Deleveraging the Liquidity Trap

Linking to an article on the Wall Street Journal (“Spanish Banks’ Bad Loans Keep Rising“), Edward Hugh writes on Facebook,

In order to maintain investor confidence Spain’s banks have to control the rate at which non performing loans appear in their returns, so they have to keep financing a large number of questionable ones to slow down the rate of impairment. This is what makes it hard to generate additional new loans when you are “deleveraging”, and why businesses constantly complain of a “lack of credit”.


I wonder if this is a factor in the United States, as well (where usually the “lack of credit” is blamed on the Federal Reserve’s policy of paying banks to sit on their excess reserves — see Todd Keister and James McAndrews, “Why Are Banks Holding So Many Excess Reserves?“).  It was to avoid this problem, though, that the Federal Reserve bought so many toxic assets during the first round of quantitative easing, between late November 2008 and late March 2010.

  • Silvano

    Demand for credit surge since firms desire avoid fire sales of real estate properties and inventories. Since banks want to avoid losses in their books in order to delay recapitalizations (or because they are unable to do that) they slow down the liquidation of ‘malinvestments’.

    Despite the Euro area is a single currency union, banks have been rescued on national basis: Obviously country which experienced real estate e credit bubble were highly leveraged and had trade balance deficits. The effect has been a deep “balkanization” of banking activities. From this perspective foreign creditors has been bailed out and the bill has to be met by local taxpayers. Spanish banks are full of Spanish bond, Italian banks of Italian bonds and so on. The ECB continue to act as a lender of last resort, but practically the result is that banks of creditor countries deposit their surpluses to the Central Bank while banks of debtor countries need to be financed directly by ECB. There aren’t truly “continental” retail banks able to balance their cash needs. To make an example: imagine that there are only 2 states with two local banks (Alabama and Texas) and that the Bank of Alabama fueled a local housing boom financing it with short term loans from the Bank of Texas (since Alabama’s savings are insufficient and Alabama’s current account is in deficit). Consequently, the Bank of Alabama is short in everyday net settlement but until it can borrows capitals from Bank of Texas the boom keeps going. When the bubble pops the Bank of Texas stops financing the Bank of Alabama which instead of going burst is partially rescued by the State of Alabama and partially kept alive by Fed. Anyhow until Alabama has a deficit in current account and the Fed is the only lender (no foreign investors, no more confidence from the Bank of Texas, not enough domestic savings) the situation will persist. To put it simply: in Alabama there is a gap between investment (too much, poor, unprofitable, etc.) and savings (overconsumption). When this gap is wide in the short term one way to increase savings is also curtailing investments through failures (only profitable firms can use operating profits for financing and unemployed people consume less) but this could be depressing if the monetary rate of interest starts to be higher than the natural one.

  • Joseph Fetz

    You’re forgetting capitalization. American banks were undercapped but highly liquid after the purchases of toxic assets. It made much more sense to park that liquidity in an interest bearing account at the Fed and to recap by moving treasuries and stocks. Assuming no major moves in stock and bond yields, the banks are pretty much recapped and ready to lend, as can be seen by the 3 month rise in M2 over the summer. M2 flattened through the autumn but kicked back up again on the latest release.

    QE was primarily an interest rate game, not a purchasing scheme (necessarily). As long as the underlying assets were highly valued, the low interest rate didn’t matter that much on the banks’ balance sheets, same with stocks with low dividends. It was all about recapping the banks using government debt as the source of funding.

    Now they (the banks) are recapped and M2 is doing its funny dance.

    • Joseph Fetz

      Sorry, I should clarify that point about QE being an interest rate game as opposed to a purchasing scheme. The low interest rate and having a ready buyer in the Fed was the driver of purchases, not the other way around. Essentially, the lowering of the interest rate is what lowers the risk (to the banks) in such a maneuver (of purchases).

    • Jonathan Finegold Catalán

      QE1 was the capitalization. QE1′s primary purpose, as far as I understand, was to protect them from bankruptcy; that is why the Federal Reserve provided them with so much liquidity.

      It is interesting to note that many banks were not necessarily undercapitalized. Before the crisis, most banks were actually overcapitalized. Banks were forced into bankruptcy when mortgage-backed securities were marked-to-market and it was found that based on these values banks were “undercapitalized.” Many of these assets would see much of their value return over the following four years, which means that many of these banks would have survived the crisis. Of course, these “artificial” bankruptcies also made the credit crisis much more acute, since it forced banks to immediately restrict credit to capitalize and banks forced into bankruptcy had, in a sense, an absolute credit restriction.

      I think, with regards to American banks, the main reason why banks are not lending is because banks are making money by sitting on cash (and it’s more secure than investing that cash). Banks will lend when the benefits of lending outstrip the benefits of sitting on the cash, and depending on how much inflation this causes the Federal Reserve will control the rate of lending by changing the rate at which they pay banks for their excess reserves. The question is whether or not the Federal Reserve really has a means of extracting all those excess reserves when there is no longer an advantage to having banks hold large excess reserves.

      • Joseph Fetz

        Maybe you misunderstood what I was saying. I was saying that the purchases of those assets is what undercapitalized the banks (ultimately). Thus, the whole rigamarole of monetary policy for the years afterward was essentially meant to recap the banks (after they swapped their capital for liquidity).

        Interest on excess reserves was definitely a consideration to keep the liquidity pretty much parked, especially since the rate of interest was above the lowest rate on short-term Treasuries (which is supposed to be illegal).

        Also, the supposed “exit strategy” to reduce the potential of the monetary base is definitely something that is on my mind, especially if deposits begin to grow at an accelerated rate.

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