The Modern Monetary Mechanism and Why Bank Profits Are Up

Apr 18, 2023

Last week and this week are “bank profit season” on Wall Street. The first quarter numbers came in for the biggest banks last week, others trickle in this week. Everyone has been watching with bated breath after the series of problems at Silicon Valley Bank (SVB), Signature, First Republic and Credit Suisse.

Sighs of relief could almost be heard from Manhattan as profits came in strong. JP Morgan, Citibank, and Wells Fargo all recorded not just strong profits, but profits rose by 30% for those three overall. JP Morgan is the largest US bank and its profits alone rose 52% in the first quarter.

“Ahh. The banking sector is strong. No worries. Everything’s fine. The biggest banks are all in great shape!”

The good news is that the big banks don’t currently look like they’ll fail. This means the chance of a massive, 2008-style banking crisis is low. So, let’s admit that’s good.

But, there are two reasons this news is bad. First, it seems that a lot of deposits left small banks, and flowed into the big banks. That can cause trouble for the small banks. And, it means more bank consolidation. We now have a very small group of giant banks running our financial system. There is really nothing good about that, in my opinion.

Second, banks are naturally profiting in the Fed’s new monetary policy regime of interest on reserves. More on that below, and why it’s potentially problematic.

Big Banks Win and Get Bigger

Regional bank problems, most popularly seen with SVB’s collapse, made depositors nervous about the health of their local banks. If local banks might not be diversified enough, and if the bank regulators aren’t doing their job of keeping an eye on these banks, then it’s safer to move deposits to large banks that the regulators definitely watch and that the Fed won’t really let fail.

That’s what economists call “individually rational”. It makes sense for each person individually to move their deposits. And,a many people did indeed move their deposits from regional banks to large banks.

That could be a collective problem, however, since deposit withdrawals en masse from the smaller banks could themselves cause problems. I haven’t seen signs that this is happening yet, but flows between banks aren’t very transparent. It’s definitely something to watch.

The bigger problem for me is that this means, once again, we are moving in the direction of ever greater bank consolidation.

JP Morgan was the largest bank in the US already and it saw a 52% increase in profits for this year’s first quarter alone! The Wall Street Journal reported[1] that JPMorgan estimates it gained another $50 billion or so in deposits in just March due to worries about regional banks. Citibank and Wells Fargo fared similarly.

What Happened to “Too BIG to Fail”?

One lesson regulators thought they learned with the 2008 financial crisis was that they don’t want concentration in the banking system because they don’t want any banks that are – or are perceived to be – too big to fail.

In the words of Ben Bernanke, Fed Chair during the financial crisis, “Too-big-to-fail financial institutions were both a source (though by no means the only source) of the crisis and among the primary impediments to policymakers' efforts to contain it”[2] (Bernanke, 2010).

The main problem is seen within the definition of too big to fail itself: “A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.” (Bernanke, 2010)

First, flip that around. Suppose there are no such banks. Then, by definition, there aren’t any single banks that will cause the entire financial system to collapse. Eliminating such banks sounds like a good thing. And it is.

If any too-big-to-fail banks are known to exist, that itself highlights that there is a problem, a fragile point or weakness, in the financial system. So, the first problem is that the existence of such banks puts the whole system in danger. And that system underpins the world economy and hence endangers everyone’s livelihoods.

We might not be able to eliminate them completely, but we certainly don’t want to engage in policies that foster their growth. Yet that seems to be the exact result of our recent policies.

Second, when a bank or firm is identified as too-big-to-fail, it means that the government sees it as such and therefore won’t let it fail. That is a license for the bank to take almost any risk or engage in a wide range of bad business policies, and pay no real penalty. That’s a pretty bad incentive for the people running these institutions. It’s also a bad incentive for the people lending to these institutions. Those “lenders” are also us, little people, who put our deposits in these banks. Deposits are us loaning banks our money. If the bank is known to be too big to fail, then we have less incentive to monitor what the banks do because, well, who cares… they are too big to fail, so they won’t. The government will ultimately bail them and us out. And, who knows? If there’s no cost to taking risks, maybe some of the banks’ crazier risks will pay off big! And if not, we’ll all get bailed out.

These incentives are bad all around. Good regulation generally tries to mitigate this problem, called “moral hazard”, but the US government just announced it will essentially back all deposits at key institutions. That has all the same negative incentives, discouraging depositors from worrying too much about what the banks do.

Finally, the “too big” also reflects concentration in the market. For markets to work well, and provide the benefits we normally expect like lower prices, quality service, expanded opportunities, and all in the name of serving your customer, they generally need to be bustling and competitive. The more competition, the more options are available, the more each business fights to keep costs down, and the more each competes to serve customers better.

The less competitive a market it, the less a giant, mega bank or corporation needs to worry about serving customers. They can focus on big deals with big government, with other giant mega companies, and so on. The customers have to use them anyway, because they are the only – or the only “safe” – option in town, so customers get taken advantage of.

Everything about the consolidation of the banking sector is a bad signal to me. It will not lead to anything good over time in my opinion. There’s a reason people are skeptical of big, concentrated power. It usually leads to no good, and this will likely be no different.

A Sign of Our Times: Deposit Rates

And this lack of interest in and need to compete for customers is no clearer than in the fact that, while the Fed has raised interest rates in the economy, banks have not raised the rates they offer depositors (i.e., their customers).

Traditionally, the Fed raised interest rates to slow overall demand in the economy. The Fed did this by pulling money out of the economy. This starved people and banks for cash. As banks fought for a shrinking pool of cash, banks raised interest rates on checking and saving deposits to encourage people to make more deposits, saving more at the banks.

When consumers receive their pay checks, they can do two things with that money. They can spend it or save it. Spending it on goods and services is called “consumption”. For most people, saving it means putting it in a bank[3].

When the interest rate on deposits at banks rises, people have an incentive to save more which requires them to consume less. The resulting drop in consumption is one of the key factors slowing demand for goods and services and hence slowing inflation. Consumption, after all, is still the largest percentage of total demand in our economy, around 68% of total US GDP.

Federal Funds Rate and Bank Lending Rates

The federal funds rate (in blue) is the rate that banks have to pay for funds in overnight markets. It’s the policy rate that the Fed controls and announces when it “raises interest rates”, as we can see, it’s done every few months since March 2022.

And, with each hike in the cost, banks have raised their prime loan rates (in green), “one of several base rates used by banks to price short-term business loans.”[4] The difference between the rate they charge for loans (green) and pay for credit (blue) is their profit. Notice that at first, the blue line moved up a little faster than the green line. Then over the last part of the graph, the distance between the lines got wider. That’s where profits increased.

But that’s only one source of money for the banks. Another source is how much they pay us for our deposits. Adding that to the picture gives us the following, somewhat depressing, graph.

What they pay us, the depositors, is in red.

No further comment needed.

But, I will remake the graph so our red line is on the right side so you can actually see it’s there.

Here you can see that they have actually raised the rates they pay depositors (red), but look at the right side. The average rate paid to depositors in the US is 0.06 percent (not 6%, it’s 0.06%) but the average rate on loans is now 8%.

This tells me that depositors are not a serious source of funds for banks today. That’s of course partially by design. In the best case, it’s the unintended consequence of the Fed’s modern monetary framework called “Ample Reserve Framework”[5].

The Fed’s Ample Reserve Framework and Interest on Reserves

Traditionally banks got money from depositors. They then took those deposits and held some fraction in their vault, called “vault cash”, and some in an account at the Fed, called a “reserve account”. Both vault cash and their Fed accounts were called “reserves” with the idea that banks were holding this cash in reserve for a rainy day when they needed to pay some depositors.

But reserves sit idle and, by definition, aren’t being used and therefore aren’t profitable, generating no interest or return. Hence, banks viewed them as a cost and tried to hold as little as possible. This left the system fragile to bank runs.

To ensure banks held enough reserves, the Fed required them to hold a fraction of incoming deposits as reserves, naturally called “required reserves”. This was done for prudence’s sake so banks always had some cash on hand for mild bank runs when depositors wanted their money back.

Here’s what reserves looked like from 1960 to June 2008 in the USA.

These fluctuated up and down as banks managed their liquidity. There was a buildup in the late 1980s probably reflecting ever improving economic times and improved banking system health. You can see the drop during the 1991 recession as money left banks. You can see the spike around 2001 after 9/11 when the Fed suddenly flooded the system in fear of a bank panic following the terrorist attack.

Those events were large and significant, and jump out at anyone looking at this graph. But, through this whole period banks tried to minimize the reserves. They earned the bank zero return, and hence reflected a pure cost for banks. They were the cost – the foregone interest earning – banks paid to stay liquid.

In January 2019, the Fed announced[6] that banks no longer have to hold any “required reserves”. In other words, banks could hold zero reserves if they want!

The Fed could do this because, in 2008, they began paying banks for all the reserves they hold at the Fed (see above footnote on “Ample Reserves”). As a result, the amount of reserves in the banking system rose to unprecedented levels as banks now earn a positive return on this idle money sitting in their Fed accounts. Not a bad business!

Here’s THE SAME GRAPH just including the 2008 to 2023 period. Hopefully this gives you a sense of the dramatic change our monetary system underwent as a result of the Fed’s new policy.

In the earlier graph, you could see that reserves were almost at the $50 billion mark in June 2008. By December that same year, they were at $800 billion. That’s a 1,500% increase in about 6 months. And the Fed paid banks on all $800 billion!

And this was just the start. By mid-2014 banks held almost $3 trillion in reserves. With Covid and the post-Covid era, they ran them up to over $4 trillion.

Adding that to our story about rates and bank earnings we get the following graph.

The purple line is the interest rate the Fed pays banks to hold that $3 trillion or so of reserves that sit idle in accounts at the Fed.

As a reminder, the blue line and the red line (which I put back into the left scale with everything else…but it’s still there) are the costs banks pay to obtain funds. They earn money on those funds according to the green line and also the purple line. The green line funds have some risk and effort. After all, you have to review credit applications and take some risk lending to people and businesses. But the purple line is completely riskless. It is literally money that is taken out of circulation and held for free at the Fed. Wait… not for free. The Fed pays for that!

This has many, many implications. I’m still working through all of them myself. And so is my whole profession. We still do not understand the full implications. No one does. That includes the Fed.

Full Circle: Rate Hikes to Slow Demand and Slow Inflation

But one implication I wonder about is whether this weakens the effectiveness of Fed rate hikes on slowing consumer spending. If banks don’t need to compete for deposits, then they don’t need to raise deposit interest rates to attract depositors. If deposit rates don’t rise, then consumers don’t have an incentive to reduce consumption in order to save more and take advantage of the higher deposit rates.

Sure, loan rates are still higher. Credit card rates are still higher. And those things will still slow spending and hence slow aggregate demand.

But (a), if there were, say, 4 things causing consumption to fall in the past, reducing the effect through deposits, leaves us with, say, 3 things now. However you cut it, that weakens the effect. By how much may be an empirical question, but it weakens it some.

And (b), it seems to me that the new regime means we only use the most painful mechanisms now. In the past, consumers who reduced their consumption to save more at least got the benefit of higher interest rates on their deposits and hence more money in the future. That was the whole point of saving! Today, the consumers just consume less because it costs more at the store and on their credit cards. There’s no benefit to that for consumers, just pain.

It's another example of bad government policies creating a problem – inflation – and then other government policies making them worse, and ensuring they are the most painful for the people least able to bear the cost, and to the benefit of the wealthiest and most politically connected. In this case the banks.

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[1] WSJ article: https://www.wsj.com/articles/jpmorgan-chase-jpm-q1-earnings-report-2023-47154f00

[2] Bernanke (2010). Speech before the Financial Crisis Inquiry Commission, Washington, D.C., September 02, 2010, entitled, “Causes of the Recent Financial and Economic Crisis”. Link: https://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm

[3] I’m keeping this simple. The simple choice of consume or save is accurate. But savings can take many forms as well like buying stocks, adding to a retirement account and so on. For now, just trust me that the eventual effect is the same because it affects the balance sheets of banks. Also, sure, you can hold some savings under your mattress. That’s called “cash in circulation” and it’s a small fraction of the overall money supply. And, also, if you use your money to pay down past debts like your housing loan, student loans, or something similar, that’s just “negative saving”.

[4] That’s the Fed’s definition: https://fred.stlouisfed.org/series/DPRIME

[6] Read it here: https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm (Scroll to the bottom “Reserve Requirements”.

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The Modern Monetary Mechanism and Why Bank Profits Are Up

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