Quote Originally Posted by mmreilly View Post
Looks like I'm about five years late to the discussion, but while I agree that changes in banking regulation affected money supply growth in the early and mid-1990s, I suspect that the change in reserve requirements was a secondary factor. It seems to me that the more likely factors were the implementation of minimum capital requirements and significant changes in bank profitability during that period.

The first international agreement on minimum bank capital levels ("Basel I") was agreed in 1988 and phased in from 1990-1993. During this timeframe, banks were forced to increase their ratio of equity to assets (i.e., loans and securities), and they had three ways to accomplish this: raising capital by issuing shares, retaining earnings, and shrinking their loan portfolios. Banks are generally hesitant to dilute their existing investors through share issuance except in the context of an acquisition, and so there were really only two viable ways for the banks to increase their capital ratios.

Unfortunately for the banks, the phase-in of these increased capital requirements occurred during the tail end of the S&L crisis and the early 1990's Latin American debt crisis. Loan credit losses peaked in 1992 at their highest levels since 1935.

Bank Losses Capital.png

These events reduced aggregate bank profitability to the lowest levels since the Great Depression, constraining their ability to build capital through earnings.


As a result, banks were forced to limit loan growth in order to improve their ratio of equity / assets (and the loan losses resulting from the various crises at that time contributed to this loan runoff as well.) For some weaker institutions, regulators including the FDIC explicitly prohibited new loan issuance so that the banks would be forced to build up capital. As loan growth was constrained, so was the growth in the money supply.

By 1994, bank profitability had recovered tremendously, improving to historical peak levels and remaining there for the rest of the decade. The average bank equity / asset ratio had increased from below 6% in 1988 to nearly 8% by that point. Having met the new capital targets, banks were then able to lever up their balance sheets, and could generate the equity to support accelerated loan growth. As loan growth accelerated, the various monetary aggregates began to grow faster as well. Certainly the growth of the GSEs, securitization, and other financial "innovations" contributed to the growth in overall debt and the money supply as well.

While we do of course have a fractional reserve banking system, capital requirements rather than reserve requirements have been the main limiting factor affecting credit and money supply growth since at least the late '80s.
nice addition to this discussion. thx. you in the banking industry? you seem to know a lot about it... more than the original author, anyway.