Two weeks ago we broke the story that the bulk of the excess reserves, and thus cash, generated as part of QE2 has gone not to US banks, but to foreign banks operating in the US. One of the generic rebuttals of this observation was that it is naive to assume that European banks have been buying up the Treasurys issued by the Fed (and flipping these to their clients) which would also leads to a contemporaneous increase in excess reserves (over $630 billion since the start of QE3). This was a good question and we did not have a ready answer. Luckily, Stone McCarthy has come up with a resolution. In a just released note to clients, SMRA hints at how these banks have loaded up on cash without having to also see domestic assets surge (and instead just have just seen the net liability owed to foreign offices increase). The answer: Eurodollars.
First, a reminder of just how much foreign held cash surged in since QE2:
How Did the Reserves or Cash Assets Get to Foreign Banks Operating in the US?
The skewing of the distribution of reserves towards foreign banks operating in the US was not because the LSAPs were disproportionately from these banks or from the clients of these banks.
Rather the Eurodollar market provided a vehicle enabling a skewing of reserve balances towards foreign banks operating in the US.
Effectively the affiliated foreign branch of a US bank (whether a domestic or foreign institution) would borrow dollars in the Eurodollar market. A Eurodollar is nothing more than a dollar denominated deposit at a bank outside the US. The bank holding the Eurodollar deposit will ultimately have a dollar denominated claim against a bank domiciled in the US. That US bank in turn holds reserve balances at their local Federal Reserve Banks.
When Eurodollar deposits move from one foreign bank to another, the claim against the original US bank follows the eurodollar deposit.
If a bank domiciled in the US borrows dollars from a bank outside the US, including its own foreign branch, effectively what happens is the reserve balance of the US bank underpinning the Eurodollar account is reduced, and the reserve account of the borrowing bank in the US is increased.
Overall US bank reserves are left unchanged, but the distribution of those reserves is changed from one bank in the US to another, possibility even from the books of one Federal Reserve Bank to another.
In other words, foreign banks operating in the US have an artificially pumped up cash balance creating a false sense of security, with the fungible cash having been borrowed from abroad. This also means, that when and if European banks realize they need the cash "lent out" to US-based subsidiaries, and demand the $600 billion+ in dollars, all they will see is a white flag of surrender, as the US-operating banks disclose they have pledged the cash for one thousands and one uses, and its sudden withdrawal would end up crashing the capital markets. It also means that explanations that this cash was used by European banks to satisfy regulatory capitalization shortfalls are absolute gibberish. And yes, if and when there is a surge in dollar needs out of Europe, the Fed will have two choices: QE(x) and FX liquidity swaps.
Regardless of the dynamics of the capital flow, what is without doubt is that US banks have little to no incremental cash courtesy of the $600 billion expansion in Fed excess reserves. And the other question: what did US banks do with all the money "printed" over the past 8 months, is still as relevant as always.