Banks

No-Reserve Banking And Less Capital, Too!

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BANK CAPITAL REQUIREMENTS

The Federal Reserve Board voted last week to move ahead with a proposal to scale back the amount of capital that banks must hold as part of their assets. A Reuters report indicated that the amount of capital that banks must set aside will depend on the size of the role they play in the global financial system.

Is reducing capital requirements for banks a good idea?  The Federal Reserve and the banks think so. The banks want to use the restricted capital to buy more Treasury bonds. Fed Chair Powell said it was “prudent” to reconsider the current requirements.

Here is a short summary of the situation from an article at https://www.pyments.com …

“Currently, banks are required to hold a flat percentage of capital in reserve against all assets, per the report. The CNBC report said that for this purpose, lower-risk assets are treated essentially the same as high-yield ones, and banks are practically penalized for holding Treasuries.

The current requirement was put in place after the 2008 financial crisis, increased over the years, and has for years been the target of banks that argue that it unnecessarily restricts their ability to facilitate trading in lower-risk assets, such as Treasury bonds, the Reuters report said.” (source)

Treasury Secretary Scott Bessent wants to see the requirements relaxed, too. Bessent said “we are very close to moving” on this issue and he thinks it would allow greater flexibility for banks to increase holdings in government bonds. That may be so, but…

ARE TREASURIES LOWER-RISK ASSETS?

For the past three years, Treasury bonds have proven to be anything other than a “lower-risk asset”. Below is a chart that shows how badly U.S. Treasuries have performed…

TLT (Long-Term Treasury Bond ETF) 2020-25

Who needs more restricted capital? Let’s buy more Treasury bonds, instead. They are safe and liquid. Oh-oh…

SILICON VALLEY BANK 

Existing higher capital requirements put in place in 2008 did not help Silicon Valley Bank (SVB). Liquidity problems forced SVB to sell Treasury bonds that had declined by 30% or more.

The argument for higher capital requirements is that it can reinforce and support overall capital structure (strong capital base) and maintain solvency. The additonal capital can be a source of temporary liquidity, when necessary.

Unfortunately, it did not work that way for SVB. Their flawed lending strategies (borrow short and lend long) put them at a huge disadvantage. Being forced to liquidate long-term bonds at huge losses in order to meet customer withdrawl demand erased any illiusion of solvency and catapulted them straight into bankruptcy.

Regardless, there is another issue that looms large in the SVB debacle and portends ill for all banks.

SVB’s bankruptcy, and some other bank failures in 2023, occurred three years after the Federal Reserve suspended the 10% reserve requirement for banks. What was “fractional-reserve banking” became “no-reserve banking”.

NO-RESERVE BANKING 

Under the fractional-reserve system, banks were required to keep a portion of customer deposits on hand. The amount could vary, but was formerly 10% of the deposits on hand. The reserves were required in order to meet ongoing withdrawl demand. The other 90% could be lent out to individuals and businesses.

If too many people wanted too much of their money in a short period of time, the bank might not be able to satisfy the demand for withdrawls of money. (see Fractional-reserve Banking – Elephant In The Room).

However bad the problem was before, it is worse now. Previously, the 10% threshold gave us an indication of just how seriously worse was the situation of any particular bank if they dropped below the threshold. Now, we know nothing.

The 10% reserve requirement was reduced to 0% on March 15, 2020, just as the economy entered its forced shutdown. The entire banking systm now functions on a 0% reserve requirement.

CONCLUSION 

Banks are horribly illiquid. Solvency is an illusion – not a reality. Relaxing bank capital requirements at this time probably doesn’t add much to the exagerated risk that already exits in the banking system.

The additional capital won’t prevent financial institutions from going bankrupt; they already are. (see Bank Stress Test Results Are Just Window Dressing)

Kelsey Williams is the author of two books: INFLATION, WHAT IT IS, WHAT IT ISN’T, AND WHO’S RESPONSIBLE FOR IT and ALL HAIL THE FED

Bank Stress Test Results Are Just Window Dressing

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  • window dressing: an adroit but superficial or actually misleading presentation of something, designed to create a favorable impression.
    “the government’s effort has amounted to little more than window dressing” (Oxford Languages)

BANK STRESS TESTS – FEELING GOOD AND TALKIN’ THE TALK

The Federal Reserve recently reported the results of its annual economic stress tests for banks. The test supposedly indicates how banks can be expected “to perform under certain hypothetical economic conditions.”

The reason it is termed a stress test is because the hypothetical conditions are negative in nature…

“The 2024 stress test shows that the 31 large banks subject to the test this year have sufficient capital to absorb nearly $685 billion in losses and continue lending to households and busi- nesses under stressful conditions.” Executive Summary @ federalreserve.gov

The June 26, 2024 press release stated that the “Federal Reserve Board annual bank stress test showed that while large banks would endure greater losses than last year’s test, they are well positioned to weather a severe recession and stay above minimum capital requirements“.

This year’s test was modified to be more stringent in order to reflect the possibility of more severe liquidity problems for banks in light of numerous bank failures experienced last year, highlighted by Silicon Valley Bank (SVB). Below is how the matter was addressed by Fed Chair Jerome Powell at that time…

“So, I guess our view is that the banking system is sound and it’s resilient—it’s got strong capital [and] liquidity. We took powerful actions with [the] Treasury and the FDIC, which demonstrate that all depositors’ savings are safe and that the banking system is safe.Mar 22, 2023 

The statement was a bit premature as other banks subsequently failed. Anxiety was calmed however, and fears were tempered. A followup statement by Chair Powell provided additional reassurance…

“The U.S. banking system is sound and resilient, with strong levels of capital and liquidity. (Powell, July 23, 2023)

QUESTIONS AND CONCERNS 

What if conditions are worse than those simulated in the stress tests? In financial and economic matters, it most always seems to be that way. The current stress test parameters allow for declining interest rates. The Fed may want to see rates lowered in a crisis, but wholesale dumping of worthless credit obligations would send interest rates through the roof. We saw that in 2008 with residential mortgages specifically and bonds in general. The Fed might not be able to stem the tide with purchases for their own account as they did then.

Banks are notoriously illiquid. There are no reserve requirements. The 10% fractional-reserve requirement based on total bank deposits was eliminated several years ago. That’s not much, but, at least it provided a measure of (il)liquidity and a margin of solvency. For example, if a bank has $1MM in deposits and lends out $900,000, the remaining $100,000 is still available to meet withdrawal demands. Now that the reserve requirement has been eliminated, it is not unrealistic to assume that some (or, most) banks probably have loaned out more money than they have in total deposits. In other words, there are no reserves, so how can a bank be expected to meet net outflows/withdrawal demand?

The reserve requirement was eliminated for two reasons: 1) to support efforts to flood the economy with money in response to the forced Covid shutdown and resumption of economic activity afterwards and 2) most banks were probably in danger of violating the existing 10% reserve requirement; remove the requirement and the problem goes away – for a little while, maybe. (see more about fractional-reserve banking)

The banks aren’t satisfied, though. They want less stringent requirements.

CONCLUSION

The extent and duration of pending financial and economic crises will be worse than any previous ones. The events themselves and their negative effects will confirm that bank stress tests and their results are inadequate, unreliable, and virtually worthless.

Kelsey Williams is the author of two books: INFLATION, WHAT IT IS, WHAT IT ISN’T, AND WHO’S RESPONSIBLE FOR IT and ALL HAIL THE FED!

Fractional-Reserve Banking Is The Elephant In The Room

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(Note: This article is an updated version of an original article published in 2017.  On March 15, 2020, the Federal Reserve Board reduced reserve requirement ratios to zero percent effective March 26, 2020.  The action eliminated reserve requirements for all depository institutions.)

FRACTIONAL-RESERVE BANKING

The expression “elephant in the room“…

“…an important or enormous topic, question, or controversial issue that is obvious or that everyone knows about but no one mentions or wants to discuss because it makes at least some of them uncomfortable or is personally, socially, or politically embarrassing, controversial, inflammatory, or dangerous. (source) 

A wordy definition, yes; but it is applicable to our topic of Fractional-Reserve Banking. After reading the rest of this article, you should be able to see just how important and enormous  Fractional-Reserve Banking is; as well as how dangerous.

Lets’s start with some history.

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