A Sure Sign That Banks Are Less Fearful

Look to your left, look to your right -- no matter where you look, you're sure to find an opinion on the credit markets and the health of banks such as JPMorgan Chase (NYSE: JPM  ) and Wells Fargo (NYSE: WFC  ) . Multiple perspectives are great, but sometimes, you just want the facts. On that note, many investors know that the TED spread can provide an objective measure of perceived credit risk in the U.S. economy. What I suspect is less known, however, is that the money multiplier can provide a read on the actual level of lending activity.

Expand that base!
To understand the money multiplier, we first need to take a quick look at two other terms: the monetary base and the money supply. The monetary base, which is controlled by the Fed through open-market operations, includes circulating currency and bank reserves. But by virtue of fractional reserve banking, banks are able to hold just a portion of their deposits as reserves and lend out the rest. Then some percentage of these loans usually returns to banks in the form of additional deposits, which in turn provides the basis for more loans. In no time flat, the total money supply has grown larger than the monetary base.

The money multiplier, if you haven't guessed it, is the precise multiple by which the money supply exceeds the monetary base. When times are good, one might expect the money multiplier to increase (assuming that the base is held constant), representing the fact that banks feel confident loaning out a greater portion of their deposits relative to their reserves. If the economy kicks into a tailspin, though, and banks get nervous, the multiplier is likely to fall.

These days, who's in the mood to multiply?
During summer 2008, the multiplier registered roughly 1.6 (based on the M1 measure of money supply). Although it’s now back up around 1, the multiplier recently dipped to 0.9 -- signaling the temporary death of fractional reserve banking. None of this comes as much surprise, given both banks' hesitancy to lend and their need to hold a mountain of reserves against debt gone bad.

Searching for signs of improvement
Anyone with an Internet connection can monitor the multiplier by logging onto the St. Louis Fed's FRED database. It is important to keep in mind that the Fed has nearly doubled the monetary base from last year in an effort to restore credit. As such, a return to normal lending activity would involve not only a rising money multiplier but also a shrinking monetary base.

Of course, such a phenomenon should not be construed as the definitive economic green light of the future. Moreover, these metrics won't tell you whether Bank of America (NYSE: BAC  ) is in better shape than Citigroup (NYSE: C  ) . That said, the multiplier can provide a fairly reliable read on where we are in the credit lock-up and, accordingly, might help you decide when you want allocate your portfolio resources toward more aggressive stocks. Believe it or not, there will again come a time when the market scrambles for such retailer names as Abercrombie & Fitch (NYSE: ANF  ) . Heck, at some point down the road, you may even want to invest in a bank. 

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Fool contributor Mike Pienciak enjoys multiplying and other arithmetic operations. He does not hold shares in any company mentioned. The Fool's disclosure policy contains no fuzzy math.


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