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Are central bank actions aimed at saving banks?

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Sunanda K. Chavan
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Are central bank actions aimed at saving banks? - August 6th, 2011

Recent events in the United States, Greece and China have drawn fierce attention to the importance of properly functioning financial systems and the critical role large financial institutions play in modern economies.

In the United States, the Federal Reserve is charged with maintaining economic stability, specifically focusing on unemployment and inflation. The near collapse of the financial system in 2008, followed by the longest recession in the post-World War II period, severely tested both fiscal and monetary policy makers.

Fear of financial seizure fueled both the government bailout of banks in 2008 and subsequent efforts by the Fed to maintain easy credit conditions and inject “lending and spending” into the economy, fueling economic activity and lowering unemployment. Critics of the Fed’s actions charged that, even if successful, a massive injection of money into the economy would ultimately lead to higher inflation.

Yet, neither unemployment nor inflation appear to have been significantly affected by the Fed’s extraordinary two-year effort to pump reserves into the banking system. Instead of lending these reserves, banks continue to hold them, exhibiting little interest in making risky loans to either cash-strapped consumers or commercial developers.

Does this mean the Fed’s efforts failed? Not necessarily. One reason banks are not lending is the little-noticed, yet significant, legislation enacted by Congress in 2007 which allows the Fed to pay interest on reserves held by banks. Previously, excess reserves in a bank’s reserve account just sat there, earning nothing, thus incentivizing banks to move them to profitable use. Now, banks have less incentive to make risky loans to homeowners and developers, especially in the current uncertain environment. Interest, although at an exceedingly low rate (currently one quarter of one percent), can be earned risk-free from the Fed. Meanwhile, banks allow balance sheets to improve over time, and eventually resume lending as confidence improves.

In Europe, concern over Greece’s deficit spending and the size of the Greek national debt (120 percent of GDP) combined with political unrest and rumblings of discontent with the Euro have finally forced the European Union to take action.

This is because the Greek crisis, while ostensibly a sovereign debt and failing economy problem, is just as importantly a financial system and banking sector concern: Greece’s creditors are primarily large banks in France, Germany and the Netherlands (and, of course, Greece). The EU is keen to see that these banks, whose balance sheets are in even worse shape than those of their American counterparts, do not collapse under the weight of this debt.

China, too, has concerns over its banking sector, despite -- or perhaps because of -- its rapid growth over the past decade.

The rapidly expanding Chinese economy has seen bank lending explode and real estate prices in Chinese urban areas have tripled over the past 10 years (sound familiar?) Central banking authorities have raised interest rates that banks charge each other, in a so far unsuccessful attempt to constrain lending. In addition, the amount of funds banks are required to hold in their reserve accounts is almost double that of banks in the U.S. and Europe, and this level has been raised at least four times in the past year. As in the rest of the developed world, authorities in China appear to be worried about the health of the country’s financial sector.

Although many industrial sectors are important to an economy’s well-being, the performance of the financial sector is crucial, especially as an economy emerges from a slowdown. In a speech at the London School of Economics in January 2009, Fed Chairman Benjamin Bernanke emphasized that “a sustained recovery (requires) a comprehensive plan to stabilize the financial system and restore normal flows of credit.” Hence the focus on banks.

So what might a “comprehensive plan to stabilize the financial system” look like? In a future article, I will examine some of the options facing policy makers and regulators in Washington.

Trip Shinn is professor and associate director for the Center for Economic Analysis School of Business at Macon State College.
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