Do You Know What The Effects Of Quantitative Easing Has On Commercial Banks?

This post was originally posted here. The writer, Kyith Ng is a veteran community member and blogger on InvestingNote, with a username known as @kyith and has 1095 followers.

Quantitative easing means to liquify the financial markets and the main economy, a lot of money was pumped into the financial system.

The straightforward deduction is that if you create money from out of nowhere, either your currency is going to shit or that inflation will run rampant.

We are not seeing both in the United States right now but a lot of the people are speculating it will be a matter of time.

I wonder whether that will really happen. I say this because I can’t say I am that competent to make that deduction. Usually, we have to know to a good extent what I am talking about to make that conclusion.

I do think that from what I hear, we have created an interconnected system that will create more than 2 standard deviations, 3 standard deviation volatility.

One of my favorite people on the financial blogosphere Cullen Roche of Pragmatic Capitalism explained that when the Federal Reserve infuses money, it is an exchange of very short-term liquid money with long-duration money/bonds.

In a way I understand it but if I cannot illustrate it out well, then maybe I do not understand it as well.

In any case, BCA has a good explanation about what happens when the Central Bank buys back commercial securities from the banks.

It sought to help to explain the relationship of Central banks with the monetary system.

I used to not get the relationship of Central Banks that well but the way to think about them is like the Bank of the financial institutions. They somewhat act as the lender of last resort.

If banks produce the lifeblood of the financial system, then they have to be functioning.

But what if the banks are not functioning?

That is probably the Central Bank’s job to lubricate the system.

The relationship can be best illustrated by observing the balance sheet of the Central Bank and a Commercial Bank as the Central bank announces they will buy commercial loans/bonds.
The central bank and a commercial bank’s balance sheet before and after they decide to take on a bond purchase

In the above diagram, the top section shows the balance sheet of a Central Bank and Commercial Bank. The bottom section shows the balance sheet after they decide to purchase $100 worth of bonds that belonged was on the books of the Commercial bank.

The main operating segment for a bank is to take in your deposit by giving you interest, and then borrowing your deposit out at a higher interest.

To ensure that you can always withdraw your deposit and not have a “run-on-the-bank”, the Central bank will mandate the commercial bank to keep a reserve with them.

If the Central bank mandate a higher level of reserve, the commercial bank can only lend less. If they mandate a lower level of reserve, the commercial bank can lend more. This is one of the ways they regulate the money system.

Now, when there is a crisis of confidence in the financial system, counterparties have a heightened distrust of whether each other can honor each other’s financial obligations. What the Central bank can do is to either guarantee certain transactions.

Or they can do something novel which is to buy the securities on the commercial bank’s balance sheet. In this case, the Central bank first said they will purchase the higher-quality bonds, then bonds through exchange-traded funds.

To do that, they have to create money out of thin air, through money printing, which you can see as New Excess Reserves Created of $100 on the Central banks’ Liabilities.

In accounting double entry, the matching entry is a $100 New Bond Purchase.

This New Bond Purchase comes from buying over the existing bond held on the assets in the commercial bank. The commercial bank receives $100 in cash.

What you would notice is that

1. The Central Banks balance sheet expanded both on the assets and liabilities
2. The Commercial Bank balance sheet is the same
3. The deposit in the Commercial Bank stays the same.
4. What is different is the quality of the Commercial bank’s balance sheet. The bonds were of certain risk. Now that $100 of bonds is replaced by something of higher quality (or less risky)

Net-net the money supply was not affected by these Quantitative Easing operations.

Where money supply will be created, according to BCA, is when the Central bank lends to or purchases securities from both the commercial banks and economic agents.

If instead of all deposits, the commercial bank held liabilities in pension fund deposits, then the case might be a bit different.

We introduce the before and after the balance sheet of a Pension fund in the third column.

The New Excess Reserve Created at the Central bank is used to purchase additional Pension fund deposits instead of commercial bonds at the commercial banks.

What this does is that the Commercial bank’s balance sheet expands both on the asset and liabilities end.

The subtle difference is instead of improving their own balance sheet, they go get themselves more levered.

The summary is that Quantitative Easing operations create new money when Central banks purchase assets or lend to non-banks (like the Pension fund). When Central banks purchase assets from commercial banks, no new money is created.

What actually creates new money outside of Quantitative Easing is when commercial banks purchase securities from or loans to economic agents (like the Pension fund in the example).

Can We forecast How Much Money is Created Through QE Operations?

One conclusion we may draw from the previous discussion is that we may not know if the money buys back from the commercial banks or from non-bank entities.

Basically, there is no easy way of predicting the percentage of which.

We do know that the Central Banks may just be getting bigger and bigger.