BANK´S HEFTY RESERVES CREATE DISQUIET / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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NOVEMBER 29, 2009, 2:29 P.M. ET

Banks' Hefty Reserves Create Disquiet

By PETER EAVIS

There is a $1 trillion stash of cash idling in the banking system. It's too big to ignore, and it's a cause for concern.

In normal times, banks hold a bare minimum of funds in reserve to support their liabilities. But these bank reserves now exceed the U.S. Federal Reserve's regulatory floor by $1 trillion. Before the credit crisis intensified in September last year, excess reserves—effectively cash banks hold above their regulatory requirements and usually hate holding—totaled just $2 billion.

The Fed's extraordinary policies aimed at shoring up the economy and banking system are the reason excess reserves have ballooned. As the central bank prints money to buy, say, mortgage-backed securities, much of that extra cash ends up in the banking system, potentially as excess reserves.

So why do excess reserves create disquiet?

First, inflation hawks view them with distrust. In theory, these sleeping funds could be "activated" to support a huge volume of new loans, which in turn could fuel demand and inflation. True, the Fed can increase interest payments it makes on excess reserves, which would encourage banks to keep holding them and not activate new lending. But that works only if the Fed doesn't wait too long to raise that rate. And recent history suggests the Fed usually is too slow to hike key rates after a downturn.

For now, though, the inflation fears look overdone. Bank credit is actually falling, despite the excess reserves. That raises an opposing fear: That banks remain nervous, even after all that has been done to support them. They would rather cling to low-yielding cash than lend it.

"If they don't make a loan, they can't make a bad one," says John Mason, associate professor at Penn State. And, he says, banks have plenty of reasons to remain cautious and liquid, such as looming commercial-real-estate losses and big debt maturities.

A third camp takes a laid-back view of excess reserves. At this early point after a recession, an increase in bank lending can hardly be expected, they say. As a result, it is misleading to link falling loan totals and high excess reserves to make a convincing case that bankers are paralyzed by uncertainty. The Fed's special policies were always going to create cash that ended up in the banking sector, regardless of banks' willingness to lend, they say.

But excess reserves have surely made banks feel safer, something backed up by history. The Fed's moves to trim excess reserves in the late 1930s, by raising minimum requirements, arguably helped create another economic downturn. "The Fed apparently wasn't aware that banks wanted to hold these reserves," says Paul Kasriel, economist at Northern Trust. "The result was that banks started to cut lending."

The current Fed has extra tools to avoid such mistakes, such as the ability to pay higher interest on excess reserves to keep them dormant if necessary. But if it waits too long, it risks getting behind the curve on inflation if the economy roars back.

Excess never looked less fun.

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