Reply #39: TARP and Fed facilities unravel: John Kemp [View All]

[UpInArms]

http://www.reuters.com/article/bondsNews/idUSLD69089920081113

Developments over the last week suggest the U.S rescue programme has fallen into just this trap and is now rapidly unravelling.

The twin pillars of the rescue programme are the multiplicity of liquidity and lending programmes being offered by the Federal Reserve and the Treasury's Troubled Asset Relief Program (TARP).

Both programmes are now in deep trouble. In fact the various rescue packages risk becoming a textbook example of how poorly designed programmes can fail to achieve their objectives.

LIQUIDITY EVERYWHERE BUT MAIN STREET

The Fed has grown its balance sheet from $884 billion to $2.055 trillion in the space of two months and extended almost $1 trillion in additional support to the banking system through the various emergency lending programmes enacted or expanded over the last year.

But precious little of this additional liquidity is finding its way through to households and corporate borrowers. In fact, most of it is now sloshing around the banking system like so much excess ballast. Banks have increased their reserve holdings on deposit with the Fed from $8 billion to $494 billion. This is $488 billion more than the Fed estimates they would ordinarily need to hold for payment clearing and prudential purposes.

Increased reserve holdings have absorbed perhaps half of the liquidity placed into the banking system from the Fed. Much of the rest has almost certainly been invested into the mountain of Treasury bills the U.S Treasury has been issuing. Only a very small proportion is left for re-lending to the real economy.

It is much safer for the banks to lend surplus funds to the Fed and the Treasury than lend to one another let alone to households and corporations. There is no credit risk. Nor is there any liquidity risk because reserve balances can be accessed on demand, and the Treasury bills have short maturities and can be readily re-discounted.

The Fed has made these perverse incentives worse by agreeing to start paying interest on excess reserves. Previously, the lack of interest payments gave banks an incentive to minimise reserve balances. But now reserves pay interest the net cost is low.