Right Not to Trust (the Fed)

So we have been writing about the massive excessive reserves of the USA banks held with the Fed Reserve.  At an official rate of 0.25% (in the "prudential market" lets call it) versus more than 3% in the capital market.   The opportunity cost seemed large, let alone the US$18 trillion lost lending.  Hmmmm!!!


Excess reserves of course, is capital reserves in excess of reserves required under prudential guidelines.

We concluded that this US$1.5 trillion hoard of excess reserves was as a consequence of a loss of trust between bank counter parties and / or (ii) there is a lot of short term risk (OTCderivatives?) they [banks] may have but we do not know, against which they are holding this capital (and not required by prudential standards).

And via zerohedge we have the answer…..and it turns out we were correct.   The banks do not trust each other and the banks require substantial extra capital in the event of the credit downgrade.   A credit downgrade would trigger derivative margin calls, and those margin calls would need to be capitalised.  

For example, Morgan Stanley has just filed its 10-Q with the SEC, and shows that it requires another US$10 billion.  About another third of its current capital base.   So that in the event that it is downgraded three levels by a rating agency, it has sufficient capital to cover its margin calls.  

Let's also recall that the derivative market is reputedly US$700 trillion.  And further that Morgan Stanley, our example, is one of those Too Big Too Fail designated banks, that in the event of a failure are backed by the government.  So we know in advance that it will be bailed out.

So why call it "excess capital" Fed?  It is not excess.  It is in fact the level of capital required to maintain its  credit rating.  You could call it the amount that the banks require so that you (Fed) do not have to spend my money bailing them out.  If their shareholders are earning the revenue on these derivatives, they should carry the cost of offloading the risk as well.  [In a previous blog we also referred to reading a Federal Reserve piece on the excess reserves that frankly was a crock of.   Serious shortcomings there.]

It should be required capital to have the capacity to cover your derivative margin calls.  Looks to me like the rating agencies are doing the Fed’s job for them.  For a change, I should add.