Why Banks Aren’t Lending: The Silent Liquidity Squeeze

Published on Global Research.ca, by Elen Brown, July 15, 2011.

Where did all the jobs go?  Small and medium-sized businesses are the major source of new job creation, and they are not hiring.  Startup businesses, which contribute a fifth of the nation’s new jobs, often can’t even get off the ground.  Why?

In a June 30 article in the Wall Street Journal titled “Smaller Businesses Seeking Loans Still Come Up Empty,” Emily Maltby reported that business owners rank access to capital as the most important issue facing them today; and only 17% of smaller businesses said they were able to land needed bank financing.  Businesses have to pay for workers and materials before they can get paid for the products they produce, and for that they need bank credit; but they are reporting that their credit lines are being cut. 

They are being pushed instead into credit card accounts that average 16 percent interest, more than double the rate of the average business loan.  It is one of many changes in banking trends that have been very lucrative for Wall Street banks but are killing local businesses … //

… Local Business Lending Depends on Ready Access to Liquidity

Without access to the interbank lending market, local banks are reluctant to extend business credit lines.  The reason was explained by economist Ronald McKinnon in a Wall Street Journal article in May:

Banks with good retail lending opportunities typically lend by opening credit lines to nonbank customers. But these credit lines are open-ended in the sense that the commercial borrower can choose when—and by how much—he will actually draw on his credit line. This creates uncertainty for the bank in not knowing what its future cash positions will be. An illiquid bank could be in trouble if its customers simultaneously decided to draw down their credit lines.

If the retail bank has easy access to the wholesale interbank market, its liquidity is much improved. To cover unexpected liquidity shortfalls, it can borrow from banks with excess reserves with little or no credit checks. But if the prevailing interbank lending rate is close to zero (as it is now), then large banks with surplus reserves become loath to part with them for a derisory yield. And smaller banks, which collectively are the biggest lenders to SMEs [small and medium-sized enterprises], cannot easily bid for funds at an interest rate significantly above the prevailing interbank rate without inadvertently signaling that they might be in trouble. Indeed, counterparty risk in smaller banks remains substantial as almost 50 have failed so far this year.

The local banks could turn to the Fed’s discount window for loans, but that too could signal that the banks were in trouble; and for weak banks, the Fed’s discount window may be closed.  Further, the discount rate is triple the Fed funds rate.

As Warren Mosler, author of The 7 Deadly Innocent Frauds of Economic Policy, points out, bank regulators have made matters worse by setting limits on the amount of “wholesale” funding small banks can do.  That means they are limited in the amount of liquidity they can buy (e.g. in the form of CDs).  A certain percentage of a bank’s deposits must be “retail” deposits – the deposits of their own customers.  This forces small banks to compete in a tight market for depositors, driving up their cost of funds and making local lending unprofitable.  Mosler maintains that the Fed could fix this problem by (a) lending Fed funds as needed to all member banks at the Fed funds rate, and (b) dropping the requirement that a percentage of bank funding be retail deposits.

Finding Alternatives to a Failed Banking Model:

Paying interest on reserves was intended to prevent “inflation,” but it is having the opposite effect, contracting the money and credit that are the lifeblood of a functioning economy.  The whole economic model is wrong.  The fear of price inflation has prevented governments from using their sovereign power to create money and credit to serve the needs of their national economies.  Instead, they must cater to the interests of a private banking industry that profits from its monopoly power over those essential economic tools.

Whether by accident or design, federal policymakers still have not got it right.  While we are waiting for them to figure it out, states can nurture and protect their own local economies with publicly-owned banks, on the model of the Bank of North Dakota (BND).  Currently the nation’s only state-owned bank, the BND services the liquidity needs of local banks and keeps credit flowing in the state.  Other benefits to the local economy are detailed in a Demos report by Jason Judd and Heather McGhee titled “Banking on America: How Main Street Partnership Banks Can Improve Local Economies.”  They write:

Alone among states, North Dakota had the wherewithal to keep credit moving to small businesses when they needed it most. BND’s business lending actually grew from 2007 to 2009 (the tightest months of the credit crisis) by 35 percent. . . . [L]oan amounts per capita for small banks in North Dakota are fully 175% higher than the U.S. average in the last five years, and its banks have stronger loan-to-asset ratios than comparable states like Wyoming, South Dakota and Montana.

Fourteen states have now initiated bills to establish state-owned banks or to study their feasibility.  Besides serving local lending needs, state-owned banks can provide cash-strapped states with new revenues, obviating the need to raise taxes, slash services or sell off public assets. (full text).

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