Did QE Make Banks Say No To More Money? 2
Why would a bank turn away deposits?
Considering that banks always seem to be competing for deposits, together with their reputation for being greedy; hearing (or reading) that they are turning away money seems incomprehensible.
But, before we can answer that question, we first need to understand what deposits are to banks, and how they are related to bank reserves.
Firstly, deposits are liabilities for banks, which they must pay interest on, and is one of the myriad ways in which a bank can fund its operations.
When a bank takes on more deposits (assuming not in cash), it does so by receiving reserves, transferred to them from another banking institution. This means that they have to consider regulatory (SLR) and capital ramifications on top of the interest costs they incur on those deposits.
Now, a bank is faced with two questions. First, “Do we need the extra funds from the new deposits?”; and second, “Will these funds, and the reserves that come with them, lighten our regulatory burden?”.
These questions deal with how a bank weighs the costs and benefits of taking on new deposits and the reserves that come with them.
If a bank answers “NO” to both questions, then logically, they will turn away deposits.
The first question is a matter of whether the bank, as a business, needs more funding for its operations. If this sounds confusing, remember that banks do not lend out reserves, which by extension means that they do not lend deposits.
Further, it also means that the common perception that banks take in deposits in order to lend them out is inaccurate.
For the sake of clarity: banks do not take in deposits to lend them out.
Banks take in deposits as a means to fund their business operations, and the price they pay for this funding is the interest rates they offer depositors. As such, deposits are another source of funding for banks, along with the debt and equity capital markets.
The second question is a matter of whether the bank is willing to incur the regulatory cost of holding more reserves, that is, meeting SLR requirements given that the Fed’s concession has ended.
But what exactly is this “regulatory cost”?
To put it simply, a bank has a certain amount of capital*, which serves as a “budget” for the risks that the bank takes.
These risks are the assets on the bank’s balance sheet in all their varying degrees of riskiness, ranging from vanilla stuff like USTs, bank reserves and loans, to more risque items like over-the-counter (OTC) derivative and repo exposures.
Regulation requires banks to hold capital against each of these assets, according to how risky they are.
This means that the bank must spend part of their “budget” for each type of asset it chooses to hold, which is the regulatory cost. In turn, this cost must be weighed against the return each asset provides in order to optimize the use of the “budget” as a whole.
As such, by introducing the SLR concession, the Fed allowed banks to free up space in their “budget”, which theoretically allowed banks to make more loans.
Which begs the question, what happens when this budgetary space is removed?
*If you are interested in the details and specifics of this, look up bank capital ratios. Things will get very complicated very quickly
To be concluded…
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