At this point, it is important to draw the distinction that bank reserves are not a form of money that can be used outside of the banking system. Also, and more importantly, they are not lent out.

Banks do not make loans by lending out reserves, they make loans and create money in the economy ex nihilo.

Why is this important?

Because knowing what bank reserves can and cannot do enables us to understand the implications of banks having too many of them.

The first, and most visible of which, is that they are currently discouraging their largest corporate clients from depositing more cash. While holding more deposits may not be a problem in normal times, in the post pandemic era, they pose quite a headache.

This is due to a regulatory concession the Fed gave the US banking system at the start of the pandemic last year, which allowed banks to exclude USTs and reserves from the calculation of their supplementary leverage ratios.

Without going into too much detail, the issue here is how much capital a bank has to hold against their assets, including USTs and deposits held with the Fed (bank reserves).

With the concession, banks don’t have to hold capital against USTs and reserves, and can use the extra balance sheet capacity to make more loans.

However, the concession was important in other ways, namely by creating a regulatory loophole that allowed the Fed to engage in trillions of QE without penalizing banks.

Since QE is an asset swap where the Fed pays for banks’ Treasuries with reserves, conducting trillions more in bond purchases would saddle banks with trillions more in reserves. These extra trillions come on top of what are already very high levels of reserves in the banking system, accumulated from a decade of previous iterations of QE.

Furthermore, deposits were piling up on bank balance sheets, as everyone in the economy simultaneously hoarded their cash in response to the first wave of lockdowns.

As a result, the Fed could not engage in QE without penalizing banks for it. This is because banks selling their USTs to the Fed would have to hold capital against the reserves they receive for the sale, which prevents them from using that same capital to back more economically productive assets, like new loans.

Needless to say, this would have the banks up in arms for being grossly unfair, not to mention economically negligent, and so the concession was born.

Unfortunately for banks, the concession had to end sometime, which turned out to be the 31st of  March this year.

Which brings us right back to the curious issue of banks turning away large corporate deposits.

To be continued…