to see the negative impact that current bank actions have played on the present economy.