Fed and Leverage on US Banks

**xuedong_zhang** Mon Nov 19, 2007 4:20 pm

Fed and Leverage on US Banks
I mean how fed control the 20x leverage borrowing power of banks. We know, China Central Bank can change the leverage(reserve) rate to control liquidity or RMB. I am less clear how Fed function like that.

From what I read from the web, seems Fed can inject money into the reserve bank, then the the other bank can borrow this money as their reserve in the fed reserve bank, which then determine how much money they can loan out?

Is this true?

**blast_investor** Mon Nov 19, 2007 5:53 pm

xuedong_zhang wrote: I mean how fed control the 20x leverage borrowing power of banks. We know, China Central Bank can change the leverage(reserve) rate to control liquidity or RMB. I am less clear how Fed function like that.

From what I read from the web, seems Fed can inject money into the reserve bank, then the the other bank can borrow this money as their reserve in the fed reserve bank, which then determine how much money they can loan out?

Is this true?

Yes, The Fed in effect can control this leverage ratio for banks in various way. The Fed is the Central Bank of USA, which prints US Dollar as needed.

The Fed effect on leverage can be explained here:
http://en.wikipedia.org/wiki/Federal_Reserve#Regulation_of_fractional_reserve

The smaller the reserve on deposit, the higher leverage ratio for banks.

Not only the Fed regulate deposit reserve issue, Fed can directly loan money to banks on discount window programs and other programs. Major banks (Merrill) are allowed to borrow money directly from the Fed.

Here is news in August, in that news, the Fed urged banks to borrow money directly from Fed:

http://www.nytimes.com/2007/08/23/business/23discount.html?ref=business
4 Major Banks Tap Fed for Financing

The Fed has lots of information on its web page:
http://www.federalreserve.gov/

**xuedong_zhang** Tue Nov 20, 2007 1:05 am

That's something I do not understand the system.

People are talking about the capital ratio, which means the bank can not issue any risky loans 20x of its capital. So write off the assets (capital) will en-danger bank's ability to write loans.

I don't understand how the fed reserve can change this, lending money to bank cannot change this capital ratio requirement.

Maybe most bank will not reach this ratio, so they can always write loans and the question is how to get the money.

The reserve ratio requires the bank to keep part of its deposit in federal reserve, buy changing this requirement, the bank can get more cash, or they can lend money directly to these banks.

Am I right?

blast_investor wrote: xuedong_zhang wrote: I mean how fed control the 20x leverage borrowing power of banks. We know, China Central Bank can change the leverage(reserve) rate to control liquidity or RMB. I am less clear how Fed function like that.

From what I read from the web, seems Fed can inject money into the reserve bank, then the the other bank can borrow this money as their reserve in the fed reserve bank, which then determine how much money they can loan out?

Is this true?

Yes, The Fed in effect can control this leverage ratio for banks in various way. The Fed is the Central Bank of USA, which prints US Dollar as needed.

The Fed effect on leverage can be explained here:
http://en.wikipedia.org/wiki/Federal_Reserve#Regulation_of_fractional_reserve

The smaller the reserve on deposit, the higher leverage ratio for banks.

Not only the Fed regulate deposit reserve issue, Fed can directly loan money to banks on discount window programs and other programs. Major banks (Merrill) are allowed to borrow money directly from the Fed.

Here is news in August, in that news, the Fed urged banks to borrow money directly from Fed:

http://www.nytimes.com/2007/08/23/business/23discount.html?ref=business
4 Major Banks Tap Fed for Financing

The Fed has lots of information on its web page:
http://www.federalreserve.gov/

**blast_investor** Tue Nov 20, 2007 1:59 am

xuedong_zhang wrote: That's something I do not understand the system.

People are talking about the capital ratio, which means the bank can not issue any risky loans 20x of its capital. So write off the assets (capital) will en-danger bank's ability to write loans.

I don't understand how the fed reserve can change this, lending money to bank cannot change this capital ratio requirement.

the Fed is US Government of Central Bank. Easy, Fed change reserve rule. Say, the Fed allow 30x leverage tomorrow. Isn't that more money allowed?

the Fed is rule maker, banks follow Fed rule.

Quote:
Maybe most bank will not reach this ratio, so they can always write loans and the question is how to get the money.

The reserve ratio requires the bank to keep part of its deposit in federal reserve, buy changing this requirement, the bank can get more cash, or they can lend money directly to these banks.

Am I right?

Reserve change is mainly on leverage ratio. Just as hypothetical case, $50 million reserve on $1 billion deposit is 20x maximum leverage ratio. $20 million reserve on $1 billion deposit is 50x leverage ratio. The cash difference between 50 and 20 million is small. But 20x verses 50x is big on bank's ability to fund loans.

Just as my above example. now Fed changes rule allows 30x. $1 billion capital could only loan $20 billion in the past, because of rule change, now banks can loan $10 billion more tomorrow (hypothetical).

How to get extra $10 billion cash for bank's loan fund? From deposit money of depositors (from own bank or other banks deposit),that is one way. Aother way from the Fed directly. Just put $10 billion of mortgage as collateral on discount window, the Fed give you $10 billion cash. Now bank has this extra $10 billion cash funding this $10 billion mortgage paper on discount window.
$10 billion extra was in fact created by the Fed. It was not allowed before the rule, but with Fed changing rule as hypothetical case, Fed can create this $10 billion extra new money for loan funding.

Small banks can get cash from Fed as customer of major banks.