The BS on Bank BS

We have argued for some time that the notion the Fed needs to "sop up" all the excess reserves it created was a bad idea. Those cash hoards appear as liabilities on the Fed balance sheet and thus are assets on bank BS. If, as many have advocated, those balances need to be carved back (or a mighty inflation will unfold), then something else would need to replenish elsewhere or financial system capacity would shrink dramatically. (Long time readers know we have struggled with the Structural Trap concept where capacity reduction, although painful, may be the answer.)

Vince Foster (@exantefactor on Twitter) pointed me to a note from Nomura that gets into the dirty on this topic. At present, Fan/Fred MBS is treated as Level 2 in Fed and Basel III regulation, thus subject to haircut. The only scenario where banks clear the Liquidity Coverage Ratio (LQR) and High Quality Liquid Assets (HQLAs) is with excess reserves. Recent demand for Treasuries may have improved as this problem moves off the back burner.

The combination of QE and rear view regulatory changes are icing up the growth potential by corning the banks into cash and Treasuries. FI trading desks are being gutted as "prop" trading dies. The system could tighten up rapidly as it is already structurally constrained. Perhaps, the painful reduction of capacity (and halting the regulatory pendulum) would be a better long term plan.


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