Friday, July 9, 2010
Theories Explaining the Behavior of Excess Reserves
Let's take a look at this post regarding a bank and firm's decision on reserves. I do agree with the article and the theory 2 is certainly correct, but what the article misses is the theory 1 is equally correct when we are under crisis such as the one we recently passed through. The banks, for example, were searching opportunities during the crisis to sell their products - loans - but it was hard for them to find good customers because people were cautious about borrowing money from the banks in light of prevailing crisis. Even though the central banks had made open several options for banks to increase their reserves during this time, the banks were ended up having excess reserves due to a sluggish demand of their products, not because of abundant supply of reserves from the central bank. Moreover, even though the theory 2 is capable of changing the behavior of banks during external economic shocks,this theory cease to maximize the efficacy of reserve requirement as a monetary policy tool, which is crucial to combat the crisis and bring the economy back on track. Therefore, the theory 1 is the best explanation of the behavior of reserves during the crisis time.
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While theory 1 is certainly plausible, theory 2 appears to be more realistic in most instances. Even though an individual or corporation may be satisfied with its current amount of money, and doesn’t see it fit or necessary to do anything with it, most economic agents do look at excess cash reserves as a buffer. Per Bryan Caplan’s article, the explanation of theory 2 is much more intuitive than theory 1. Majority of economic agents will respond to exogenous income shocks. So although theory 1 may be applicable in certain situations, theory 2 is much more realistic overall.
ReplyDeleteAvadella White
ReplyDeleteI believe both theory 1 and theory2 should be taken into consideration as a part of analyzing why there are excess reserves. It seems plausible that both theories are relevant and have played a role during the recent financial crisis. At the beginning of the crisis, perhaps theory 2 was extremely important as financial institutions and corporations analyzed their financial status. However, as these institutions completed their analysis and observed the response to the financial crisis by the Federal Government and the Federal Reserve, I am certain confidence that they would receive the financial support they needed from these entities rose. I believe this increased banks willingness to make loans. I believe the show stopper for utilizing the excess reserves, as was indicated, was finding qualified borrowers who wanted loans. Most financial institutions have access to FDIC(insurance raised to $250,000), the ability to borrow money from the Federal Reserve, other banks and from the government sense the government has decided that they are too big to fail. I can not imagine that financial institutions are really concerned about the need to maintain excess reserves as a safety net at this point, but rather are very confident that if they need financial support they will get it from our government and/or the Fed.
I agree that theory #1 describes the behavior of reserves during the financial crisis more accurately, although theory #2 was definitely a factor as well. During the financial crisis banks began questioning the value of investments in the market; no one really knew the extent to which they were exposed to the subprime meltdown. This reflects theory one, they were afraid to invest and uncertain if new loans would be profitable. At the same time the banks were acutely aware that we were headed for a recession, they accumulated reserves to act as a buffer against additional crisis and against any additional write downs they might have been forced to take. For these reasons I cannot help but conclude that both theory #1 and #2 were experienced during the crisis.
ReplyDeleteRecently, corporations have also been behaving in this way. Non financial companies are currently sitting on $1.8 trillion in cash because they continue to forecast low demand (theory #1, the corporation doesn't think that additional production would be profitable); additionally, they are holding it as a buffer and see the money as an insurance policy (theory #2).
-Matthew Moore
http://www.cbsnews.com/stories/2010/07/15/politics/washingtonpost/main6680641.shtml
I agree that both theories can somewhat be applied to a financial crisis. I also do believe that theory 2 is absolutely correct however I think that theory 1 is only partially correct. It is true that during the financial crisis that the person or organization that sits on a huge sum of money has nothing good to spend it on but not that it is satisfied with existing products. Any investor or individual who has in their possession a huge sum of money that is not investing or having a professional invest for them could possibly have nothing good to spend it on but to say they are satisfied with the existing products is not agreeable. For a financial analyst who makes a living on finding successful investments; they will find no satisfaction in a financial crisis. They will definitely pull back their funds and hold off on investing but to apply Theory 1 in that they will be satisfied in a financial crisis makes me feel that Theory 1 is not the best theory as it relates to a financial crisis.
ReplyDeleteRenell Anderson
ReplyDeleteI believe both theories are foundationally sound, however the uniqueness of some of the contributing conditions that caused our most recent crisis were somewhat different than any experienced in similar combinations ever before in history.
Looking at Theory #1,
It has been called among other things “The Alterative Assets View” by Ben Bernanke (1983) when referencing the post 1927 -1933 crisis. Bernanke stated “Following the bank holiday, nearly 40 % of the banks in business in 1929 were no longer operating. Since there was no central credit reporting agency during this time, the failed banks meant that information on past borrowers was lost. There was little that banks could do in this situation to overcome the issues of asymmetric information and adverse selection. This discouraged banks from lending”.
While the conditions of the most recent crisis are not identical the similarities are close enough to conclude that it is possible that the presence of asymmetric information made it less desirable to resume “business as usual” practices quickly and contributed to the reluctance to lend or invest.
Regarding Theory #2
The identification of the most appropriate reserve target buffer was nearly impossible to do because of the way the CDO’s, SIV’s and other “creative investment vehicles” had been bundled. As time progressed it became more and more obvious that many of the underlying debt objects could have contributed to addition decay of confidence and increased fear of the potential failure of more mammoth financial institutions than those that failed. That’s why monetary policy (stimulus injected funds), were not being used more aggressively and quickly by institutions that were awarded them.
The need clearly exists for far more structure, regulation and oversight of our financial structure and institutions to avoid or minimize the tremendous chaos that will accompany future crises.
I think that with Theory 1, it isn’t taking into account what the banks are trying to in order to salvage their existing loans and it also doesn’t take into account that future productivity is bleek due to the fact that banks aren’t making as many loans as they were before the crisis. In order to combat the housing loan crisis, the banks and government is offering modifications for your current loan. One of the ways in which to modify your home is to get a “quick loan” from the bank that allows you to pay off your past due mortgage amount then tack that loan on the back of your existing loan and pay it off at the end of your loan over a 10 year period. While at first glance this may appear to be helpful, the banks profit is higher because they stand to make more money off of your past due balance and you keep your house at your interest rate which will more than likely go up. Banks are more leery now banks are more leery now about offering loans due to the fact that more people have bad credit. The reason more people have bad credit now is due to the banks. But that doesn’t mean that it won’t change in the next year or two. So in my opinion Theory 2 is more applicable because it seems more realistic and accounts for speculation and has an optimistic viewpoint that things will recover in the near future. Theory 2 just seems more in tuned with how people and the economy work.
ReplyDelete-Alysia J. Sturges
Petrica Molnar:
ReplyDeleteI believe that both theories have truth and falacies in them. To start we have to look at the history of banks and bank CEOs. You see banks are typically corporations and so seek the profit motive. They are looking to make the most in returns for their stock holders. Also banks suffer from the principle agent problem, that is the banks CEOs don't own the compainies. All this points that banks will make slightly risky investments in order to make profits. Theory one makes sense in this case as they are looking to make loans, but well there is relatively few people taking them. This is a little exaturated however because there is a bit of caution now in case of banks and people when taking loans. The rules are stricter and it is a bit harder to get a loan. Theory 2 on the other hand seems a bit more exaturated. Looking at the theories I gave you earlier banks are not going to hold excess reserves because of the opportunity cost they are lose doing so. However it makes a little sense to hold a buffer it case of extreme capital loss. So I agree with professor on this.
No 2 is more appropriate(relevant to financial crisis). During the financial economic crisis, the market became more pessimistic. In order to improve the economic condition the Federal Reserve was injecting more money into the banks and encouraging banks to offer loans, but companies were hesitant to take loans as consumer spending was less.
ReplyDeleteWe all know that Liquidity is most important during financial downturns. A bank becomes insolvent when it is unable to sell its assets to meet the liabilities, because of the fall of the asset values.
During the current financial crisis, banks were unable to sell assets to meet the unexpected withdrawals although that is what they had to do to survive. Also as banks non- performing assets increased, they had to increase their reserves. What banks started doing as a precautionary measure was to seek the most liquid assets. The banks did not want to take the increased risk of failure at the cost of lending out its excess reserve.
ANTARA MAJUMDER
Certainly, I would agree with both theories, but in my opinion, theory 2 would make much more sense in why banks are holding so much excess reserves. Prior to the financial crisis, banks had more incentive to sell their products because the FED was not paying interest on excess reserves and banks would not earn anything off the reserves. Currently, the FED could perform open market operations and the money would not even get lent out because institutions can just sit on the money and earn an interest on the reserves without any moral hazard problems. Basically, the large increase in excess reserves is not a reflection on a banks unwillingness to lend, but on recent changes in FED policy. Once the FED announced its interest rate policy, excess reserves spiked to an all time high and kept increasing up until the middle of 2009. Now, if the FED decides to lower rates on excess reserves, then member banks will probably be forced take on more risk and lend to consumers and small businesses. Aside from risky lending practices, theory 1 could also suggest that banks are hoarding cash because foreclosure rates continue to rise forcing them to hold on to excess reserves to pay off future bad debt. Either way, I think changes in FED policy on excess reserves could also change lending practices once again.
ReplyDeleteBrian Frisch
Theory 1 and theory 2 are both plausible and clearly apply at certain times of crisis, but in our current economic crisis it seems to me that theory 1 applies best. Theory 2 seems like it would apply, however banks weren't exactly fearful to lend in all circumstances, the collapse of the housing market meant lending to risky applicants obviously decreased, and the fear of no return on loans was there, however banks are always out to maximize their own profits. The thing is that people began to decrease the amount and scope of private borrowing when crisis was on the horizon; doubts arose concerning the viability of the financial sector and banks could not unload their normally designated loan money, and hence excess reserves built up. Holding excess reserves in accordance with theory 2 denies the purpose the Fed meant for required reserves, in that deliberately holding excess reserves would not equate with required reserves acting as a monetary policy tool.
ReplyDelete-Javier Janbieh