Financial System Liquidity

Over the past 12 months, Federal Reserve bank credit has declined moderately as the
Fed largely stayed away from QE and even allowed credits to run off. The private
sector component of the banking system did step up and expand its asset base by over 5%
yr/yr. However, following the deceleration of the economic recovery into the summer,
the banking system eased off on asset expansion. With the new open ended QE 3 program
now underway, the Fed has stepped up its lending, targeting mortgage backed securities.
Thus, the Fed is again now helping to underwrite liquidity growth within the system.

The banks' primary goals over the past year have  been to maintain balance sheet liquidity
and rebuild equity capital, including by allowing the system's aggregate loan loss reserve
to deplete on business recovery and the charge off of more bad credits. Commercial /
industrial lending has been moderately strong, consumer loans have taken a slight positive
turn and the large real estate loan book has been flat. The latter reflects charge offs, loan
sales, and a keen interest in mortgage refinancing. However, public funding via asset
based securities has continued to decline.

The banks have not been working hard to fund asset expansion. Two key categories --
low / no jumbo deposits and commerial paper -- remain in decline as the banks return to
lending in a modest and gradual fashion. The Fed has judged that economic demand
conditions and the slow pace of recovery for the banking system's loan book call for
additional liquidity backstopping even as the banks continue to improve their finances
and lending activity.