Yesterday the President announced his intention to propose a Financial Crisis Responsibility Fee that would require the largest and most highly levered Wall Street firms to pay back taxpayers for the extraordinary assistance provided so that the TARP program does not add to the deficit. The fee the President is proposing would:

  • Require the Financial Sector to Pay Back For the Extraordinary Benefits Received
  • Responsibility Fee Would Remain in Place for 10 Years or Longer if Necessary to Fully Pay Back TARP
  • Raise Up to $117 Billion to Repay Projected Cost of TARP:
  • President Obama is Fulfilling His Commitment to Provide a Plan for Taxpayer Repayment Three Years Earlier Than Required
  • Apply to the Largest and Most Highly Levered Firms

The immediate reaction from market watchers: THIS WILL INHIBIT BANK LENDING AND FURTHER SLOW THE RECOVERY PROCESS. One source actually says this will slow bank lending by $1 TRILLION.

I don't agree with that stance. Before going deeper into my perspective, below is some background on the money creation process. Skip if you already have a firm understanding.


The goal of a bank is to maximize net worth for its shareholders. This objective is achieved by lending out money at a rate which exceeds the cost of borrowing. Because lending is a risky business (haha do I need to explain that?), shareholders require that banks keep excess reserves to protect the security of their deposits. These reserves are stored in their vaults and are used to meet the demands of depositors.

Banks have three types of assets:

  1. Liquid Assets like US Treasury bills
  2. Investment Securities like US Treasury bonds and Agency MBS
  3. Loans made to corporations and consumers.

The Federal Reserve's role in this whole process is to provide banking services to commercial banks like JP Morgan Chase, Citi, and Bank of America. The Federal Reserve controls the amount of money banks can lend and therefore controls the amount of money in circulation.

There are three ways the Fed does so... they can do this via adjustments to the required reserve ratios, raising or lowering the discount rate, and by purchasing or selling assets to/from banks via open market operations (purchasing TSYs and MBS from banks).

Required reserve ratio is the minimum percentage of deposits that banks must hold as reserves. When banks have extra reserves, they are able to lend out those funds, which creates money.

The discount rate is the rate at which the Fed will lend reserves to banks in need. Currently the discount rate is at historic lows which implies banks can borrow cheap excess reserves to  make new loans (thus creating money and earning more profit).

Open market operations are the purchase or sale of govern securities. The Fed has taken additional actions to provide liquidity in the marketplace by purchasing agency MBS in the open market. When the Fed buys from banks, they are taking assets off their balance sheet in exchange for money (reserves). The more the Fed buys in the open market, the more excess reserves banks can accumulate,  the more more they can lend, and the more they can create money by lending to businesses and households.

Plain and Simple: Whenever the banking system has excess reserves, banks can create new money. Whenever the banking system lacks reserves, they decrease their loans and rebuild reserves...this slows the growth rate of money supply.


I have a bone to pick with the folks who say this will slow down bank lending. I have an even bigger bone to pick with the folks who say this will slow down bank lending AND have been shouting BEN IS PRINTING MONEY!!!! INFLATION INFLATION INFLATION!!!

In July, 2009, the New York Federal Reserve released a research paper titled WHY ARE BANKS HOLDING SO MANY EXCESS RESERVES?

Here is an excerpt:

"Since September 2008, the quantity of reserves in the U.S. banking system has grown dramatically, as shown in Figure 1.1 Prior to the onset of the financial crisis, required reserves were about $40 billion and excess reserves were roughly $1.5 billion. Excess reserves spiked to around $9 billion in August 2007, but then quickly returned to pre-crisis levels and remained  there until the middle of September 2008. Following the collapse of Lehman Brothers, however, total reserves began to grow rapidly, climbing above $900 billion by January 2009. As the figure shows, almost all of the increase was in excess reserves. While required reserves rose from $44 billion to $60 billion over this period, this change was dwarfed by the large and unprecedented rise in excess reserves."

Below is a chart from the Federal Reserve's H.3 Data

The spike in excess reserves in the banking system is obvious.

These excess reserves have yet to be lent by banks to consumers and small businesses...regardless of President Obama's numerous requests. (This is a topic for another conversation...but there isn't exactly a surplus of qualified borrowers out there either).

While I acknowledge the anxieties of those who state the "responsibility fee" will further slow already stagnate lending markets, I think we should take a step back and look at this from another perspective.

According to the "Financial Crisis Responsibility Fee" fact sheet...

"The fee the President is proposing would be levied on the debts of financial firms with more than $50 billion in consolidated assets, providing a deterrent against excessive leverage for the largest financial firms. By levying a fee on the liabilities of the largest firms – excluding FDIC-assessed deposits and insurance policy reserves, as appropriate – the Financial Crisis Responsibility Fee will place its heaviest burden on the largest firms that have taken on the most debt.  Over sixty percent of revenues will most likely be paid by the 10 largest financial institutions."

These are the large commercial banks who have the most reserves to lend, the banks who are "too big to fail". If these reserves were turned into money via making loans to consumers and small business, it would most definitely inflate the money supply. THIS IS WHERE INFLATIONARY FEARS ARE ROOTED.

With that in mind, given the current sensitive state of the long end of the yield (nervous about rate hikes and inflation), perhaps the Obama Administration is indirectly raising the Fed Funds rate for the banks who pose the biggest inflationary threat to the economy?

Instead of using a traditional Federal Reserve policy tools, all three of which are described above, perhaps the Fed and President Obama are imposing this bank tax as a means of draining excess reserves in the banking system? Perhaps this is just a way to start fighting inflation before it becomes a bigger problem?

For those of you who are nervous about a continued slowdown in bank lending, there will still be a ton of excess reserves left in the banking system to lend out. You should also read the New York Federal Reserve paper I called attention to above.

Unfortunately, when you strip out all the political positioning that is behind this "fee", the crux of the bank lending problem is no where near in "recovery mode". We still have a major credit crisis going on here...the credit of all the prospective borrowers in this country has been slowly deteriorating over the past two year.  Banks have no incentive to lend excess funds to borderline borrowers.

Until the credit of credit of prospective borrowers is repaired, which will require job creation, the macroeconomic recovery (especially housing) will be a SLOW STAGNATE PROCESS.