Quote Originally Posted by jk View Post
The fed is already making noises about ceasing to pay interest on excess reserves. This action, in combination with a forthcoming q.e. ii, will move liquidity out of fed deposits and into the real economy, likely into financial assets first as the banks prefer to game the financial markets rather than make loans. The money will then slosh elsewhere.
The Fed is currently paying interest on both required and excess reserves:
http://www.federalreserve.gov/moneta.../20081006a.htm

I believe the unstated goal of that program was to help replenish bank capital. When loans go into default, they destroy bank capital. If capital levels drop below the required minimums, a bank must be closed. Through programs such as the Term Auction Facility (TAF), the Fed was able to temporarily exchange certain bank assets for cash. That cash became bank reserves, which now earn interest; and interest income (less expenses) becomes bank capital. Before such a program (or one of its successors, such as TARP), there was no mechanism for the Fed to inject capital into a bank. The bank is actually just using certain assets as collateral for loans from the Fed, and those loans have to (in theory) be paid back at some stage. In fact, loans through TAF were originally intended to be short-term only.

That's the basis of my hypotheses as to why banks "aren't lending": because they are obligated to buy back those assets from the Fed. If they were to make loans, that would reduce the amount of excess reserves they have available for that purpose, and of course any losses against those loans would aggravate the problem even further.

In addition, are you sure that excess bank reserves can be invested in the stock market? I know that required reserves can't be (they have to be held in the bank's account at the Fed, or as vault cash), but I'm uncertain about excess reserves (though excess reserves can of course be loaned to other banks through the Fed Funds program). Even if they can be, once again, I would expect banks to be very conservative with those funds, since they are still obligated to pay back loans from the Fed.