### Central Banks digging trenches, part 2

The news today:

The Bank of England relaxed restrictions on the amount of money financial institutions need to hold with the central bank, encouraging them to lend more to each other as it tries to reduce overnight borrowing costs.

Commercial banks, which agree to hold a specific amount of money at the Bank of England at the end of each month-long maintenance period, can now undershoot that target by 37.5 percent and still earn interest at the benchmark interest rate, the central bank said today. That compares with a previous restriction of 1 percent.

This is a simple deposit multiplier story. The “Money Supply” is M1 and M2 money. Call it cash in our pockets, and money in the bank.

As measured, for example, for the US in September of 2005:

Fractional deposit banking occurs most commonly: banks take in your $1,000, keep, say,$100 and re-lend (or deposit in other banks) the $900. So the actually supply of money is not$1,000, it is $1,900. Then the next bank will take that$900, keep $90 in their deposits and re-lend$810. The Simple Deposit Multiplier says the increase in the money supply from that \$1,000, with a 10% reserve requirement, will be ($1,000\times \frac{1}{0.10}=10,000$).

Thus, if the Central Bank In Question wishes to increase the money supply (say, if there is a credit crises, crunch, etc.) it can “just” lower the Federal Reserve Requirement. If we lower the Reserve Requirement to, say, only 8%, we get $1,000\times \frac{1}{0.80}=12,500$, a 25% increase in the total money supply.

The Downside?

This is economics: there is always a downside. The downside is that the security of your deposits is now lower. The banks have, in reserve, less money to make good on their promise to give you back your money when you want it. Moreover, as we saw, there is more money – i.e. more of those promises. It also encourages banks to lend more money to one another, as they find themselves lumped with more of the debt they used to be selling on to the bond markets.

One does not like to draw parallels with Japan because, frankly, one does not wish to see them. However, England is now joining the likes of the United States and Australia, going beyond pushing money back and forth in overnight markets to deal with overnight rates, and changing the rules of the game.

By changing them, more importantly, they are giving financial agents an ‘out’, and further encouraging risky behaviour. You throw compulsive gamblers out of casinos: you don’t let them leave their debt to ride, hoping that the next throw will save them. What we’re seeing our Central Banks enacting are rule-changes that encourage banks to fill in the public face of bad debt with new lines of credit.

Meanwhile, you and your neighbour own those deposits. If we go under, you lose your job and your savings might go missing – are you getting a higher rate of interest, to compensate you for that extra risk? You are not, and this is one of my biggest problems with this. Financial problems are always caused and never solved by letting financial agents take risks with Other People’s Money to cover their own asses (or savings, or stock portfolios).