Thursday, August 25, 2011

Banks don’t lend reserves, it’s bank loans that create deposits

So many people seem to miss this basic concept of Chartalism, and you can see it evident in many people’s comments and attempts to refute MMT posts. Many people find it hard to accept this concept because it defies the basic teachings of mainstream theory, as they learned it in school.
But take a step back, and look at loans and deposits, and how they come about. You want to borrow money from a bank so you can buy a truck from me. Your bank does not have to have the funds to lend you when it funds your loan. All it has to do is go and borrow from the central bank’s deposit window, or otherwise borrow from the interbank market.
Your bank (which lends you the money) credits your account with the amount. You then take the money, go and buy the house from me, and I deposit the amount in my bank. My bank now has money to lend to your bank, so it can pay off its loan from the central bank.
Same thing if I want to buy a house from you. My bank simply credits me the funds, then I go and pay you with the amount, you deposit it into your bank. My bank now has a loan, and it can borrow the funds it lent me from your bank, which now has additional deposits, which has now circuited from me to you then to them, when my bank lent me the loan.
If no bank lent anyone any money, where would any of us get the additional deposit to put in the bank? And without new deposits, which the mainstream claims funds bank loans, how do banks manage to keep loans growing? This is beyond fractional reserve banking, which as a concept means the bank takes a fraction of its deposits and lends out. If banks were contrained by fractional reserve banking, bank lending growth would have slowed to a crawl (or standstill) long ago.
Banks do not need deposits at all to fund loans. The presence of the central bank discount window which bridges any unfunded loans enables them to simply fund any creditworthy client with the funds, knowing that they will always be able to fund it. All they need is to make sure they charge you higher than their cost to borrow, and that they have the (usually Basel-recommended) capital ratio to back the loan.
What is true for a two-bank economy is true for an economy that has several banks, many borrowers, and many depositors. Loans have to be made by some bank first before anyone else can get any money to deposit. Neither you nor I are allowed to print counterfeit money just because we want to increase our deposits. We need to borrow it, or sell a good or service to someone who does. Banks do the rest.
Now go and read this, and see if you understand now.
P.S. And as Mike Sproul's example in the comments shows, a purely 'electronic debit and credit' debt transaction by a commercial bank doesn't even need Fed discount borrowing. No payment of reserves are necessary.


Mario said...

yes. exactly. Just fyi in paragraph you start your example with buying a truck then switch to a home. No biggie, but just thought to tell you.

Loans have to be made by some bank first before anyone else can get any money to deposit.

Just asking...what about money from the government directly? Does that come form "outside" the bank system or no? Unless they send you cash, then it has to go through a bank right so the situation holds right?

that they have the (usually Basel-recommended) capital ratio to back the loan.

can you explain to me the difference between capital ratios and reserves? Reserves really are there as Bill states in the link you provide for clearing purposes and really nothing else. Right? So what do capital ratios do then and are they effective at all? I mean did capital ratios come into play during the GFC crisis at all and did they work? It seems to me (although I don't know) that they didn't come into play much at all and they did not work, but I don't know for sure.

Mario said...

I thought reserves really were there as a (minimal) protection against a run on the banks for the customers, so do capital ratios do that too?

Rogue Economist said...

Mario, answers to your questions

1. Loans have been made for both houses and trucks, I wanted to give 2 different examples.

2.Money from government a.k.a. government deficit spending is added money that was not borrowed into existence. Whether it goes through a bank or government pays you direct (doubtful), it adds to reserves/deposits. It's just not the focus of this particular post, tough.

3. Capital ratio pertains to bank capital. This is owner's equity that will bear the first risk of loss if the bank ends up with a soured loan, before depositors start losing their money. Basel recommends a loan ratio of no more than 15 times capital. Bigger than that, the depositors' money starts getting more at risk.

Reserves is well, the depositor's money, plus any that the fed injects.

4. Fed-injected reserves help against a bank run, but this is essentially a loan from the fed to the bank. It has to be paid back by either raising capital or getting back the depositors.

Mario said...

very interesting rogue. Thank you.

Basel recommends a loan ratio of no more than 15 times capital.

so that's 15 times the total of owner's equity on the balance sheet then? So the more OE a company has the more loans they can write? That would mean then that it's the company's balance sheet that limits the amount of loans a bank can satisfy then right?

4. Fed-injected reserves help against a bank run, but this is essentially a loan from the fed to the bank. It has to be paid back by either raising capital or getting back the depositors.

which means then that the Fed has a built-in bias to protect the banks and ensure they are at least perceived as stable so that the Fed's loan to the banks in terms of reserves can be paid back. Sounds like an inherent flaw in the system no? Banking is tricky b/c of this b/c eventually someone other than the government has to be responsible for those reserves. B/c if the government absorbed a reserve drain, then banks would have no need to actually worry about it. But if the government doesn't absorb those losses, then whoever does, will do everything in their power to make sure those depositors come back "home" to the banks...which essentially is where we find ourselves today with banks and regulators and policy makers catering to the banks and propping them up in all sorts of ways instead of really helping the people.

But really, what's the big deal if the Fed had to write off all those reserves? Operationally they can handle that, since it's all created by the Fed out of nothing anyway. The big issue would be the confidence and faith in the US banking system and its economy's stability at large. Very interesting. I think this is what the president and bernake are really saying they did whenever they once again (as always) remind us that "this was the greatest economic collapse we've seen since the Great Depression"...blah, blah, blah. I'm getting tired of hearing that stupid freaking phrase for 3 years now. It's like the economic equivalent of milking 9/11 for all you can with the Patriot Act, Iraq Invasion, War on Terror, etc., etc. It's just despicable and disgraceful to me and it's getting boring too quite frankly. Can we get a new script in here please!!! LOL ;)

Rogue Economist said...

Yes, the more equity, the more loans they're allowed to make. But it's not just the balance sheet that limits loans, it's also limited by the number of people who want loans that the bank is willing to lend to.

The fed has a bias to protect banks because that was its original mandate, to be the lender of last resort. In an ideal world, the fed monitors (and understands) the kind if risks banks take, because they will have to come in and rescue them if a run happens.

Ideally, the bank owner has main responsibility for solvency and prudence, that's why there should be enough owner's capital to begin with. However, with banks now owned hundreds of thousands of nameless shareholders, while bank decisions are made by executives whose only skin in the game is their bonus, then yes, the government ends up having the main responsibility, when banks with insufficient capital take on more risk than they can.

Mario said...

very interesting points rogue.

Maybe banks shouldn't be allowed to go public then? That would probably help b/c then banks would have a less diluted OE among various shareholders. However knowing banks they might try to pull a facebook type deal and still stiff fellow shareholders.


Hans said...

I have ax this question at PC but no one answers it..

Can banks lead excessive resevers?

Hans said...

That should read lend...

Rogue Economist said...

Mario, but if you prohibit banks from going public, it becomes harder for them to raise capital, and hence, to grow loans. The answer should be in better regulation of executives.

Hans, yes of course banks can lend reserves. They don't need to already have it to lend, but if it's already there, they can lend it in place of raising the funds elsewhere.

Mario said...

that's a good point. I just don't see how that can be done effectively in banks.

With merchandise, manufacturing, and other service industries you can tie revenues directly to exec pay but if you did that with banks then they'd just make crazier loans to get more lending going.

something with banking is just terrible dysfunctional it seems to me and I can't exactly put my finger on it just yet.

Rogue Economist said...

You can't run banks the way you run companies that maximize revenues. Because of the implicit government commitment to protect it, it should be run like a utility, and with risk management as prime objective.

Executives who think sales are the prime objective are just talking their book, and thinking of their bonus.

Hans said...

Thank you for the answer, Mr Rogue!

Rogue Economist said...

You're welcome Hans. I don't know why no one would answer you. Maybe people are talking past each other, since this phrase confuses many: "Banks don't lend reserves".

I take it to mean 'banks don't need reserves to lend', but if they already have it to begin with, it can be useful in lending (if they have good reasons to lend).

Mike Sproul said...


A lending bank doesn't even need reserves from the Fed. If a bank has 100 paper dollars backing 100 checking account dollars, then it can lend 200 additional checking account dollars while getting the borrower's $200 IOU (backed by collateral from the borrower). That bank now has $100 paper reserves plus the $200 IOU backing 300 of its checking account dollars, and the Fed was not involved.

Rogue Economist said...

Ah yes.. the miracle of electronic debit and credit. No fed borrowing necessary.