Exactly How Does Qe Facilitate Bank Lending?

[The Spaniard]

This question has been asked before on HPC but not yet answered satisfactorily.

We assume that QE replaces Gilts with new BoE money on the asset side of a bank's balance sheet.

Neither the total assets, nor the total liabilities of the bank is affected.

Hence the arithmetic difference between the assets and the liabilities is also not affected.

Basel regulations limit the bank's lending capacity to a fixed multiple (25?) of this arithmetic difference.

So precisely how is the lending capacity of the bank increased by QE?

Is the BoE money a higher grade/tier asset than Gilts in some technical sense?

Professionally knowledgeable explanations are particularly welcome.

[57percent]

(someone who knows more than me will no doubt have a better answer, but here's my thinking)

I believe it's to do with the ratio of narrow money to broad money.

If you follow the fractional reserve ratio (or capital adequacy) model to it's most efficient

endpoint, all the narrow money will be held by the banks and the total amount of broad money

is the narrow money multiplied by the maximum amount the banks can leverage.

Pre credit crunch this was something like 175bn x 30 = 5.2tr (very rough numbers)

Now at that point there's only 2 ways to continue to inflate the broad money supply

- print money

- increase the banks leverage

At the same time, the banks were realising that they'd leveraged too far. Firstly the increase

money supply (inflation) had not fed to wages, so people could never pay the money back and

secondly their exposure/leverage was so much (30x) that they only needed 3% of loans to default

before they were insolvent.

So the only solution is to print money. They can't call it that, so they pretend it's temporary by

calling it QE. Where the money initially goes doesn't really matter, but it will eventually feed into

the bank reserves (presuming a perfect closed system) and in turn will reduce the broad to narrow

money ratio and allow the banks to lend (or survive).

If they've created 175bn, then the equation could be:

reserves 350bn - broad 5.2tr (banks have decided to hoard, so their leverage is less)

reserves 350bn - broad 10tr+ (banks have continued to leverage at 30x and lent loads out)

I don't understand how they can ever destroy the QE money???

[Peter Hun]

Where the money initially goes doesn't really matter, but it will eventually feed into

the bank reserves (presuming a perfect closed system)

Isn't the problem that it isn't a closed system and the money if fleeing overseas?

[leicestersq]

This question has been asked before on HPC but not yet answered satisfactorily.

We assume that QE replaces Gilts with new BoE money on the asset side of a bank's balance sheet.

Neither the total assets, nor the total liabilities of the bank is affected.

Hence the arithmetic difference between the assets and the liabilities is also not affected.

Basel regulations limit the bank's lending capacity to a fixed multiple (25?) of this arithmetic difference.

So precisely how is the lending capacity of the bank increased by QE?

Is the BoE money a higher grade/tier asset than Gilts in some technical sense?

Professionally knowledgeable explanations are particularly welcome.

I think it is your assumption that is wrong, and hence getting in the way of your understanding.

The Bank of England just adds new money to its balance sheet, there is no replacement of anything. Only once it has done that does it buy the gilts. In buying the gilts it puts that cash out there into the world, and that ends up as increased deposits in the commercial banking world. This can then be used to lend against.

[the_austrian]

I think it is your assumption that is wrong, and hence getting in the way of your understanding.

The Bank of England just adds new money to its balance sheet, there is no replacement of anything. Only once it has done that does it buy the gilts. In buying the gilts it puts that cash out there into the world, and that ends up as increased deposits in the commercial banking world. This can then be used to lend against.

So they are fixing the problem of insufficient reserves... But reserves are a voluntary requirement, most banks don't have any so why would this make a difference?

[roman holiday]

Isn't the problem that it isn't a closed system and the money if fleeing overseas?

Yes, this is what I have been thinking. There must be a lot of money going into all those new IPOs being offered on the Chinese SE.

But even if this was not he case, I do not think QE will be successful in effecting reflation... perhaps at best just softening the deflation.

Edited July 29, 2009 by roman holiday

[the_austrian]

Isn't the problem that it isn't a closed system and the money if fleeing overseas?

Money held abroad doesn't affect prices in the UK?

[57percent]

I'm not convinced by the moving money abroad part.

It will reduce the value of pounds relative to other ccys, but it doesn't change the number of pounds in the system

or the narrow/broad ratio.

If you took the new money hid it, then the QE impact is zero.

Some (most, nearly all), will end up in the banking system.

Whether banks will increase lending is another question.

[The Spaniard]

I think it is your assumption that is wrong, and hence getting in the way of your understanding.

The Bank of England just adds new money to its balance sheet, there is no replacement of anything. Only once it has done that does it buy the gilts. In buying the gilts it puts that cash out there into the world, and that ends up as increased deposits in the commercial banking world. This can then be used to lend against.

You are supposing that the BoE buys Gilts from a non-bank (with new money), for example an investment trust.

In this case the investment trust's bank balance is increased.

This is an increase in the bank's liabilities which would actually decrease it's lending capacity.

For this reason I don't see how QE money can be used other than to buy bank-owned assets.

[SarahBell]

Because FuzzyLumpkins now can find 3 eggs in the secret space at the bottom of the garden rather than two before and that children is the magic of quantative easing.

[The Spaniard]

If you took the new money hid it, then the QE impact is zero.

Some (most, nearly all), will end up in the banking system.

Whether banks will increase lending is another question.

Thank you for your well constructed replies, 57%.

Under the Basel rules I still do not see how replacing a Gilt asset with an equal narrow money asset on the balance sheet of a bank will increase the allowed lending of that bank, unless the new money somehow has a greater weighting (higher tier?) than did the Gilt.

As you say it would certainly change the ratio of broad to narrow money, but my understanding of Basel is that this ratio is no longer the limiting factor.

[57percent]

Remember QE is just printing and distributing money.

The only difference is they're saying that at some point they'll destroy it.

The only thinking is how to distribute it. They've decided to buy mostly govt bonds, causing a

temp rise in price (reduction in yeild). Before long, the market will reprice these as normal.

They could have dropped the cash from a helicopter, slightly increasing the price of everything.

Once this money hits the banking system and is then leveraged out then everything will rise in price.

..... until it's reversed ....

[The Spaniard]

Banks have been hoarding their (excess) reserves to meet potential obligations (e.g. overseas creditors) thereby pushing up the cost of interbank lending and hence credit.

By making reserves more freely available, the cost of interbank lending should fall and hence the demand for credit rises.

That makes sense.

The banking system is not over-leveraged and technically it still has further lending capacity under Basel.

The participating banks hold some assets in the form of Gilts but these assets are relatively illiquid in so far as they cannot be used for inter-bank lending.

So, without changing the lending capacity of the banks under Basel, the Gilts are exchanged for new BoE (narrow) money.

Inter-bank lending is thus enabled, hence extra-bank lending is also enabled.

Have I understood you correctly?

[roman holiday]

But why would they want to lend into a deleveraging economy?

[Bloo Loo]

Remember QE is just printing and distributing money.

The only difference is they're saying that at some point they'll destroy it.

The only thinking is how to distribute it. They've decided to buy mostly govt bonds, causing a

temp rise in price (reduction in yeild). Before long, the market will reprice these as normal.

They could have dropped the cash from a helicopter, slightly increasing the price of everything.

Once this money hits the banking system and is then leveraged out then everything will rise in price.

..... until it's reversed ....

reversed...how is that going to happen?

[babesagainstmachines]

The QE isn't to help the banks. It's to cover Government spending and keep thecost of government borrowing artificially low.

The support to the banking sector was asset swaps and lending through the various BoE schemes before QE was announced. Swap you £1bn CDO for £900million of Government bonds. Lend me £800million based on this £1Bn of MBS. etc

Remember, all them things that were trading at 50% below par and had to have to value fixed by the BoE or all the banks were insolvent?

God, it seems so long ago now.

[Charterhouse]

I'm not sure it helps it by actually doing anything with money. Gilts can be repo'd to borrow money anyway so if it was that banks were holding gilts and not lending they could have repo'd the gilts anyway.

I think it's much more that they are effectively buying gilts to lower the risk free cost of funds and this in turn should lower the rate at which funds are provided to the end users. In fact however it has not worked, because banks don't care about the risk free rate of funds, they care about libor and the swap curve, and that has hardly budged.

There are many many things that the BoE could have done rather than buy gilts to have a better effect, and the fact that they didn't do them leads me to much teh same conclusion as dazednconfused, that at least part of the motivation is to i) help the DMO to sell a record number of gilts and ii) effectively monetise part of the UK debt and thereby stave off deflation.

[mdman]

So the answer seems to be we can't agree on the answer for sure.

I thought QE had 2 effects -

- overpaying for gilts driving down yields (and therefore cost of borrowing for anything dependent on gilt yields, directly or indirectly)

- enabling banks to recapitalise (somehow)

[Charterhouse]

So the answer seems to be we can't agree on the answer for sure.

I thought QE had 2 effects -

- overpaying for gilts driving down yields (and therefore cost of borrowing for anything dependent on gilt yields, directly or indirectly)

- enabling banks to recapitalise (somehow)

I agree. By point;

- Yes, the money that is printed is only really printed to take care of the mark-to-market loss that will definitely occur from overpaying for gilts. Imagine that the BoE sells the bonds back into the market at a loss - the only cash ultimately printed is the MTM transfer from them to the original gilt sellers.

- Yes, or rather to make more money by i) supposedly lowering the risk free curve so banks can make more money by lending at the same rate and ii) by giving them some of the profit from the overpaying for gilts that we just discussed.

[Timm]

State buys gilts with printed money.

State sets BoE rate at 0.5%, so bank buys gilts from state to get return.

State spends money.

The extra money flows around the economy, buying things and getting put in banks who lend out against it.

This is inflationary.

How inflationary, we shall see...

[tpbeta]

QE has no effect on inflation or deflation or lending or borrowing. That was the Japanese experience and they invented the strategy.

The QE money is just sitting in the BoE reserves because no-one wants to borrow it. It's a balance sheet recession. Listen to Richard Koo.

http://media.csis.org/er/090326_koo.mp3

56-45 minutes in.

[equitystasher]

Could QE be the reason for stock market rises?

[The Spaniard]

http://www.bankofengland.co.uk/monetarypol...qe-pamphlet.pdf

Supplying more money

how it works

Direct injections of money into the economy, primarily by buying gilts,

can have a number of effects. The sellers of the assets have more money

so may go out and spend it. That will help to boost growth. Or they may

buy other assets instead, such as shares or company bonds. That will push

up the prices of those assets, making the people who own them, either

directly or through their pension funds, better off. So they may go out and

spend more. And higher asset prices mean lower yields, which brings down

the cost of borrowing for businesses and households. That should provide

a further boost to spending.

In addition, banks will find themselves holding more reserves. That might

lead them to boost their lending to consumers and businesses. So, once

again, borrowing increases and so does spending. That said, if banks are

concerned about their financial health, they may prefer to hold the extra

reserves without expanding lending. For this reason, the Bank of England is

buying most of the assets from the wider economy rather than the banks.

The extra money has worked its way through the

economy, resulting in higher spending and therefore

growth.

So, the BoE buys (with new money) a Gilt from, for example, an investment trust.

The investment trust then has more money in its bank account, thus increasing the liabilities of this bank, but without any obvious corresponding increase in the bank's assets.

Surely the bank must acquire an equal and opposite asset, but how and where?

[Bloo Loo]

So, the BoE buys (with new money) a Gilt from, for example, an investment trust.

The investment trust then has more money in its bank account, thus increasing the liabilities of this bank, but without any obvious corresponding increase in the bank's assets.

Surely the bank must acquire an equal and opposite asset, but how and where?

indeed, the trust has cash in its account now, earning nothing, whereas before it had a gilt earning interest.

the idea is that the trust will invest the cash and earn interest.

they have swapped a gilt for cash. balance.

[The Spaniard]

indeed, the trust has cash in its account now, earning nothing, whereas before it had a gilt earning interest.

the idea is that the trust will invest the cash and earn interest.

they have swapped a gilt for cash. balance.

Sure, the trust's balance sheet doesn't change much with its asset for asset swap.

My question is that the trust's bank has acquired a liability (the trust's deposit) but apparently not a corresponding asset.