Thursday, April 29, 2010

Odd Non-Controversies

It’s odd to stumble upon something old—well, old in internet time—and wonder, now why wasn’t that controversial? Ben Bernanke’s February 10th testimony to Congress contained an odd little comment that should have engendered controversy but didn’t. This comment seems to fit all the stereotypes (servant to bankers, etc.) we have of Bernanke:
The authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Federal Reserve to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements. Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Federal Reserve has ample time to consider the best long-run framework for policy implementation.The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.
The comment was buried in a footnote of his testimony, but that doesn’t stop the tracking parties unleashed by the internet: someone, somewhere is going to read that comment. But it didn’t happen, contemporaneously.

So Bernanke believes that banks are keeping too much in reserves at the Fed. Currently, this is probably true—banks are hoarding cash instead of lending it out—but it doesn’t have to be true. The proposal that Bernanke unveils in the beginning of the footnote (indeed, throughout the testimony) to be able to adjust the interest rate the Fed pays/charges for keeping reserves at the Fed is, while new, not terribly extreme. It’s the proposal that he ends with—ending minimum reserve requirements—that’s quietly extreme.

Currently banking operates at on a fractional reserve system. If you’re a bank, you keep some of your capital in reserve to pay off depositors should they come calling. If too many come calling at the same time, it’s a bank run and you need liquidity. Bernanke is proposing simply to have the discount window—where banks can borrow money from the Fed on short-term notice—serve as the source of funding for everything. That would free up even more money to be lent at bank’s discretion.

Ultimately, it’s a proposal that looks like it’s a servant to the bankers once again. Bernanke apparently believes that banks should have even more discretion in terms of judging their own capital needs and profit needs. The flaws with this proposal are pretty obvious: namely, that banks aren’t always so great at judging their needs, that their biases currently run towards lending too much and at too much risk, and that they can count on the government to bail them out. Bernanke appears to be further entrenching this system with the proposal.

It’s also interesting given one of Bernanke’s comments earlier in the testimony: “To preclude any future need for the Federal Reserve to lend in similar circumstances, we strongly support the establishment of a statutory regime for the safe resolution of failing, systemically important nonbank financial institutions.” This is Bernanke’s sole policy recommendation to the House. Can it be interpreted as a narrow version of Bernanke’s support for financial reform, i.e. does he disagree with the requirements in the financial reform bill for greater capital reserves? If I’m right about my earlier speculation, he is. Which I think is fairly odd.

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