Banks Are Not Mystical

The recent crisis has been beneficial in at least one way – it has begun to shed light on some of the myths of our monetary system that have poisoned economics and politics for many decades.  If I had to rank some of these myths I would almost certainly put the currency user vs. currency issuer myth at the top of the list.  But a close second is the myth of the money multiplier.  Students are generally taught that our banking system works through some sort of “loanable funds” market or “money multiplier” whereby banks obtain deposits so they can then loan them out.  There’s just one problem with these ideas – they’re not right.

These ideas have all come to a head in recent weeks when Paul Krugman and Steve Keen got into a bit of a back and forth about the operational realities of the banking system.  I won’t comment specifically on the ideas of either men, both of whom are fantastic economists, but I think this conversation exposes the degree to which most people continue to misinterpret modern banking and requires some brief discussion.

The standard banking model says that banks are reserve constrained and that the amount of loans a given bank can make is a multiple of its reserves.   But the recent crisis has shot king sized holes in this myth.  The Fed has substantially expanded the amount of reserves in the banking system, but lending has flat-lined:

This is a monumentally important chart so it’s important to understand a few points if you’re going to understand why the above chart looks the way it does:

  • Reserve balances are determined by the Federal Reserve who acts as the supplier of reserves to the banking system.  Banks can never “get rid” of reserves in the aggregate.  They can shuffle them among each other, but only the Fed can destroy or create reserves through open market operations.   The Fed oversees the payments system and in doing so must act to ensure that banks can obtain reserves in order to settle payments and meet reserve requirements as needed.
  • Bank lending is not reserve constrained (in fact, many countries don’t even have reserve requirements at all).  This means that banks do not need reserves before they make loans.  Instead, banks make loans first and obtain reserves in the overnight market (from other banks) or from the Fed after the fact (if needed).   New loans result in a newly created deposit in the banking system.
  • Banks are capital constrained.  Banks can always find reserves from the central bank so banks do not check reserve balances before making loans.  Instead, they will check the creditworthiness of the borrower and their own capital position to ensure that the loan is consistent with the goal of their business – earning a profit on the spread between their assets and liabilities.
  • Banks attract deposits because they want to maintain the cheapest liabilities possible in order to maximize this spread on assets and liabilities.   Banks are, after all, in the business of making a profit!
That pretty much sums up the above chart.  You don’t need to understand balance sheet recessions or liquidity traps to know what’s going on there.  You just need to understand how banking works.   Yes, it’s true that the balance sheet recession has been a truly unique period in American history.  But the above chart is only unique in that it exposed this great myth to the public.   When the demand for credit collapsed the Fed was nearly helpless in reviving the credit markets.   Despite a $1.6 trillion reserve injection the lending markets just didn’t budge.  This might have appeared like an anomaly to some, but to those who understood banking this made perfect sense.  More reserves were never going to result in more loans.  This was not because it had temporarily become true, but because this is the way banking works.  Not just inside a balance sheet recession or liquidity trap or whatever you want to call it, but always….

About

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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KainIIIC
4 years 5 months ago

Oh wow, check out this pile of turd that Krugman layed out:

http://krugman.blogs.nytimes.com/2012/04/02/oh-my-steve-keen-edition/

Basically, he didn’t take the time to read two paragraphs down where he made pretty much the exact same point that Krugman harped against. I like Krugman, I really do, but I’m really starting to realize what people say when they say that PK is his own worst enemy. He seems to be melting down a bit.

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Erik V
4 years 5 months ago

Krugman’s arguement is that the Fed could change they way it conducts policy in the future and therefore we should not consider our current monetary system as “some kind of fundamental law about how monetary policy does or doesn’t work”. That’s fine. Any MMT/Rer would acknowledge the Fed could theoretically stop supplying the reserves required to meet its target rate and let the Fed funds rate do what it would. But that would be a different monetary system than the one we have. Seems like much less disagreement that he wants to admit.

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Dan M.
4 years 5 months ago

I agree… really do… but I still think there is a “constraint” there. In aggregate, the banking system has no “overnight market” it can access (on a macro level). Therefore, as the banking system as a whole approaches their reserve requirement, they will start having to pay interest on the reserves that they’ll now need to borrow from the fed.

I can’t imagine that that event (the banking system having to go to the fed window) isn’t at least SOMEWHAT of a “constraint.” I’m probably way more MMT than PK on this, but I still think that saying “banks aren’t reserve-constrained” is a BIT of an exaggeration… maybe I’m wrong, though.

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Erik V
4 years 5 months ago

You’re not far off from understanding it. The constraint is a soft constraint (price), not a hard constraint (quantity). The quantity of reserves will always be sufficient to fufill reserve requirements, no matter how many loans banks originate. However, if the Fed started raising the Fed funds rate (and Discount window rate), then other short term rates would rise and the spread on bank lending would become less profitable, which may lead to less credit creation. Banks could try to maintain profitability by increasing the rates on loans, but borrowers may (and at some point definitely will) demand less credit at higher rates. So the Fed can influence credit creation, but as long as it is profitable, banks can create as much as they want.

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Dan M.
4 years 5 months ago

Ok, I think we’re in agreement, then… I guess it comes down to semantics of the word constraint… and the quantity vs price thing helps a lot with visualization.

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Dan M.
4 years 5 months ago
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Dunce Cap Aficionado
4 years 5 months ago

I read that and I’m not entirely sure what he’s getting at. Can anyone breakdown what PK’s saying there? He seems to be saying ‘Fullwiler’s wrong because at one time the ‘cost’ of getting the reserves in the overnight market fluctated wildly.’

But he’s not an idiot so I must be reading him wrong, because that in no way prevents banks from obtaining reserves.

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Dan M.
4 years 5 months ago

Like I said at Pragcap, it seems to me that the bank is taking on additional risk to secure funds from the fed than if they were to simply hold reserves, so there is some form of “constraint” to their lending because all of a sudden they have a line of credit liability that 1) costs them more money than the reserves they hold, and 2), could go up in price.

I’m probably viewing this wrong but that’s my 2 cents… for now.

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Dan M.
4 years 5 months ago

I’m very glad PK and MMT/MMR are hitting on this point, because it’s one area I feel like I still have left to 100% understand… before MMT, I loved the loanable funds model in terms of thinking about when the gov’t can borrow and what affect on business lending it was actually having, as well as what a “fair rate” of return people should be getting on their savings.

A couple questions:

1) If banks don’t need reserves, why did they offer us any interest at all? Further, if the fed window is an option, why would they ever offer depositors a higher rate of interest than the fed window charges them?

2) Can you please explain more of the importance of this “overnight rate” and managing that? Why don’t we just tell banks what their reserve requirements have to be and call it a day? Why do we have to manage the risk-free rate?

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