Stage 3 – Banks Restrict Lending

The next stage in America‘s Financial Endgame™ concerns the reason why non-government credit has been growing so slowly.  It seems very paradoxical that an environment where banks hold record levels of reserves and can borrow money from the government at record low rates have created a contraction in lending.  After all, banks can borrow from the Fed for almost nothing … why wouldn’t they want to create loans where they could profit from the “spread” between retail loan rates and the low interest that is paid to either their depositors or the Federal Reserve?

This seems logical … after all, the way banks make money is by borrowing at a low rate of interest and write loans at a higher rate of interest.  There is a completely counter intuitive situation that has emerged, since the incentives seem to be completely aligned for banks to start making lots of loans.  Granted, there are new restrictions requiring more reserves for US banks, but that shouldn’t be restricting the growth of credit to the extent that it is currently being held back.

Of course, there is one more critical factor to consider.  In Q4’08, the Federal Reserve began paying 0.25% interest on Fed deposits by banks.  This meant that banks could collect an interest spread by borrowing from the Fed for nearly zero interest, holding the capital in as reserves, and collect arbitrage profits with no risk.

Now it becomes quite clear why bank lending has not been growing.  There is no reason for banks to write loans for anybody but the lowest of low risk borrowers when they can generate risk free profits from the Fed by simply holding reserves and collecting the interest rate spread.

So why is the Fed doing this?

The short answer is to hold back the surge of inflation that would result if banks created new loans instead of collecting interest from the Fed.  The secondary answer is that the interest rate creates a “soft cap” on short-term treasury rates since.  The reason for this is because if short-term treasury yields increase beyond 0.25%, bank capital will flow into treasuries because of the attractive arbitrage spread vs. the interest rate paid on deposits at the Fed.

This has the effect of semi-permanently holding down the effective interest rates on government debt.  By enabling this revolving door of arbitrage profits for banks from either interest on deposits at the Fed or from treasuries, all of the major banks have become a de facto financial ally of the US government.

What this ultimately means to us as individuals and investors is that the unbelievably low interest rates on government debt will most likely continue into the future until something happens to shift the market equilibrium.  Of course, some shift in the current situation is all but inevitable, because our current “equilibrium” is not sustainable.  High levels of government debt combined with a perpetual large government deficit is not sustainable … regardless of what the people say on CNBC.

Ultimately, America’s Financial End Game™ is about understanding the drivers behind what is currently happening in America’s financial system, the likely events that are going to shape the future of our economy, and the expected results of those events.  Once we understand these drivers, we can begin to create a personal action strategy to ensure that we are able to thrive in the coming uncertain times.

The next stage of this analysis will examine what happens as deficits continue to mount, while the government spends without restraint …