Federal Reserve Chairman Jerome Powell spoke to the House Financial Services Committee last week.
Later in the discussions, the Basel III endgame proposal came up. The proposal pertains to bank reserve requirements for both lending and trading activities.
Interest rates get all the attention when it comes to the Federal Reserve’s (the Fed’s) monetary policy. But bank reserve requirements are just as important.
Bank reserves are simply the money that banks keep on hand to back any loans or investments they make. Greater reserves equate to less risk.
Central banks set reserve requirements as a percentage of a bank’s deposits. There are some nuances to this calculation, but since 1982 the base reserve requirement has been 10% for banks here in the United States.
That means US banks have been free to lend or invest $90 for every $100 they receive in customer deposits. They must hold the other 10% in reserves.
We call this a fractional reserve system. Because the bank’s only need to hold a fraction of their customers’ deposits in reserve.
But that changed on March 26, 2020.
In response to the Covid hysteria, the Fed reduced bank reserve requirements to zero. Which means we went from a fractional reserve to a no reserve system.
Here’s why this matters…
We talked yesterday about how interest rates send signals. Those signals help us allocate resources efficiently.
Which is to say, they help us decide which companies and projects are likely to be good investments. Then we can choose the best investments and avoid the worst.
Bank reserves play a similar role. The greater reserves a bank must hold, the more picky it must be with the loans it makes.
In this way reasonable reserve requirements also help the economy allocate resources efficiently. Because the banks must be extra careful about what they finance.
Low quality companies and projects that receive funding represent a misallocation of capital. They direct scarce resources like labor and materials to suboptimal tasks. That’s a drain on economic productivity and growth.
Economists refer to this dynamic as malinvestment. We can think of it like this…
If we want a robust economy, we need capital and talent focused on its highest and best use. Thus we hinder the economy if we finance uneconomical efforts.
What’s more, funding unviable projects can prolong bad business practices, poor management, and flawed strategies. This is what creates zombie companies. These are companies that can only survive by borrowing more and more money.
Goldman Sachs estimates that 13% of all publicly traded companies in the US today are zombie companies. The Fed puts its estimate at 10%. Artificially low interest rates and low bank reserve requirements are what keep these companies alive.
This brings us back to the Basel III endgame proposal. It would require banks with over $100 billion in assets to increase their risk-based capital requirements by roughly 16%.
Basel III would also introduce a standardized model for calculating a bank’s risk. Today each bank uses its own model.
So the proposal seeks to impose greater fiscal responsibility upon the banking system. Large banks would have to be more diligent with both the loans and the investments they make.
Paired with normalized interest rates, this would likely signal the end of the cheap money era. Only the most credible companies and projects would get financing going forward.
And then many of those zombie companies mentioned above would go under. That would free up capital for newer, more innovative companies… which would set the stage for a strong economic recovery.
The question is – will Basel III be implemented?
Fed Chair Jerome Powell told Congress last week that he expects “broad and material changes” to the proposal. But he didn’t offer any extra details on the matter.
That sets the stage for an interesting show.
On one hand, Powell’s getting pressure to cut interest rates. On the other, the big banks will pressure him not to tighten reserve requirements so much.
Yet, a return to fiscal responsibility requires real interest rates and meaningful reserves.
Stay tuned…
-Joe Withrow
P.S. For a deeper dive on what the Fed is really up to and the most important macroeconomic story of our day, please see my book Beyond the Nest Egg – How to Be Financially Independent Outside of a Broken System.
You can find it on Amazon at: https://www.amazon.com/Beyond-Nest-Egg-Financially-Independent/dp/B0CGG5G6XH