Banks Choose Defense Over Offense by Hoarding Cash

They were supposed to use the money to reignite the economy. Instead, they kept the cash in order to keep themselves looking adequately liquid. No decision is without consequence, however.
The nation’s biggest banks - Citigroup (C), Wells Fargo (WFC), Bank of America Corp. (BAC), and JPMorgan (JPM) – are indeed holding enough cash or liquid assets to meet the minimum regulatory requirement. The problem is, they’re taking it to an unhealthy extreme.  
As of the end of September, the four banks were collectively sitting on $1.53 trillion in liquid assets (like cash and short-term treasuries), which is 67% higher than liquidity levels seen as of June of 2008…. before the bulk of the financial system’s implosion. That amount is 21% of all the banks’ total assets; the industry norm – prior to the meltdown – was closer to 10%.  
Why pile up the money versus using it to lend? After all, the return on lending activity is around 7%, versus a return of less than 1% on those cash and near-cash reserves. The primary reason for sitting on the money – most of which came from U.S. taxpayers as part of the TARP bailout – is simply risk control. That cash will offset the negative balance sheet impact of another economic implosion, unlikely as it may be.  
The fear is understandable, but the cash-hoarding is not viable in the long-term.
Those reserves were intended by the government to stimulate the economy. If they’re not being used for lending, clearly the simulative effect is nil.  And sure enough, consumer credit - the nation’s collective credit line - again reached new multi-year lows in August, contracting by a total of $12 billion. The figure is now 4% less than the prior August’s levels, as well as at multi-decade lows. [Note that it can be difficult to determine if it’s consumers’ lack of demand for credit or actually tighter lending standards that cause the contraction – it’s probably a mix of both.]
The other downside to cash hoarding is disappointing bank profits. As stated above, banks could currently earn 7% by lending, versus less than 1% by sitting on it. That degree of risk aversion came several years too late, however. The ‘effect’ side of the cause/effect equation so far hasn’t been a burden, but as the economic recovery digs deeper roots, investors of these banks aren’t going to be satisfied with tepid returns.
The third, albeit indirect, consequence of the cash hoarding is the growing disgust of the banking industry from citizens and taxpayers. It’s ultimately their money, but not being used to their benefit. Again, the fallout hasn’t been felt yet, but the country has not forgotten.
The fix? That’s the interesting part. Until banks ease up on the hoarding, not only will consumer spending be stifled, but banks could disappoint their investors. Ironically, it’s rising interest rates that will likely push banks off the fence and back into lending market. The key will be finding an interest rate level that banks like well enough to start lending again, but one that’s also low enough for consumers to accept.
The Fed has managed to walk that tightrope before, but never in this sort of environment. And, that’s the core of the challenge…..some experts feel that the banks’ liquidity could actually shrink (relatively) with a rise in interest rates, which is a legitimate risk when rates are literally as low as they could possibly be.
The bottom line is, we’re not out of the woods yet on several fronts