Excess reserves present a juicy target for critics who claim the banking industry is depriving the economy of the fuel it needs to grow.

These funds, deposits at the Federal Reserve that exceed required minimums, exploded from less than $2 billion in August 2008 to an unprecedented, staggering $1.2 trillion last week — a total that is only headed higher. According to the Fed's latest data, required reserves were just $71.6 billion; add that to the excess reserves and the total is now nearing $1.3 trillion.

Many people view these figures as proof that banks are hoarding cash rather than lending it.

It happened again last week at a House Financial Services subcommittee hearing on what Congress could do to get credit flowing to small businesses.

David Borris, an entrepreneur who was representing the Main Street Alliance, pointed lawmakers to the reserves banks keep with the Fed beyond the minimum requirements.

"Those excess reserves represent money that could be out circulating in the economy on productive loans, including loans to small businesses," Borris testified. "Instead, those excess reserves are sitting at the Fed and the banks are collecting 0.25% interest for holding more money out of the economy."

But the reality is more complicated, and experts agree that huge amounts of reserves tell you little about lending volumes.

The Fed alone — not actions by banks — dictates how large the reserve number is. And it is the Fed's expansion of its balance sheet, begun in the fall of 2008, that has ballooned reserve levels at banks.

Here is a simple example: When the Fed buys financial assets like government debt or mortgage-backed securities from banks, the act of the Fed paying for the assets actually creates the reserves. Say it agrees to buy $20 billion of such assets from a primary dealer. When the transaction settles, the Fed will make an accounting entry on the books of the primary dealer's bank and voila, bank reserves are created.

And that's why it's easy to predict the aggregate figure will go higher. The Fed is only halfway through its QE II strategy. It still plans to buy another $300 billion of Treasury securities by the end of June, and that will drive existing reserve levels to $1.6 trillion. (To be sure, the aggregate figure could be offset by other Fed moves or driven even higher. It will depend on future Fed decisions.)

So the more the Fed buys, the more reserves it creates. But those reserves do not prevent or encourage an individual bank from making a loan. When we talk about individual banks all we're talking about is the distribution of reserves, not overall levels.

"All the banks could be making loans like they have never done before and there is still going to be $1.3 trillion" [in reserves], a person familiar with the matter told me. "Or every single bank could decide, 'I am not lending anything' and just sit on their funds, and you are still going to have $1.3 trillion."

New York Fed President William Dudley tackled the topic recently.

"In terms of imagery, this concern seems compelling — the banks sitting on piles of money that could be used to extend credit on a moment's notice," Dudley said in a Feb. 28 speech to NYU's Stern School of Business.

"However, this reasoning ignores a very important point. Banks have always had the ability to expand credit whenever they like. They didn't need a pile of 'dry tinder' in the form of excess reserves to do so."

He added: "In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves on their own balance sheet."

One reason this topic is so misunderstood is it's still relatively new.

The Fed has long required banks to hold reserves against their deposits but only won the right to pay interest on those reserves in 2006. The Financial Services Regulatory Relief Act said the Fed could start paying interest on bank reserves, including excess reserves, in October 2011. But the law that authorized the Troubled Asset Relief Program in 2008 accelerated the effective date to October of that year.

The financial crisis had hit, and the Fed needed new tools to control the cost and supply of money. Paying interest on reserves was an effective way to get banks to hold on their balance sheets many of the assets that the Fed was creating through its new credit facilities, like its Large-Scale Asset Purchase program.

Initially the Fed paid banks 75 basis points on reserves, but that rate has been scaled back to 25 basis points.

While making a loan could provide a higher return to banks, three other factors are depressing lending. One is the lack of demand from creditworthy borrowers. Higher capital rules are another. And finally many banks are just too busy sorting through the pile of defaulted loans sitting in their existing portfolios.

So while it may be true that some banks are stockpiling cash, high reserve levels are more a consequence of the reluctance to lend than the cause. And aggregate reserve levels will fall only when the Fed decides to change its monetary policy course and tighten up.

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