Cash and money: thoughts on the global financial infrastructure under QE

Part 1 of 4

It’s strange and perhaps worrying that whereas just a few months ago, QE was an acronym that no one would have recognised and even fewer understood, today it’s part of the common language. Yet in reality we know very little about how it will play out, although we can observe that a relatively small number of large US, European and Japanese banks (with HSBC in the forefront it seems) have a very large stock of dollar liquidity sitting as an asset on their balance sheets at present as a result of the various attempts at currency market interventions, which include QE.

In practice, the ’money’ created by the central banks in the US, the UK and elsewhere is not paper money per se but rather ‘book entry’ bank deposits credited to the vendors of the relevant government bonds by the respective central banks. For example, when the Fed purchased Treasuries from the markets, the seller will have received transfer of the proceeds into their own bank account and, although they may have then used this money to buy another asset elsewhere in the system (and thereby transferred the deposit to another), the Federal Reserve’s and others’ QE Regimes did not ‘print money’ in any physical sense, but they did create bank deposits in favour of depositors somewhere in the financial system.

We can discern that the recipients of these deposits (particularly in the USA) have exhibited a preference for holding their new deposits in relatively few, very often global, commercial banks. These deposits were of course the liability of the commercial banks concerned and their counterparty asset will have been a claim of the Fed, which could have been physical cash but in practice will have been a very low yielding deposit at the FRB. The latter are commonly known as reserve deposits but not only do these deposits yield nothing, also they frequently involve an insurance premium payable to the FDIC by the commercial bank, which can mean a negative effective yield for the banks on these assets – so for these few mega banks, the return on these dollars is either zero or negative once costs and FDIC insurance premia are factored into the equation. This of course implies that the commercial banks need to ‘do’ something with these funds but the banks are however constrained from lending these dollars to the real economy by a combination of weak or perceived weak capital adequacy positions, general caution, and often low levels of credit demand in the real sectors.

As a result, the small number of banks involved put a significant chunk of the funds into purchases of capital efficient (domestic) government bonds or lending via the heavily collateralized repo and other intra financial system credit markets to the non-bank financial sectors, such as the investment banks, hedge funds (usually via the investment banks) and other investment related financial institutions.

Although US bank asset growth has been very modest in aggregate since the global financial crisis, the banks have at times been very active creators of credit to other parts of the financial system and we would go so far as to say that this activity has been not only the primary source of what liquidity growth there has been in the economy over recent years, but also instrumental in framing the environment in the various asset markets. Certainly, there would seem to be some visual correlation between the performance of the risk markets and the level of the banks’ activity in lending to the non-bank financial system. This is dangerous and needs careful watching.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla