The complex relationship between banks and the Fed

The last financial crisis was focused on ensuring the integrity of the banking system to support the real economy. Massive liquidity and capital were given to banks to support lending and the real economy. In hindsight, there were missteps with the bail-out and the foundational view that some banks were too big to fail. An opportunity for restructuring was lost. Since the Financial Crisis, banks deposits are more concentrated and the surviving firms have done well without penalties for their excesses. 

The current crisis is different. There was the critical financial liquidity crisis in March, but there was no bank crisis. The Fed effectively managed the liquidity crisis with swift action and no shortage of liquidity, yet the current situation is now one of business solvency and getting a constrained economy growing. Money can relieve financial liquidity pressure, but it cannot remove constraints on aggregate demand and supply. Money can lower rates but not directly engage in lending and supporting business solvency.

The current path of monetary policy over time subverts the ability of the financial sector, banks, to provide effective lending. Lending has to be profitable. Banking needs capital and a return that will attract that capital. 

There are three policy effects that work against banks. We know that the effects are negative both from history and the current languid gains from banks. One, low nominal rates near zero hurts banks as yield spreads compress. Two, any policy that provides forward guidance or attempts to control or flatten the yield curve will only further hurt bank earnings. There is no gain from lending long and borrowing short. Three, a poor economy and little ability to generate earnings from spread and curve differences will only further tighten lending standards. Lower ROE from lower earnings and increased loan loss reserves will not allow banks to more aggressively lend.

The most recent survey of senior loan officers shows a significant tightening of lending standards. Deposits have grown but the money is only being used to purchase government debt at low rates. Given the low capital weighting for holding government debt, new deposits are not going to firms, small businesses, and consumers but for Treasury financing. Banks, at this time, have headwinds that will have both financial and real effects.

The big question is how the Fed will be supportive of banks and the financial system so financial firms are able to generate earnings that can be used to support lending. Without a profitable banking system, any recovery will be muted. This is the forward guidance that is currently necessary.