Excess Reserves Don’t Necessarily Lead To Excess Credit Creation

I just can’t leave this topic alone. But it’s interesting to contrast the Malaysian experience with what’s going on in the US and Europe right now.

In my post on hyperinflation, I made the assertion that credit creation is no longer an asset side phenomenon driven by the logic of fractional reserve accounting, but limited on the liabilities side of the balance sheet by capital ratios. This in turn means that excess reserve creation carried out by western central banks isn’t necessarily inflationary.

Here’s some supporting evidence, in the Malaysian context. First the track record of loan growth since 1998 (log annual changes):

After recovering from two recessions in the space of five years (1997-98, 2000-2001), loan growth was fairly steady at around 4% in the first part of the decade, before picking up around 2005. The last three years have seen much faster loan growth, even considering the recent recession.

The next chart shows the effective reserve ratio, defined as statutory and excess reserves as a ratio to M3:

The only point in time where the effective reserve ratio was near or at the statutory level was in 1998 – right in the depths of the Asian currency crisis. Right now, the current reserve ratio of 15% is 150% higher than the statutory level. Put another way, the money multiplier (which is the reciprocal), has crashed and been low ever since, though it has recovered somewhat in the last couple of years:

So reserves appear to have decoupled from loan growth, and by implication, money supply growth. Do the capital ratios make better sense as a practical limit on credit creation? For the most part, yes:

I don’t have the actual capital adequacy ratio numbers so I’m using a proxy here, which is the ratio of total assets over the capital base. Note that this is much more stable than the reserve ratio, though there was a sharp drop in 2008. And that’s exactly what I was looking for – if the limit on credit creation was the capital base, you would expect increases in loans to only.occur if the capital base also increased. And that means the ratio of the balance sheet size to the capital base should be approximately stable.

One other aspect of this should also be mentioned. In a fractional reserve accounting framework, money is only created when loans are given out by the banking system. The same is not true of banking system investment in financial assets. Malaysia’s increasingly deep and broad capital markets provide an alternate route for corporate financing, which means less reliance on the banking system for funding while at the same time reducing the potential of banks to turn excess reserves into money circulating in the economy:

As you can see, there’s been a gradual structural shift in corporate finance from bank lending to the capital markets – apart from a couple of short periods, capital market financing has grown at double digit rates this whole past decade.

But what’s true of Malaysia is even more true of the advanced economies – current data on US banks show approximately the same 60/40 ratio of loans to other assets.

And that puts another stake in the heart of the excess reserves eventually leads to inflation narrative.

Technical Notes:

All data from BNM’s Monthly Statistical Bulletin, except US bank data from the Federal Deposit Insurance Corporation