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My understanding of fractional-reserve lending is that it allows for banks to only keep a small fraction of raw currency in reserve, and lend out the rest. When this lent out money is put into banks, the banks can once again only keep a small fraction of this and lend out the rest. Overall, if there is a 5% fractional reserve ratio requirement, then the banks can become up to 20x leveraged.

However, recently with covid, I believe that this 5% requirement has been temporarily abolished. So, I'm trying to figure out how leveraged banks currently are.

How much have they artificially increased the money supply? Is it higher than 20x now? What information can I use to calculate this as the situation updates?

I found this table on this webpage:

enter image description here

I'm finding it hard to understand exactly which figures correspond to what.

I tried calculating $\frac{\text{Central Bank Balance Sheet}}{\text{Money Supply M0}} = 1.37$ which seems way too low, and also $\frac{\text{Money Supply M0}}{\text{Money Supply M1}} = 314$ which seems way too high.

Edit: some units are in USD Million, some in USD Billion, causing my calculations to be wrong, but still, I can't figure it out.

Any ideas?

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2 Answers 2

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I'm trying to figure out how leveraged banks currently are.

The leverage in the banking sector actually decreased. It is true that the reserve requirement were suspended, but at the same time Basel III introduced new capital requirements that are de facto stricter than old reserve requirements so banks are paradoxically better capitalized than they were before reserve requirements were abolished.

The graph below shows equity as % of assets. The higher the equity as a % assets is the less leveraged banks are, conditional on riskiness of loans they make. The data and graph are from Fed.

enter image description here

How much have they artificially increased the money supply?

There is nothing artificial abut how lending increases money supply (other than the whole economy is man-made), to see how much private lending expands money supply you would want to calculate ratio of either M2 or M3 (broad money) to monetary base MB.

I will pick M2 since that is the more widely used measure, FRED provides M2 in their WM2NS dataset and they provide data for monetary base in their dataset BOGMBASE. Below I plotted M2/MB for you. The latest figure is approximately 3.4.

So private lending expanded money supply to about 3.4 times the size money supply would be without it.

You can see that M2/MB dropped from about 10 in the past to about 3.4 now. This is likely direct consequence of strict bank regulation on lending, the above mentioned capital requirements mandated by Basel III which are far stricter than simple reserve requirements before, and also a result of Fed deciding to move into "excess reserve regime". After 2008 Fed decided to pay banks for holding excess reserves (see Fed), this encourages banks to lend less because they can get essentially riskless returns for just parking their reserves at Fed instead of lending to the point where there are no available reserves left in the system (of course after 2019 there are no reserve requirements, but capital requirements of Basel III still indirectly force banks to have some reserves but their value depends on riskiness of their assets).

enter image description here

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  • $\begingroup$ Private bank lending, as multiple of the monetary base, is influence not only by capital regulations, but also by the shortage or surplus of "good" collateral and creditworthy borrowers in the private sector. There is a financial feedback loop in the collateral value of durable assets. Asset prices rise via leverage with debt and asset prices decline when it is difficult or impossible to refinance an asset via the issue of new debt. Modern monetary policy is more about the saturation of collateral assets with debt, asset price overshoot and collapse, and less about money supply versus prices. $\endgroup$ Jan 12, 2022 at 17:55
  • $\begingroup$ thats completely unrelated to the answer above and off-topic and most of MMT claims are dubious and not accepted by professional economists $\endgroup$
    – 1muflon1
    Jan 12, 2022 at 18:14
  • $\begingroup$ If you state that leverage is caused by regulations then it is relevant to whether leverage is caused by market forces. $\endgroup$ Jan 12, 2022 at 18:16
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    $\begingroup$ "There is nothing artificial abut how lending increases money supply (other than the whole economy is man-made)" Haha, that is very true. Thank you for your answer. $3.4$ is much lower than I thought, that is quite surprising. Interesting to see that it has dropped from a much higher figure. $\endgroup$ Jan 12, 2022 at 20:32
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Original Answer

There is another way to analyze leverage in the bank sector. This is the amount of bank credit supported by a given level of bank reserves in the monetary base.

In the book Stabilizing an Unstable Economy, by Hyman Minsky, there is a chart of the ratio of total bank reserves to total bank credit. The FRED chart for bank credit (Billions):

https://fred.stlouisfed.org/series/TOTBKCR

The FRED chart for total bank reserves (Billions):

https://fred.stlouisfed.org/series/TOTRESNS

One can use the FRED tools to plot the ratio TOTRESNS/TOTBKCR. This plot will decline substantially prior to the 2008 financial crisis showing that banks expanded bank credit on a relatively small stable pool of bank reserves. However when the financial crisis develops in late 2008 the Federal Reserve is forced to provide large quantities of reserves to the aggregate bank sector under the implementation of monetary policy called Large Scale Asset Purchases (LSAP).

When the bank sector is forced to deleverage by saturated credit markets and unstable money markets the central bank is forced to replace some of the private market leverage with public financial instruments. Otherwise the "real" economy would be seriously disrupted by disruptions in the private credit and money markets.

Banking on Leverage

I am unable to find a clean source of leverage statistics kept by the FDIC. The FDIC may have better data than FED in this area.

So per the comment on my original answer the ratio of bank reserves to total bank credit is a liquidity ratio and not strictly a measure of leverage.

https://www.bis.org/speeches/sp140226.htm

Banking is all about leverage. Put simply, banks are highly leveraged institutions that are in the business of facilitating leverage for others.

Leverage – or, as it is sometimes called, gearing – is a fairly basic concept in finance. In simple terms, it is the extent to which a business funds its assets with borrowings rather than equity. More debt relative to each dollar of equity means a higher level of leverage.

Banks, in modern banking systems, use central bank reserves to clear interbank payments on the bank payment tier of the payment clearing system.

Nonbanks, in modern banking systems, use bank liabilities, in the form of transaction deposits, to clear payment on the nonbank tier of the payment clearing system.

So technically the leverage in the bank or bank sector is given by the ratio of of debt to equity used to hold the bank assets. The ability to expand bank credit on a small relatively constant pool of bank reserves would be evidence that banks can expand leverage on the debt and equity side of the balance sheet without requiring the central bank to provide more net reserves in the aggregate bank.

Banks were considered well capitalized prior to the financial crisis in late 2008. But the banks were creating their own capital by issuing net new loans, issuing net new deposits, and converting those deposits to net new equity claims as necessary to comply with capital adequacy regulations. The bank sector had more adjusted equity due to collecting fee income for originating loans for distribution to nonbanks. This adjusted equity, however, was not sufficient to absorb the bad loan expense for the poor underwriting standards when the financial crisis manifested. The bank sector had off balance sheet liabilities tied to the bad loans in the nonbank sector which were not recognized as high risk under the scheme of regulation. The lesson is that bank leverage is a complicated outcome based on the analysis of market forces and regulations in a political-economic context. The textbook models of these interactions do not capture the complexity of actual systems.

Prices and Quantities in the Monetary Policy Transmission Mechanism

However, there is a sense in which the focus on balance-sheet quantities is appropriate. The mechanism that has amplified fluctuations in capital market conditions is the fluctuations in leverage and the associated changes in haircuts in collateralized credit markets. As the uncertainty of the future of mortgage-backed securities (MBS) increased in 2007, haircuts on MBS and ABS increased, forcing institutions to either unwind or move assets from off-balance-sheet vehicles onto bank balance sheets. This shifted funding of long-term assets from collateralized asset-backed commercial paper (ABCP) and repo markets into the uncollateralized money markets, with the effect of massively increasing money market spreads, such as the LIBOR-Treasury spread.

Financial intermediaries tend to hold long-term assets, financed by short-term collateralized liabilities. In order to obtain funds, intermediaries lend out assets they already own and receive cash, which in turn can be invested in additional assets. The constraint on how much of such collateralized lending can be done is imposed by the level of haircuts. Haircuts can be thought of as the percentage downpayment an intermediary has to make in order to finance an asset. When a haircut is 20 percent, the intermediary can take out a maximum leverage of 1/20% = 5. When haircuts increase from 20 percent to 50 percent, the intermediary has to unwind to 1/50% = 2 times leverage. In this way, haircuts determine the amount of leverage that investors can obtain in repo markets. The haircut is the overcollateralization of a specific type of collateralized borrowing agreement such as the repurchase agreement (or repo) or other forms of collateralized borrowing such as agreements of the DTC.

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  • $\begingroup$ Thank you for your response, this is probably what I was looking for. $\endgroup$ Jan 12, 2022 at 20:37
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    $\begingroup$ this answer does not actually show how much banks are leveraged, it only mentions way how someone can measure that, and also it does not show they expand money supply $\endgroup$
    – WilliamT
    Jan 12, 2022 at 21:09
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    $\begingroup$ this answer still does not show how much banks are leveraged, it just says how someone can measure leverage in banks $\endgroup$
    – WilliamT
    Jan 13, 2022 at 2:02

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