‘Loans Create Deposits’ – in Context

Introduction

Loans create deposits. We’ve heard it many times now. But how well is it understood? The phrase is typically invoked accurately, in conjunction with a rejection of the ‘money multiplier’ fable found in economic textbooks. From an operational perspective, banks do not “lend reserves” to their non-bank customers. “Loans create deposits’ is an operation in endogenous money. And where central banks impose a level of required reserves based on deposits, the timing of the demand for and supply of reserves in respect of such a requirement follows the creation of the deposit – it does not precede it. The money multiplier story is bunk. And ‘loans create deposits’ is correct as an observation.

Nevertheless, there is a larger context for deposits, which includes their fate after they have been created. Deposits are used to repay loans, resulting in the ‘death’ of both loan and deposit. But there is more. As part of the birth/death analogy, there is the lifetime of loans and deposits to consider. This sequence of birth, life, and death in total may be helpful in putting ‘loans create deposits’ into a broader context. There is potential for confusion if ‘loans create deposits’ is embraced too enthusiastically as the defining characteristic, without considering the full life cycle of loans and deposits. Indeed, we shall see further below that ‘deposits fund loans’ is as true as ‘loans create deposits’ and that there is no contradiction between these two things.

Monetary Systems

The monetary system and the financial system are constructions of double entry accounting. It has been this way for a long time. This did not start in 1971. The fact that there was gold serving as a fixed value backstop for certain monetary assets shouldn’t obscure the fact that a monetary system is a fiat construction at its foundation. Gold at one time was a hard constraint on the behavior of the monetary authorities. But the authorities will inevitably create paradigms of operational constraint and guidelines in any monetary system. These restrictions include central bank balance sheet constraints (e.g. gold backing; Treasury overdraft constraints; supply and pricing of bank reserves that are consistent with the monetary policy interest rate target) and other guidelines (such as the reaction function of the policy rate to various measures of inflation, output, or employment). The full category of potential constraints is broad and varied. But none of this alters the fact that a monetary system is basically a bookkeeping device for the intermediation of real economic activity. It is a construct that enables moving beyond a barter economic system that can only be imagined as a counterfactual.

The Choice for Banking

Starting from this monetary bookkeeping foundation, a fundamental choice exists. Will the system include a competitive banking sector? More broadly, will financial capitalism exist in substance and form? Will there be competition? Within this landscape, will there be more than one bank? While a banking singularity (a single, concentrated, nationalized institution) is usually considered to be non-pragmatic, it serves as a useful theoretical reference point for understanding how banks actually work. The competitive framework that is often taken for granted is in fact a choice for banking system design – including the presence of a reserve system that enables active management of individual bank balance sheets.

‘Loans Create Deposits’

When we say ‘loans create deposits’, we mean at least that the marginal impact of new lending will be to create a new asset and a new liability for the banking system – typically for the originating lending bank at first. A bank makes a loan to a borrowing customer. That is a debit under bank assets. Simultaneous, it credits the deposit account of the same customer. That is a new bank liability. Both of those accounting entries represent increases in their respective categories. This is operationally separate from any notion of reserves that may be required in association with the creation of bank deposits.

In another version of the same lending transaction, the lending bank presents the borrower with a cheque or bank draft. The lending bank debits the borrower’s loan account and credits a payment liability account. The bank’s balance sheet has grown. The borrower may then deposit that cheque with a second bank. At that moment, the balance sheet of the second bank – the deposit issuing bank – grows by the same amount, with a payment due asset and a deposit liability. This temporary duplication of balance sheet growth across two different banks is captured within the accounting classification of bank ‘float’. The duplication gets resolved and eliminated when the deposit issuing bank clears the cheque back to the lending bank and receives a reserve balance credit in exchange, at which point the lending bank sheds both reserve balances and its payment liability. The end result is that the system balance sheet has grown by the amount of the original loan and deposit. The loan has created the deposit, although loan and deposit are domiciled in different banks. The system has expanded in size. The growth is now reflected in the size of the deposit issuing bank’s balance sheet, with an increase in deposits and reserve balances. The lending bank’s balance sheet size is unchanged from the start (at least temporarily), with loan growth offset by a reserve balance decline.

Money Markets

In this latter example, it is possible and even likely, other things equal, that the lending bank additionally will seek to borrow new funding from wholesale money markets and that the deposit issuing bank will lend funds into this market. This is a natural response to the respective change in reserve distribution that has been created momentarily for the two banks. Without further action, the lending bank has lost reserves and the deposit bank has gained reserves. They may both seek to normalize these respective reserve positions, other things equal. Adjusting positions through money market operations is a basic function of commercial bank reserve management. Thus, this example features the core role of bank reserves in clearing a payment from one bank to another. The final resolution of positions in this case is that the balance sheets of both banks will have expanded, indirectly connected through money market transactions that follow on from the initial ‘loans create deposits’ transaction. However, this too may be a temporary situation, as the original transaction involving two different banks will inevitably be followed up by further transactions that shift bank reserves between various bank counterparties and in various directions across the system.

The Money Multiplier Fable

The money multiplier story – a fable really – claims that banks expand loans and deposits on the basis of a central bank function that gradually feeds reserves to banks, allowing them to expand their balance sheets with new loans and reservable deposits – according to reserve ratios that bind the pace of that expansion according to the reserves supplied. This is entirely wrong, of course. In fact, bank balance sheet expansion occurs largely through the endogenous process whereby loans create deposits. And central banks that impose reserve requirements provide the required reserve levels as a matter of automatic operational response – after the loan and deposit expansion that generates the requirement has occurred. The multiplier fable describes a central bank with direct exogenous control over bank expansion, based on a reserve supply function – which is a fiction. The facts of endogenous money creation have been demonstrated by empirical studies going back decades. Moreover, the facts are obvious to anybody who has actually been involved with or closely studied the actual reserve management operations of either a commercial bank or a central bank. In truth, no empirical ‘study’ is required – the banking world operates this way on a daily basis – and it is absurd that so many economics textbooks make up stories to the contrary. The truth of the ‘loans creates deposits’ meme is pretty well understood now – at least by those who take the time to learn the facts about it.

Central Bank Reserve Injections

A central bank that imposes a reserve requirement will follow up new deposit creation with a system reserve injection sufficient to accommodate the requirement of the individual bank that has issued the deposit. The new requirement becomes a targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the central bank. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. Thus, there is a lag between two system growth impulses – ‘loans create deposits’ as the endogenous feature and a subsequent central bank reserve injection as an exogenous follow up. The required reserve injection is typically small by comparison, according to the reserve ratio. The central bank can provide the reserves in different ways, such as by purchasing bonds or by conducting system repurchase operations with investment dealers. In the case of either bond purchases or system repurchase agreements, additional system deposits might be created when the end seller (or lender) of the bonds is a non-bank. And that second order creation of deposits may be reservable as well. But what might appear to be a potentially infinite series of reserve injections is in fact highly controlled in the real world – because the reserve ratio is relatively small. Some countries such as Canada have no such required reserve ratio. Indeed, the case of zero required reserves nicely emphasizes the nature of the money multiplier as an annoying analytical error and distraction from accurate comprehension of how banks actually work. But as a separate point, central bank injections of required reserves illustrate how not all deposits are necessarily created by commercial bank loans. ‘Loans create deposits’ is true, but not exclusive. This aspect is made clear also by the example of central bank ‘quantitative easing’, noted further below.

The Growth Dynamic

The ‘loans create deposits’ meme is best understood as a balance sheet growth dynamic, distinct from any reserve effect that might occur as part of an associated interbank clearing transaction at the time (e.g. the second example above) or as part of a deposit ratio requirement that might be activated at a later date. The banking system can be visualized in continuous time, punctuated by discrete banking transactions that are reflected as accounting entries. If one divides time into very small time intervals, individual banking transactions can be isolated as the only transactions that occur during a given interval of time. Thus, the growth dynamic of ‘loans create deposits’ can be conceived of as an instantaneous balance sheet expansion at the point of corresponding accounting entries. As noted in the examples above, this expansion may then migrate across individual banks when the lending and deposit issuing bank are different.

‘Deposits Fund Loans’

Some interpretations of the ‘loans create deposits’ meme overreach in their desired meaning. The contention arises occasionally that ‘loans create deposits’ means banks don’t need deposits to fund loans. This is entirely false. This is the point that requires emphasis in this essay.

There is no inconsistency between the idea that ‘loans create deposits’ and the idea that banks need deposits to fund loans. Bank balance sheet management must respond to both growth dynamics and steady state conditions in the dimension of nominal balance sheet size. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types – including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the central bank is not a mere slush fund that provides unlimited funding to the banking system. In fact, active liability management is important in private sector banking – in the system we actually have. Other systems have been proposed, in which central banks intervene in some way to adjust the landscape of competitive liability management (e.g. the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the MMT Mosler plan). These are ideas for significant change that should not be confused with the characteristic of competitive banking as it now exists. Some analysts tend toward language that conflates factual and counterfactual cases in this regard. To repeat – bank liability management is very competitive in the system we have, by design. The ‘loans create deposits’ meme, while true, only touches on this competitive dynamic.

We note again that loans are not the sole source of deposit creation. A commercial bank’s purchase of securities from a non-bank will typically result in new deposit creation somewhere in the system. There are cases where deposit creation results from other liability or equity conversion – commercial bank debt redemption and stock buybacks are examples of this. Existing fixed term deposits can convert to demand deposits and vice versa. And central bank quantitative easing most often results in new deposit creation – because the bonds that the central bank purchases are typically sourced from non-bank portfolios, and exchanged for deposits. Nevertheless, ‘loans creates deposits’ is a reasonable reference point and standard for the process of deposit creation.

Bank Asset-Liability Management

The ‘loans create deposits’ dynamic comprises the production of much of the money that serves as a basic source of liquidity in a monetary economy. The originating accounting entries are simple – a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital – especially equity capital – to take risk – and to take credit risk in particular.

Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The ALM function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance (e.g. the fed funds rate) has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities.

The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity.

In examining all of these effects, it is helpful to consider the position of the banking system in its totality, in conjunction with the position of individual banks that constitute the whole. For example, the US commercial banking system is composed of thousands of individual banks. Between discrete ‘loans create deposits’ events, the banking system is in continuous balance sheet churn. Specifically, deposits are moving back and forth between individual banks, as a matter of normal payment system operations. They are also moving and inter-converting in the form of term deposits at both the retail and wholesale level. This overall liquidity churn feeds economic activity of all sorts, where households, businesses, and governments are making payments to each other for various goods and services and other types of transactions, and are making choices about the portfolio structure of their liquid assets. This is the core liquidity provided by the banks to their customers. And this is the stuff that involves a good deal of transferring of reserves back and forth between banks, in order to affect accounting completion of balance sheets that are in continuous flux in size and composition.

Bank Reserve Management

The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets that are in balance, institution by institution – and where deposits fund loans, alongside various other asset-liability matching configurations. The reserve system records the effect of this balance sheet activity. The reserve account is the inverse exogenous money image of the nominal configuration of the rest of the balance sheet. The balance sheet requires asset liability management coordination in order to match up assets and liabilities both in nominal terms and in a way that is financially effective. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis.

Conclusion

In summary, the original connection by which deposits are created by loans typically disappears at some point following deposit creation – at the micro bank level and/or the macro system level. The original demand deposits associated with specific loan creation become commingled as they move back and forth between different banks. And they not only move between banks, but they can change in form within any bank. They can be converted into term deposits or other funding forms such as bank debt or common and preferred stock. The task of dealing with this compositional flux falls under the joint coordination of bank asset-liability management and reserve management. The overarching point of observation is that both system growth and system competition for existing balance sheet composition are in constant operation. ‘Loans create deposits’ only describes the marginal growth dynamic at the inception of deposit creation. ‘Deposits fund loans’ is the more apt description that applies to a good portion of what constitutes ongoing balance sheet management in competitive banking.

Comments

  1. Good points. 3 years back or so I saw some commenter elsewhere wondering why deposit rates in his country were relatively high and he perhaps thought that since loans create deposits, banks don’t have to attract deposits and concluded bankers do not know banking!

    The fact that there was gold serving as a fixed value backstop for certain monetary assets shouldn’t obscure the fact that a monetary system is a fiat construction at its foundation

    Right!

    A much bigger cousin of all this “loans create deposits” versus “deposits fund loans” is that since the government creates money, it isn’t reliant on foreigners’ funding if the currency floats!

  2. Thanks for such a clear description.
    When you say, “More broadly, will financial capitalism exist in substance and form?” I sort of gulped because that sounds like you are saying that keeping our current system is crucial for “true” capitalism. Wouldn’t it be MORE capitalist to have an alternative set up where transaction accounts were entirely separate from lending institutions (eg transaction accounts like PayPal) and lending entirely provided by shadow banks perhaps even shadow banks that could only issue securities with the same time to maturity as the loans they made? Under such a hypothetical system, there would be no need for a central bank safety net to bail out banks since the payment system could carry on fine regardless of whether unrepayable loans had been made etc. To me such a hypothetical system seems much less quasi-statist-cronyist than our current system that seems to invite bail outs.

    • Not exactly what I was suggesting. There’s a decision tree where you choose between a ‘perfectly’ nationalized banking institution – a ‘banking singularity’ as I put it – versus a system that is privately capitalized in some way. I didn’t really say that the existing system was the only possible form under private capitalization – just that the system we have is one such form, and that as such it fosters full asset-liability competition. And so in that sense, while ‘loans creates deposits’ holds, there’s also a bigger picture in which ‘deposits fund loans’.

      But you’ve made a very good point. I don’t have a super strong view on what is good or bad in terms of alternative systems. Although in the post, I alluded to the possibility of what you suggest:

      “Other systems have been proposed, in which central banks intervene in some way to adjust the landscape of competitive liability management (e.g. the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the MMT Mosler plan). These are ideas for significant change that should not be confused with the characteristic of competitive banking as it now exists”

      And I also did a previous, lengthier post on some of these possibilities:

      http://monetaryrealism.com/banking-in-the-abstract-the-chicago-plan/

      I hope to have more to say about these things at a later date.

      • JKH, in your Chicago Plan post you say, “The fact that bank credit is eventually matched by non-deposit funding within an asset-liability management process doesn’t arrest the process by which credit creates endogenous money (deposits).”
        I’m puzzled by that. If under a hypothetical regulatory regime making a $1000 ten year loan required a PRIOR sale of a ten year debt security for $1000, then the lender would not be a bank and instead would be a shadow bank and endogenous money creation would not have occurred surely? The drain of bank deposits from selling the ten year debt security would be just as great as the addition to deposits from granting the loan. It would not be “loans create deposits” but rather “loans create ten year debt securities”.

        • Sorry, I’ve just seen that the Jaromir Benes and Michael Kumhof paper advocates something quite different to the original Chicago plan. They say,
          “For credit, the original plan advocated the replacement of traditional banks with investment trusts that issue equity, and that in addition sell their own private non-monetary interest-bearing securities to fund lending.”
          – To me that is a sound, free market, non-crony way to ensure that debt financing competes on an equal footing with equity financing and that the costs and risks of debt determine the extent of credit expansion.
          BUT then they say, “The other alternative is for banks to issue their debt instruments to the government rather than to the private sector.” and that is what they describe and my confusion is because that seemed such a bad idea that I recoiled from grasping it. Basically that is a statist crony system where credit risk is socialized whilst those deemed worthy of receiving credit are enriched. It sounds evil.

  3. How does bankruptcy fit into the system?
    I take out a loan for $100.00 and then blow it at the casino. Then file for bankruptcy.
    What is that money in the system now considered?

    • If you don’t repay the loan, the bank declares a loss, and ‘writes off’ the asset.

      The write-off consists of the elimination of the $ 100 loan asset, as well as a corresponding reduction in $ 100 of equity (right hand side of the balance sheet).

      (Equity can be considered as a form of funding for the asset, so both the asset and its funding are written off. That’s the double entry accounting. Equity is a form of funding that has the capacity to absorb losses directly.)

      The balance sheet is then in balance. But the bank has $ 100 less in equity capital.

      Interestingly, there is no change in deposits.

      Apart from that, you may have made payments or not, here or there, as part of your bankruptcy proceedings. I’ve just assumed none of it went to the bank for illustration purposes.

    • initially, when applying for a loan, aren’t there requirements to have some form of collateral, in which case the bank would not necessarily need to declare a loss if the collateral comes into play even after bankruptcy is filed.

  4. Cowpoke, wouldn’t the lending bank sell off some of its capital to write down that bad loan? So if the bank held say treasury bonds as capital, then it would sell those to draw in $100 of deposits that would be annulled together with the bad loan? In good times I guess bad loans simply reduce retained earnings and so simply reduce the expansion of the bank’s capital.

  5. Ramanan, I know I asked on billyblog why deposit rates were so high in the UK. Unlike JKH’s description here, I did not think that Bill Mitchell made it clear why banks need to compete for deposits (probably just me being dumb at understanding billyblog). Actually it might have been JKH who came to the rescue in the comments on billyblog back then.

    • CBs pay for what they already own. The source of all savings/time deposits to the CB system is other transaction deposits, directly or indirectly (& only temporarily), via the currency route, or thru the CBs undivided profits accounts. But it does profit a particular bank, X-bank for example, to pioneer the introduction of a new financial instrument such as the negotiable CD until their competitors catch up; & then all are losers. The question is not whether net earnings on CD assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the banking system. This is not a zero sum game. One bank’s gain is less than the losses sustained by other banks.

      The CBs would be more profitable if they were forced out of the savings business. True, Bank of America may end up losing deposits to JP Morgan Chase (& they may have to sell some of their liquid earning assets in the process), but these are simply replaced by the other bank.

      Same applies to the contractionary IOeR policy.

  6. good post. however the point about deposits can be put simpler: deposits are the cheapest liability. a bank could theoretically have all their liabilities in interbank loans or other such products. the reason however they attempt to retain deposits is because that reduces the cost of liabilities and thus increases the spread between liabilities and assets (the point of banking).

    • Only on paper can a bank fund all its liabilities in the interbank market. For, it matters for analysts and raters and lenders how much customer deposits the borrowing bank has. Not all interbank (and money market) borrowing is without collateral. The lender may require the borrowing bank to post collateral. The good thing about deposits is that most depositors do not ask for collateral from the bank.

      Also it is possible to get away. For example Northern Rock tried to fund by other sources – mainly securitization. It proved to be a bad decision later.

      It is not just about price.

      • of course i was simplifying there. note i said “other such products”. regulators also frown on deposits not being a significant part of liabilities. Scott has a good article on this in the upcoming issue of ROKE. The general point stands: deposits are the cheapest liabilities.

        • Not necessarily cheap. I have seen banks offering deposits at rates higher than money market rates. In India there are “cooperative banks”: Although they can borrow at cheaper rates compared to deposits, they are quantity limited in doing so. For higher borrowing, there is no price.

          • same maturity?

            • Yep even demand deposits. In India, even transactional deposits that can be withdrawn on notice pay interest.

              • interesting. I’d have to explore the reasons behind that. anyway as a general principle (with exceptions of course) I think it holds.

                • Not difficult to understand. A bank may attract funds at a cheaper rate but it may also need to post collateral which may be limited. It also exposes it to risk of rolling it over. If the bank is in confident knowledge that a price above money market rates will stay longer, it can pay slightly more. Also frees up collateral.

                  So it can find itself in a situation where it can it is borrowing a small amount from the central bank at a rate lower than it is paying its deposit customers at a given day or over a period of time.

                  (This is because the other extreme – funding everything outside of deposits such as from the central bank is not practically possible)

                  Although these/above are for small banks, I think in some parts of the Euro Area deposits pay lot.

                  Yes general principle holds but my original point was that it is not just about price.

          • I’d be very interested in knowing examples of this. Even after the deregulation in late 2011, I’m yet to come across banks that offer anything more than 5% for demand deposits, so it’s news to me that some would actually compete for deposits at greater than the repo rate to exploit the 1% gap between the repo rate and the bank rate/margin standing facility rate.

            • It isn’t difficult to see Ritwik.

              Money market rates can be less than the rate the RBI band.

              You can get the money market rates in the “money market operations” of the RBI. A non-bank firm can thus lend a bank at a cheaper rate than the RBI reverse repo rate in the money markets as can be seen from that. This rate may be less than the saving deposit rate offered by the borrower bank and/or term deposits such as less than 15 days.

              So from the bank’s point of view, it is funding cheaper in the money market but that doesn’t mean it can do so without limit.

              The reason the firm is lending at a lower rate than the RBI reverse repo rate is that the alternative is to earn 0 if it is a current account or a low savings rate if parked at the bank paying lower interest rate.

              This can be easily seen for term deposits such as 7-14 days but the right data for overnight versus saving deposits is slightly non-trivial to mine.

              • Ok, I’m sure many such individual anomalies arise every once so often, but the theoretical question remains.

                Why’s the non-bank lending to the bank in the money market rather than keeping its funds in the same bank’s demand deposits. It’s not like the bank will *refuse* someone looking to park their funds in deposits.

                So in steady state the reason I’d expect deposit rates to out-compete money market rates is to use the gap between the repo rate and the bank rate due to qty/collateral constrains on repo.

                • Ritwik,

                  In my example the non-bank was getting low interest and so lent the funds to the other bank which pays a higher interest but the latter still less than what it itself was paying on customer deposits.

                  In this thread there is some discussion on something slightly related – banks in the Euro Area were paying high interest rates to the depositors even though they were able to fund themselves at the NCB at a lower rate. Seems very counter intuitive. But it can be easily explained because, the amount of lending by the NCB is limited, so paying lower interest would lead to flight of deposits and potentially requiring ELA which can be painful for the bank.

  7. Perhaps the reason for higher interest payments on deposits (than for money market) is because even though all depositors could in principle move their deposits to another bank, in practice they are unlikely to? So even a transaction account can in practice act as though it were a stable source of funding?

    • In a crisis/credit-crunch scenario, things become counterintuitive. So may be that is the reason but in each case, one can think of logical reasons. For example why do government bills rates turn negative even if the bank pays say 0.5% interest? This is because I can be paranoid and think that the banking system may cease to exist in the next 30 days so I can lose 0.05 on 100 with the confident knowledge that I can get 99.95 back as opposed to the case where I get 0.5% annualized interest (almost nothing) but stand a chance to lose the whole amount.

      • Jose Guilherme says:

        “… I think in some parts of the Euro Area deposits pay lot”.

        That is correct. In fact, in countries at the periphery of the system there have been periods when the rates on deposits were much higher than the main official rate of the ECB. Say, 3% offered by banks on demand deposits versus 0.75% for the rate of the ECB and NCBs.

        The situation got to a point where in countries such as Spain the government/NCB had to impose an upper limit on the deposit rates (by law) in order to limit the wild competition among banks to attract depositors.

        This is a subject usually fudged up on textbooks. The treatment is even worse than with the money multiplier fable. Students leave macro and money courses with no idea of how the banking system manages its policy on deposits.

        Anyway, an interesting question concerns the “normal” relationship between deposit rates and the interbank rate. Considering the different risk profiles of the two types of debt involved and for equivalent maturities – should we expect deposits to pay higher or lower rates than the interbank rate in non-crisis periods?

  8. JKH, is this the point you’re getting at…

    If bank A loans me money, and I deposit it in bank B, my deposit in bank B is now “creating” the loan bank B can make in the interbank market?

    If that is accurate, then I think using CREATE in both “Loans create Deposits” and “Deposits create Loans” muddies the distinction because the former expands the money supply whereas the latter seems to only shift existing composition among balance sheets.

    Can you clarify?

    • Didn’t say deposits create loans; I said they fund loans.

      Another simple example:

      Loan creates a deposit at Bank A.

      Bank A loses the deposit to Bank B.

      Bank A attracts a new deposit from Bank C.

      The new deposit is funding the original loan.

      • Dan Kervick says:

        How does the new deposit fund the original loan JKH? When the bank acquires that new deposit, it acquires both an asset and corresponding liability at the same time. The asset is just funding the liability isn’t it?

        It seems to me that the main reason banks seek to attract deposits is because they charge depositors all kinds of fees for their storage services and payment services, and because the deposit balance is a sort of “gateway drug” to the depositor’s other business with the bank. It may pay the depositor interest on at least a portion of the deposit for at least a portion of the time, depending on the kinds of accounts among which the depositor deposits the amount deposited. At the same time, the depositor pays various kinds of fees to the bank for transactions in and out of those accounts. Also, the account might have a line of credit associated with it so that by attracting the depositor, the bank has also reeled in a certain number of loan customers.

        • JKH,

          Thanks for the calrification. You did say FUND not CREATE in ‘Deposits fund loans’…

          But I’m left with the feeling that FUND is an inappropriate word for what you are describing. I’m mulling it over. My initial thought is that “fund” has a specific connotation to it, and by using to describe as you did in this piece, it adds unnecessary confusion.

          • Ok…

            When you say: “The new deposit is funding the original loan.”

            That sounds like the mistaken common perspective on banking where I deposit my money and the bank loans my money out, as if there is a direct connection between my deposit and a SPECIFIC loan being made.

            My understanding is that a bank’s balance sheet is consolidated, i.e. no SPECIFIC deposit, or interbank loan, or discount window loan, is lined up to another SPECIFC loan that the bank has made.

            Therefore, to say that “the new deposit is funding the original loan” seems to suggest that there is a direct connection, and not a consolidated bank balance sheet.

            What am I missing?

        • “It seems to me that the main reason banks seek to attract deposits is because they charge depositors all kinds of fees for their storage services and payment services, and because the deposit balance is a sort of “gateway drug” to the depositor’s other business with the bank.”

          Even if these were somehow not allowed or banks themselves do not do this, banks would still need to attract deposits.

          • okay let’s simplify this. banks need to make payments and meet reserve requirements. in order to do that they need sufficiently high positive balance in their reserve account over some period of time (under current rules). if deposits are drained from the bank the balance in its reserve account falls. in order to replenish it’s balance, it must acquire new liabilities or sell assets. since most assets are highly illiquid, banks usually acquire new liabilities. because banks are able to pay out bonuses and dividends based on the spread between liabilities and assets, they are incentivized to acquire the cheapest risk adjusted liabilities. deposits are often those liabilities.

            • Dan Kervick says:

              Nathan, given prevailing commercial bank interest rates paid to depositors, if banks all offered free checking and check card usage, no fees to open or close accounts, and no other transaction fees, would it be cheaper to acquire the added balances by getting more depositors or via the interbank or central bank route? My hypothesis is that it is the latter, but I’m not sure. Just the operational costs of servicing all those deposit accounts seems to make that route more costly, absent the profitability of deposit account services.

              You could have a viable pure lending bank that didn’t even offer deposit accounts at all. In that case when the borrower takes the loan in exchange for his promissory note, the bank just cuts a check which the depositor has to deposit at another bank. Similarly, the borrower has to repay all loans with cash or checks drawn on other banks. The payments to and from other banks are cleared on the central bank’s books via the bank’s settlement account.

              It seems to me that storage and payment is one thing, lending is another. While most banking institutions combine all three they are separable, and a bank doesn’t need the proceeds from one of these businesses to fund the other part of the business.

              • who said anything about proceeds?

                anyway to your question: clearly it would be cheaper to fund with deposits. you’re not thinking about the differential maturities.

                your argument is completely besides the point. i didn’t say a bank couldn’t be run without deposits, i said deposits are generally the cheapest liabilities.

                • Dan Kervick says:

                  OK, fair enough. I’m still a little bit puzzled by this “funding” talk. Yes, I know that when a bank loses a deposit, it experiences a loss in its clearing account (or cash holdings). But it also loses a liability at the same time. Same thing when it acquires a deposit from another bank: it acquires an asset and equal liability at the same time. Is it just that these movements of deposits are leading to marginal increases or decreases in the bank’s reserves-to-deposit ratio?

                  Clearly the banking system as a whole is not funding increased lending by increased deposit attraction, since there is no “outside” from which the system as a whole could be attracting them (unless we’re just talking about a reduced public desire to hold physical cash.)

                  JKH says it’s entirely false to say banks don’t need deposits to fund loans. But I haven’t seen the argument for this. I thought you were more correct when you said that, at the level of an individual bank, boosting clearing balances by acquiring a deposit might be cheaper than doing it some other way. If the bank actually needs to increase its reserve balances, that seems relevant.

                  • i intentionally rephrased the argument without the word funding because i knew many would take it as a loanable funds thing. exactly no one said that banks need to attract more deposits in order to make loans. all anyone is saying is that liabilities need to be incurred and/or held in order to both hold assets and have enough reserve balances to make payments.

              • “be cheaper to acquire the added balances by getting more depositors or via the interbank or central bank route? My hypothesis is that it is the latter, but I’m not sure.”

                There is a limited amount of collateral the central bank accepts to provide advances to banks. These are diluted in crisis situations but nontheless the central bank will stop lending much before the bank starts losing deposits.

                “You could have a viable pure lending bank that didn’t even offer deposit accounts at all. In that case when the borrower takes the loan in exchange for his promissory note, the bank just cuts a check which the depositor has to deposit at another bank. Similarly, the borrower has to repay all loans with cash or checks drawn on other banks. The payments to and from other banks are cleared on the central bank’s books via the bank’s settlement account.”

                Again you assume unlimited and uncollateralized advances from the central bank.

                • Jose Guilherme says:

                  “There is a limited amount of collateral the central bank accepts to provide advances to banks. These are diluted in crisis situations but nontheless the central bank will stop lending much before the bank starts losing deposits”.

                  This was clearly not the case in Spain and Italy, when deposits where fleeing those two countries at the rate of hundreds of billions of euros in mid-2012 – towards Germany, mainly.

                  The Spanish and Italian NCBs kept up the lending to the commercial banks and thus guaranteed the viability of the national banking systems under conditions of massive and unprecedented deposit flight.

                  • “This was clearly not the case in Spain and Italy, when deposits where fleeing those two countries at the rate of hundreds of billions of euros in mid-2012 – towards Germany, mainly.”

                    Well provided banks had the collateral and weakening of collateral standards and so on due to systemic risks and so on.

                    A single bank cannot say “f u” and finance everything at the central bank when there is no systemic crisis.

                    In Greece as well as Ireland, the central bank and the government had to take extraordinary measures – such as guaranteeing the banks’ collateral and so on.

                    Plus in the these cases, the external financing also brought in funds from outside which led to banks acquiring central bank reserves.

                    • Jose Guilherme says:

                      “A single bank cannot say “f u” and finance everything at the central bank when there is no systemic crisis.”

                      The interesting points in the Spanish banking sector case of mid 2012 were the following:

                      A) the banks did manage to get hundreds of bilions of euros in funding from the NCB at a rate of 0.75% (otherwise they would have been unable to comply with their depositors’ instructions to send funds abroad) and

                      B) yet they were at the same time trying to retain and/or attract depositors by offering rates of close to 3% on bank deposits.

                      So, they were both accepting massive official funding at low rates and soliciting private funding at much higher rates.

                      This is really a paradox looking for a plausible explanation.

                    • Jose,

                      No paradox there.

                      A fact I mention somewhere here in comments with Nathan Tankus.

                      The Spanish banks had to prevent customers from making a capital flight.

                      So pay them 3% or more had the the situation got worse.

                      And borrow from the NCB at 0.75%.

                      The latter is limited by the collateral Spanish banks have. So obviously they cannot say “f u” (using the language of my previous comment :) ) to Spanish depositors and pay them 0% or 0.5% or something like that.

                      Because that may induce depositors to shift funds abroad leaving Spanish banks in big trouble because of ELA and all that.

                    • Cullen Roche says:

                      Ramanan has this right. That was simply a case of the environment being so bad that the periphery banks were willing to offer almost anything just to keep their customers at home.

                    • Jose Guilherme says:

                      “So pay them 3% or more had the the situation got worse.”

                      But this was irrational behavior on the part of the banks. So irrational that the NCB had to intervene and mandate a cap on the interest rates that the banks were offering to the depositors. If the competition among banks went unchecked their bottom lines would have been in a (even worse) shape at the end of the process.

                      Why didn’t the banks just adopt an attitude of benign neglect? The deposit flight was a result of panic, unlikely to last forever. Meanwhile the banks were getting easy funding at 0.75%. What was so wrong about that?

                    • Jose Guilherme says:

                      “The latter is limited by the collateral Spanish banks have”.

                      Maybe that rule cannot really apply within the eurozone.

                      Suppose all depositors at Spanish banks wish to transfer their accounts to German banks.

                      They are entitled to do that: for the eurozone to exist there has to be a guarantee of free movement of deposits throughout the single currency member countries.

                      So, in order to accommodate the wishes of depositors the Spanish NCB would be forced to make the necessary advances of funds (reserves) to the commercial banks.

                      And if the banks didn’t have the necessary collateral for said funding, the NCB would have no alternative to relaxing the rules a bit. Perhaps by accepting e-mails from the banks with a “promise to pay you back some time in the future” :)

                      The key point is that for the eurozone to survive and prosper there can be no limits to the amount of funds that NCBs are willing to provide to commercial banks in case there is massive deposit flight from one to other member countries of the euro.

                      The recent Spanish (and Italian) crises are an evidence of that.

                    • Jose,

                      I won’t say irrational but since when have economic agents become utility maximising :)

                      The good thing about deposits is that they don’t require collateral. Borrowing from the Eurosystem requires collateral http://www.ecb.int/paym/coll/html/index.en.html

                      Normally a bank’s assets consists of illiquid loans and central bank deposits and some marketable securities, and some non-marketable assets such as unsecured interbank loans. The liabilities consists of deposits, CDs, due to other credit institutions, repos etc, bonds etc. The marketable securities is not a significant proportion of the balance sheet. So if a single bank loses funds – even internally to other Spanish banks, it will have to borrow at 0.75% from the Spanish NCB. This looks good – except that the amount of collateral is limited.

                      Also, even though central bankers try to remove stigma from discount window/marginal lending facility, banks do not want to be seen as using it – at least in some times. So if a Spanish bank were to reduce its deposit rate, deposits would fly to other Spanish banks and this bank would be in trouble because it wouldn’t have enough collateral and will be singled out by the stock market if word gets in that the bank is borrowed heavily.

                      And if the whole Spanish banking system had reduced deposit rates, that may have led to flight outside Spain. In the extremis, the banking system may need to go into ELA because it has low collateral and the government may have needed to intervene. Their stocks may come under more pressure than otherwise etc.

                    • should have added: The collateral requirement is such that only some eligible marketable assets are allowed and in some cases some illiquid loans. So clearly collateral is a scarce thing in such situations.

                    • Jose Guilherme says:

                      Ramanan,

                      Good points.

                      I understand that “The good thing about deposits is that they don’t require collateral. Borrowing from the Eurosystem requires collateral”.

                      But perhaps we could say that, for extreme cases of deposit flight within the eurozone, the NCBs will be forced to relax their rules for acceptable collateral so much that – in practice – their lending to commercial banks will become very similar to “deposit lending”.

                      With the nice difference of being at a lower rate than deposits , that is :)

                    • Jose,

                      “With the nice difference of being at a lower rate than deposits , that is”

                      I know but no bank would want to get into that situation.

                      Actually some Greek banks showed good profit growth in some quarter(s) because they lost deposits on which high interest was paid and in the next period, they were funding the the NCB/ELA which had low rates.

                      :)

                      How strange!

                • Dan Kervick says:

                  How much do they need? We’re not talking about troubled banks here, just the ordinary course of business in a healthy system, no? The banks are “funding” their ongoing lending operations with their existing loans as they mature. The borrowers pay off the loans, many of the receipts from which are either held in liquid form as reserves or converted into some safe asset. That’s the collateral right? No extraneous deposits needed.

                  • Dan,

                    If I am not mistaken what you meant was that a bank can potentially fund everything at the central bank.

                    So when loans make deposits and the funds fly, the bank will go into an overdraft at the central bank and at the end of the day borrow at the discount window. If if the central bank doesn’t have issues about quantities lent at the discount window, the bank is limited in how much it can use it because it needs to provide collateral to the central bank. It cannot thus keep funding itself at the central bank.

                    • Dan Kervick says:

                      I think can fund everything it needs to at the central bank, Ramanan. But how much does it need to do this? Deposits aren’t just flying out of banks as their own depositors spend. They are flying into the bank as well as depositors at other banks spend. The total lending-driven growth in deposits that takes place as the economy expands along with balance sheets is constantly accommodated by central bank injections of cash, some of which is not lent into the system at all, but paid into the system as interest on government assets, including reserve balances. Except in a crisis, the sum value of collateral grows in a natural way along with the economic expansion. When I pay off my loan, the bank’s risk-weighted asset – my promissory note – is replaced by a risk-free asset, which means the bank has more collateral and thus can continue to borrow, if needed, from the central bank to shore up unexpected reserve deficiencies.

                      A given bank might need to boost reserve balances and might try to attract deposits as one way to do this, but there is always someone on the other side of that transaction. If Bank A lures Joe Blow to move his deposit business from Bank B to Bank A, then Bank B has lost deposits at the same time Bank A has acquired them. Assuming this is going on all the time among healthy banks, that are all lending, it can’t be that the overall growth in the clearing balances needed to service the greater deposit liabilities lending is being supplied in any measure by the moving deposits.

                      It still seems to me the main reason banks seek depositors is that maintaining deposit accounts for customers is a lucrative business.

                    • “I think can fund everything it needs to at the central bank, Ramanan”

                      Dan, banks don’t have so much collateral to borrow everything from the central bank. They have to look for market funding.

                      The alternative is nationalized banking.

                    • I don’t think it is quite that.

                      You should, at least on paper, always be able to fund in the overnight market because if you are short at the central bank, then somebody else is up and you should be able to borrow those reserves from that other source at a rate slightly higher than they are getting from keeping them dead at the central bank. As a matter of construction the central bank has to supply sufficient and nobody else will want them.

                      And overnight borrowing is AIUI collateral free between the banks. So I always struggle to understand why banks just don’t fund in the overnight and forget about everything else. You don’t pay any time premium then.

                      I’m going to put up a post over at my place about a ‘New Model Bank’ to flush all this out. I want to understand whether this is dynamics or convention.

                    • “You should, at least on paper, always be able to fund in the overnight market because if you are short at the central bank, then somebody else is up and you should be able to borrow those reserves from that other source at a rate slightly higher than they are getting from keeping them dead at the central bank”

                      Welcome to crisis macroeconomics!

                      “And overnight borrowing is AIUI collateral free between the banks.”

                      Or there is a freeze.

                      At any rate, not all borrowing is collateral free. Ever heard of “secured funding”.

                      “So I always struggle to understand why banks just don’t fund in the overnight and forget about everything else. ”

                      Very bad for risk management.

                    • Jose Guilherme says:

                      “not all borrowing is collateral free…”.

                      But sometimes it’s really free :)

                      For instance, NCBs in the eurosystem provide unlimited and uncollateralized lines of credit to one another.

                      That’s the reason there can never be an import crunch in the eurozone. Unbalanced current accounts can always get the necessary financing via the NCBs.

                      Too bad the periphery countries never noticed that this is a feature – not a bug – of the system.

                    • “For instance, NCBs in the eurosystem provide unlimited and uncollateralized lines of credit to one another.”

                      Yes I know.

                      “That’s the reason there can never be an import crunch in the eurozone. Unbalanced current accounts can always get the necessary financing via the NCBs.”

                      It amounts to saying that the TARGET2 claims between the NCBs is the accommodating item of the balance of payments.

                      However it ignores the issue of what happens if a nation has large current account deficits. It ends up showing as sovereign debt crisis.

                      “Too bad the periphery countries never noticed that this is a feature – not a bug – of the system.”

                      Actually they thought that with a single currency, the balance of payments problems are removed. It came back with vengeance. Euro Area nations are forced to deflate demand to reduce their external imbalance.

                    • Jose Guilherme says:

                      In fact, all the euro ideologues (not only the southern ones) claimed that external imbalances would cease to be a concern once a single currency area was established.

                      The periphery countries swallowed this delusion lock stock and barrel and instead of the promised paradise are now being forced to accept impoverishment and recession as a price to stay in the euro.

                      And yet they are so weak that they refuse to consider the possibility of using their own state banks to refinance their public debts. Technically, this would not constitute a breach of the Treaties (the texts admit interventions by states in their own financial systems for unspecified “prudential reasons” – a catch all expression to legitimize exceptional governmental measures for guaranteeing the Stability and safety of the financial sector such as, e.g., bank nationalisations).

                      But history has its surprises and maybe one day a more maverick, Berlusconi-type leader, will call the bluff on Europe by using the unlimited and uncollaterized mechanisms of the euro to undermine the present austerity craze.

                    • Jose,

                      The unlimited credit lines of NCBs with each other seem shocking in the first instance one hears but it is alright. Needed for the system. However, it comes with the price of giving up powers of the central bank providing credit to the government. You cannot have unlimited NCB credit to each other and NCB providing credit to the government simultaneously.

                      This was already known in the 1960s! (The Europe plan had been in existence since ages before Maastricht).

                      So the NCBs granting each other credit while good, can hardly be called a free line of credit on the rest of the world.

                      The plan of using their own banks to finance the government is not a good plan. We don’t need plans which are so sensitive to what happens in the markets. If the price of government bonds fall, the banks which have a lot of government debt on their books will fail.

                      One needs someone to prevent the price to fall below a level and the ECB does that. The ECB however cannot grant unconditional credit to governments.

                      Berlusconi cannot do anything great.

                      Anyway all this is a digression.

                      The original point of Neil Wilson was that he assumes that banks (not NCBs) will automatically get funding everyday – the reason being that if one bank loses funds, others will have more. While this is not unreasonable in the first instance, it ignores the fact that the bank receiving funds may choose to not lend at all because of a crisis environment whatever price the borrower is willing to pay. (If the borrower is quoting a high price, there is more reason to be panicky).

                      Also, his argument is not specific to the Euro Area.

                      He also seems to suggest to write a post on this and suggests that it is possible for banks to fund all their liabilities on a daily basis! He ignores that even when banks don’t do it that way (nowhere close), they may still have funding pressures. Imagine what would happen if a bank needs to roll over all its liabilities on a single day!

                    • Jose Guilherme says:

                      “Not a good plan” may be preferable to inactivity and passive acceptance of economic contractions that have already surpassed the peak to trough declines of the great depression.

                      As for Mr. Silvio B. being able or not able to do something good – I’d say the proof of the pudding is always in the eating.

                      Any leader – no matter his or her origin – that dares to react against the depression-loving eurocrats would deserve the adjective “great”.

                      And using the treaty loopholes in self defense (by mandating banks to buy T bonds, for instance) seems to me a matter of common sense. At a minimum, it would take the ECB by surprise and force it to reassess its positions.

                    • Jose,

                      It is true that something really needs to be done rather than doing nothing or worse fiscal contraction but the problems of the Euro Area are not really easy. They are extremely difficult to solve.

                      A union requires a federal government at the central level but the Europeans are not game for such a plan even if Germany wants it. More importantly, it seems Germany and the European leaders and central bankers think their “fiscal union” is genuine – which it is not.

                      But even if Germany comes with a non-fake fiscal union plan, the Europeans won’t accept it because of distrust.

                      And Germany doesn’t want to reflate European demand because it will make the need for a union grow weaker. Other nations will grow a bit stronger and refuse to form a political union.

                      But a plan to form a bank to buy government bond exclusively will meet with distrust. The right solution comes by winning everyone’s trust rather than doing the opposite.

                    • Jose Guilherme says:

                      Ramanan,

                      It’s clear that Germany does no want a fiscal union and I can understand their POV.

                      A fiscal union would be expensive and it would have to be paid with German net transfers. Just like the fiscal union with the former East Germany had to be paid by western Germany.

                      Such a union would mean a common budget to pay for European pensions, European health care, European unemplyment subsidies for all the labor force of the continent, etc. That is, federalism as it presently exists in the U.S.A. It simply is not on offer.

                      What Germany and TPTB on the continent want is the continuation of present policies. Austerity for the south to correct the current account imbalances. And let the rest be damned.

                      In fact, the recently amended (and signed by all euro members) fiscal compact will impose harsh austerity on the non core until 2035 at a minimum. The southern countries will have to reduce massively their public debts to get them to the Maastricht-prescribed maximum of 60% of GDP. For periphery countries with present debt levels at 120% of GDP that will require annual budget surpluses of 3% of GDP until the mid 30s. In all likelihood such policies will engender a permanent and massive southern recession for the next decades. Yes, those objectives are unrealistic and unattainable. But the countries will anyway be forced to attempt massive cuts in spending and tax increases that will have devastating impact on aggregate demand. Not a nice scenario for the future.

                      In the end, one should perhaps not blame Germany for all this – at least not too much. She is pursuing her interests (or at least what she sees as being her interests) with a certain consistency. It’s the southern elites – who failed their own peoples by embarking on a European monetary adventure without properly considering the likely impact on their economies – the ones who should mainly carry the blame.

                    • “A fiscal union would be expensive and it would have to be paid with German net transfers.”

                      That isn’t so. A fiscal union leads to a stronger Euro Area and more production and although there are transfers, it isn’t expensive in any sense to Germany.

                      German leaders do want a union – although a muddled one. It is others who do not want it.

                    • Jose Guilherme says:

                      “although there are transfers, it isn’t expensive in any sense to Germany”

                      I’m afraid German taxpayers may show some reluctance to share your enthusiasm :)

                  • Jose,

                    Yes I know!

                    But generally people don’t realize the importance of it. A nation’s rich region is always making transfers to the poorer ones. So a rich region may pay more taxes than receive government expenditure and it is the opposite for the poorer one. However, this isn’t really due to higher rates themselves. It is more because of higher incomes in the rich region leading to higher taxes paid. The rich regions stay rich because of running a trade surplus with the other regions and this makes them rich. The Germans tend to think that they will pay higher taxes because of higher tax rates. There needn’t be any increase in the tax rate. They forget that higher prosperity of the region as a whole makes them receive payments from trade surpluses. So they forget what they receive and think of what they pay even though in a burden sense there isn’t an increase.

              • Shadow banks are lenders that do not hold deposits are they not? I thought they provided as much credit now as banks do. Shadow banks can not hold the “tax payer” to ransom by threatening to disrupt the payment system if they are not bailed out as they do not deal with deposits. The 2007 credit crunch was a run on the shadow banks. The shadow banks were (and still are) vulnerable because they borrow short term but lend long term. Might tightly regulated shadow banks that had to keep loans on there own balance sheets and that had to fund by selling debt of the same time to maturity as the loans they made be a way to avoid “alchemy” and so have a stable, correctly priced, credit system?

          • Dan Kervick says:

            Other than the deposit accounts of their loan customers?

            • Jose Guilherme says:

              “maintaining deposit accounts for customers is a lucrative business.”

              Except, perhaps, when the deposits pay 3% and yet the NCB is ready to advance funds at a rate of 0.75% :)

      • NO. deposits don’t fund loans. Clearing balances fund loans. From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, & probably its costless legal reserves & thereby it’s lending capacity. But all such inflows involve a (1) decrease in the lending capacity of other commercial banks (outflow of cash & due from bank items) or (2) is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

        Commercial bank credit creation is a “system” process. No bank, or minority group of banks (from an asset standpoint), can expand credit (& the money stock), significantly faster than the majority group are expanding. E.g., if the money center commercial banks hold 80 percent of total bank assets, an expansion of credit by the country banks, & no expansion by large NYC banks, will result, on the average, of a loss in clearing balances equal to, 80 percent of the amount being checked out of the country banks. I.e., the FED, through controlling the reserves of the NYC banks, can control the expansion of total bank credit, money center, & country banks.

  9. Joseph Laliberté says:

    Important distinction, well made.
    It might be a choc for some post keynesians to see that deposits are treated as a source of funds and loans as a usage of funds on the consolidated cash flow statement of commercial banks, but this speaks to what you called “deposits fund loans”. As much as the cash flow statement of a given commercial bank is a meaningless tool if used -in the traditionnal corporate sense- to see how much “cash” is generated by the said bank’s operation, it could nevertheless be a usefull tool to understand “ongoing balance sheet management in competitive banking”. For example, a deposit decline would show up as an outflow of funds on the cash flow statement that has to be matched by a corrresponding inflow of funds (e.g. asset sales, emission of bonds, new equity offering, etc) or a decline in reserves.

    • EXACTLY

      This was a compact post, given the scope of what it attempts to cover

      so, among other things, I omitted (inadvertently maybe) the explicit connection to macro flow of funds accounting and micro sources and uses of funds, and as you point out, the rather delicate juxtaposition of financial institution and non-financial corporate accounting methodologies

      thank you

      very important connection and observation

      and I have a sneaking suspicion that among post Keynesians, Marc Lavoie would not have a problem with this perspective

      – although I assume nothing :)

      • JKH
        EXACTLY
        This was a compact post, given the scope of what it attempts to cover
        so, among other things, I omitted (inadvertently maybe) the explicit connection to macro flow of funds accounting and micro sources and uses of funds, and as you point out, the rather delicate juxtaposition of financial institution and non-financial corporate accounting methodologies
        thank you
        very important connection and observation
        and I have a sneaking suspicion that among post Keynesians, Marc Lavoie would not have a problem with this perspective
        – although I assume nothing

        want me to ask?

      • I think so … deposits appear with a plus sign in the flow matrices of his models. The plus sign is a source of funds and a minus a use of funds.

  10. JKH,

    A great post: hopefully those with cash-centric and/or “multiplied money” descriptions of the modern monetary system will take note.

    I’d prefer something like “deposits a preferred counterpart to loans” because the word “fund” connotes financing.

    On a historical note here is Frederick Soddy, Wealth, Virtual Wealth, and Debt, George Allen and Unwin, London, 1926, p. 147:

    “THE PRIVATE ISSUE OF MONEY; A CHANCE RESULT OF THE BANK CHEQUE SYSTEM
    No doubt there are still many people, if not the majority, who will be frankly incredulous that money vastly exceeding in amount the total national money can be, and is created and destroyed by the moneylender with a stroke of the pen. How frequently does one still read in the Press that the banks can only loan their customers spare money! Most people still think of what money once was, “a public instrument owned and controlled by the State.””

    Methinks much relevance to Krugmanites (i.e. EM) and to State-centric theories of money.

    • More from Frederick Soddy, The Role of Money, George Routledge and Sons, London 1934, p. ix-x:

      “This book will show what money now is, what it does, and what it should do. From this it will emerge the recognition of what has always been the true rôle of money. The standpoint from which most books on modern money are written has been reversed. In this book it is not treated from the point of view of bankers—as those who create by far the greater proportion of money—but from that of the PUBLIC, who at present have to give up valuable goods and services to the bankers in return for the money that they have so cleverly created and create. This, surely, is what the public really wants to know about money.

      It was recognised in Athens and Sparta ten centuries ago before the birth of Christ that one of the most vital prerogatives of the State was the sole right to issue money. How curious that the unique quality of this prerogative is only now being rediscovered. The “money power” which has been able to overshadow ostensibly responsible government, is not the power of the merely ultra-rich, but is nothing more nor less than a new technique designed to create and destroy money by adding and withdrawing figures in bank ledgers, without the slightest concern for the interests of the community or the real rôle that money ought to perform therein.”

      Page x: “To allow it to become a source of revenues to private issuers is to create, first, a secret and illicit arm of the government and, last, a rival power strong enough ultimately to overthrow all other forms of government.”

      Remember the context is that the banking community plus orthodox economists were denying that banks can create money (knowing full well the opposite to be true) and at the same getting all “morally outraged” about abandoning gold-convertibility. The era was one were “gold” was hailed as the purest money and bankers were hypocrites for pretending they did not create money.

      P51: “The Banker as Ruler.—From that invention dates the modern era of the banker as ruler. The whole world after that was his for the taking. By the work of pure scientist the laws of conservation of matter and energy were established, and the new ways of life created which depended upon the contemptuous denial of primitive and puerile aspirations as perpetual motion and the ability ever really to get something for nothing. The whole marvellous civilisation that has sprung from that physical basis has been handed over, lock, stock, and barrel, to those who could not give and have not given the world as much as a bun without first robbing somebody else of it… The skilled creators of wealth [in industry and agriculture] are now become hewers of wood and drawers of water to the creators of debt, who have been doing in secret what they have condemned in public as unsound and immoral finance and have always refused to allow Governments and nations to do openly and above aboard. This without exaggeration is the most gargantuan farce that history has ever staged.”

      Soddy was called a “monetary crank” for describing endogenous money.

      Page 62-3: “Genuine and Fictitious Loans.—For a loan, if it is a genuine loan, does not make a deposit, because what the borrower gets the lender gives up, and there is no increase in the quantity of money, but only an alteration in the identity of the individual owners of it. But if the lender gives up nothing at all what the borrower receives is a new issue of money and the quantity is proportionately increased. So elaborately has the real nature of this ridiculous proceeding been surrounded with confusion by some of the cleverest and most skilful advocates the world has ever known, that it is still something of a mystery to ordinary people, who hold their heads and confess they are “unable to understand finance.” It is not intended that they should.”

      BTW Irving Fisher stole debt-deflation and the ‘100% Money’ reform from Soddy.

      • Awesome quotes! Gonna repost at Pragcap.

      • great stuff from Soddy

        but I must opine on this:

        “a new technique designed to create and destroy money by adding and withdrawing figures in bank ledgers, without the slightest concern for the interests of the community or the real rôle that money ought to perform therein”

        I’d guess J.K. Galbraith was riffing off this sort of thing

        :)

        there’s a big chasm between recognizing how this is done (loans create deposits), and understanding how banks at least in modern times manage their capital positions

        this is IMO the huge error made by the economics profession with the multiplier thinking – a failure to incorporate the meaning of bank equity capital into their models, and to distinguish it from the flow of funds (whether those flows are correctly or incorrectly understood)

        the financial crisis IMO was a failure of liquidity and capital management – but mostly bad capital management that galvanized liquidity interruption

    • Thanks, BF.

      On language:

      I may be using the word ‘fund’ loosely.

      On the other hand, it may be the least loose of all possible words to use, in this context – just maybe.

      “Flow of funds” language convention comes to mind, as per Joseph’s comment.

      More than that, similar language is used internally in banks, and in the case of deposits or other short term liabilities, it is quite distinct from that used the case of longer term debt or equity “financing”.

      And more again, the language that best applies smoothly to a telescoping range:

      To the macro financial system (as in my paragraph 3), to the banking system within that system, to individual banks within that system, to categories of liabilities within those banks, and to individual liabilities within those categories, as per another comment above.

      The language is turtles all the way down!

      Language is difficult to get everybody pleased about. I think of how Nick Rowe hates the language of the money market – from a pure economist’s standpoint, there is no single market for money – and yet the language has a long and deep and meaningful history as used in the actual institutional marketplace of the financial system.

      • As we all know, language can be a big problem. This is a hard one to rectify and communicate properly. I think what we’re really trying to say is that deposits are one way banks bridge the gap between their assets and liabilities. Of course, banking is a business of spreads so the concept of deposits “funding” loans implies that deposits are the bridge when the reality is that they’re just one half of the bridge.

        Not sure I am saying that the way I’d like to, but maybe we’re better off using some sort of analogy that more appropriately communicates the concept of bridging a divide…Just thinking out loud here.

        • If the bridge is defined as the asset plus the liability, then deposits are one form of liability, and one half of the bridge

          funding is just another word for liability in that sense

          so deposits fund loans

          • Cullen Roche says:

            The point is, deposits only “fund” loans to the same degree that half a bridge gets you across a lake. I think Brett is right that the term funding will confuse people going forward, but I don’t know if we should/can rectify that terminological issue that is likely to come up time and time again….

            • so if the word “fund” connotes financing as Brett says,

              then when WOULD you use the word “fund”?

              • Cullen Roche says:

                I honestly don’t know. I am uneasy with the term funding because it does seem to contradict the idea that loans create deposits so it could become a recurring terminological issue. I mean, I understand precisely what you mean here, but I am not so sure most everyone else will. I am just kicking around ideas because my concern is that we’ll spend the rest of eternity explaining to lay people how loans create deposits and deposits “fund” loans.

                I’m too stupid to think of a better way to communicate the concept. But maybe it’s not something we should dumb down?

                • the whole point of the post is that they aren’t contradictory

                  • Cullen Roche says:

                    Of course. But I think it’s going to be a recurring terminological issue regardless of how well you and I understand it. Gauging from the comments here and at Pragcap it’s clearly a confusing subject. Even for some people who have quite an advanced understanding of the subjects being discussed.

                    Something worth thinking about in my opinion….

            • i.e. the only difference in terms of the macro or micro flow of funds is that financing tends to be used for long term debt and equity and funding for short term deposits and money markets – that is how the terms are generally used in liability management in banking

          • Dan Kervick says:

            It has oftem seemed to me that there is a chronic verbal confusion about the term “deposit” used in some of these contexts. Suppose a walk-in depositor comes into the bank with $1000 in cash and opens an account. The depositor gives the bank the cash which goes in the bank’s vault. In exchange, the bank creates an account for the depositor and credits it with $1000.

            The money in the bank’s vault is now an asset of the bank. It is part of the bank’s vault cash which in turn is a part of the bank’s total reserves. The $1000 balance in the depositor’s account, on the other hand, represents a liability of the bank, it denotes a $1000 obligation of the bank to the depositor. Assets and liabilities have grown by exactly the same amount. The same result holds if the depositor makes the deposit by presenting a check drawn on his account at another bank. In that case, the new liability is the same as before, but the new asset is not some sum of cash in the vault, but a $1000 credit to the bank’s reserve account following the clearing.

            In the standard accounting language applied to banking, the deposit is the balance in the depositor’s account – the new liability of the bank. But informally, people often use the word “deposit” to refer to the asset: the new sum of cash in the vault – or the new increment to the bank’s reserve balance. In another informal usage, people sometimes use “deposit” to refer to an action: what the depositor did by exchanging cash for an account balance.

            On the strict initial usage, it is slightly strange to say that banks seek to attract deposits to fund – or in any case acquire clearing balances to make payments for – the account balances created by their lending. Since a deposit is a liability there is no sense in which simply acquiring a new liability helps the bank make any payments, and no bank would ever want to attract a liability alone, if it didn’t come in exchange for an asset. What the bank wants to get is the asset that came with the liability: the money in either physical cash form or reserve balance form that the depositor supplied in exchange for the deposit account balance.

            I can see why this might be useful at the margin for the bank since if the bank’s current reserve ratio is x/y and it acquires both a reserve asset and deposit liability equal to z, then it’s new reserve ratio is (x+z)/(y+z), which is greater than x/y for positive z and x<y. But I don't see how this can be a very important factor systemically, since for each deposit the bank attracts away from another bank, the inverse balance sheet effect occurs at that other bank.

            • What his means is the bank is borrowing from the customer, creating a deposit that marks up its liabilities. The bank then marks up a corresponding asset account, either vault cash or rb, in the amount it has borrowed. Usually, banks pay no interest on demand deposits, or very low interest, so this is the lowest cost of financing reserves needed for RR and settlement. Banks are “financial” institutions in that finance lending with their own borrowing to leverage their capital. Banks make a profit by making best use of their capital, which means that they “finance” as much of their their needs as prudent with borrowing rather than “funding” them with equity, in the way these terms are usually understood.

        • straightforward:

          deposits are the source of funds

          loans are the use of funds

          deposits fund loans

          • JKH, you and Bill Mitchell seem to be saying the same thing, but paradoxically:

            “I hope that has answered all those queries which sought to integrate an undertanding of how loans create deposits with the role that deposits play in the funding of bank operations.

            “Deposits do not fund loans. But they are one source of funds that the bank has available to ensure that its role in the settlement process is not compromised which would require borrowing from the central bank.

            “Banks have no operational constraints on their lending which is not the same thing as saying they do not face constraints that arise from profitability considerations.”
            http://bilbo.economicoutlook.net/blog/?p=14620

            • Alex Seferian says:

              Tom: I found your comments helpful. I checked the web and Bill writes: “Private banks still need to “fund” their loan book. Banks have various sources of funds available to them including the discount window offered by the central bank…”

              My question is: When JKH and Bill talk about funding loans, are they both referring to the need banks have to get hold or “reserves”? Is funding loan books just about obtaining Fed reserves for the purposes of ultimately being able to meet reserve requirements?

              • To the degree that banks don’t settle through intrabank and interbank netting, they settle in reserves, either by furnishing vault cash at the customer window or with reserve balances in the interbank payments system.

                When a bank makes a loan and credits a deposit account, it promises to settle on demand as the customer specifies through the type of withdrawal. Banks don’t create reserves, so if settlement involves reserves, the bank has to obtain them, as well as to meet a reserve requirement if imposed.

                Since only the cb creates reserves, the bank has to get them by borrowing elsewhere if it does not get them though attracting deposits, then it has to obtain them by borrowing elsewhere. The cb acts as LLR and charges the penalty rate in case the bank comes up short of reserves during a period.

                So attracting deposits increases the bank’s reserve account at the cb, which the bank can use to get vault cash or settle in rb. If the bank doesn’t have the necessary reserves within a period by borrowing deposits from customers, it has to borrow elsewhere, and borrowing deposits from customers is generally less costly than borrowing from other institutions or using repo, which requires collateral. So the deposits that the bank attracts attracts reserves inexpensively and this is the preferred source of funding through borrowing. Since borrowing is involved make another term is “financing”?

                • Dan Kervick says:

                  My understanding is that if banks use a netting system like CHIPS, they are still settling in reserves. It’s just that the settlement is more efficient, with fewer intermediate transactions, because the payments are aggregated and netted. The bank sends a Fedwire payment to CHIPS at the beginning of the day, and at the end of the day the bank sends another Fedwire payment to CHIPS if the bank’s closing position is negative, or receives a Fedwire payment from CHIPS if its closing position is positive.

                  • Alex Seferian says:

                    Thank you very much for the response. A few last things if OK…

                    You write: “So attracting deposits increases the bank’s reserve account at the cb…”. 2 questions:
                    1. When a bank “attracts” deposits, do the reserves linked to that deposit materialize automatically?
                    2. Whereas when a bank “creates” a loan and with it a deposit, the bank has to obtain the reserves.

                    You write: “To the degree that banks don’t settle through intrabank and interbank netting, they settle in reserves, either by furnishing vault cash at the customer window or with reserve balances in the interbank payments system.” One question:
                    3. What is the “thing” that banks settle through intrabank and interbank lending? Is it “reserves”?

                    • there are two ways to attract deposits. either by accepting cash when opening an account or having a balance transferred from another bank. vault cash counts towards general bank reserves. if they need money in their reserve account at the central bank, they sell excess cash back to the central bank. either case reserves increase. the answer to your last question is interrelated. banks settle payments with other banks using their reserve accounts (basically a checking account with the central bank).

                    • Alex Seferian says:

                      Nathan Tankus wrote: “there are two ways to attract deposits. either by accepting cash when opening an account or having a balance transferred from another bank. vault cash counts towards general bank reserves. if they need money in their reserve account at the central bank, they sell excess cash back to the central bank. either case reserves increase. the answer to your last question is interrelated. banks settle payments with other banks using their reserve accounts (basically a checking account with the central bank).”

                      Thank you but I still don’t entirely get it.

                      Assume Bank A creates a loan out of thin air, and with it the deposit. Assume then that on the same day, the customer transfers the deposit to Bank B. In this case, Bank B has “attracted” the deposit. In your 1st example, a bank attracts a deposit by accepting cash, and it does indeed help me to think of “reserves”, as you point out, as a “checking” account at the CB.

                      Now, I can see how “reserves” increase when a deposit is made with someone opening an account with cash, because cash is printed by the CB. We have the link with the CB, so check.

                      However, in my Bank A/B example, no “reserves” are linked to the deposit. Or are they? I have understood up until yesterday (until I began reading this interesting post… and now I am confused) that within a given time lag (two weeks in the US), Bank B, all other things equal, will have to obtain “reserves” equivalent to a fraction of the deposit value. Bank B will have several alternatives to do so, including: by borrowing “reserves” from another bank (a bank with an excess “reserves” position), or by borrowing the reserves directly from the CB.

                      Bank A, on the other hand, I understood will not have to worry about obtaining reserves. It no longer has a customer deposit, although the original loan will indeed remain on its books, as will the liability with Bank B. Behind this thinking is my understanding that reserves are only required for customer deposits.

                      I know I am missing something… can you help or point me in the direction of a simple text with T accounts that clearly explains this for the layman?

                    • Alex Seferian
                      Nathan Tankus wrote: “there are two ways to attract deposits. either by accepting cash when opening an account or having a balance transferred from another bank. vault cash counts towards general bank reserves. if they need money in their reserve account at the central bank, they sell excess cash back to the central bank. either case reserves increase. the answer to your last question is interrelated. banks settle payments with other banks using their reserve accounts (basically a checking account with the central bank).”
                      Thank you but I still don’t entirely get it.
                      Assume Bank A creates a loan out of thin air, and with it the deposit. Assume then that on the same day, the customer transfers the deposit to Bank B. In this case, Bank B has “attracted” the deposit. In your 1st example, a bank attracts a deposit by accepting cash, and it does indeed help me to think of “reserves”, as you point out, as a “checking” account at the CB.
                      Now, I can see how “reserves” increase when a deposit is made with someone opening an account with cash, because cash is printed by the CB. We have the link with the CB, so check.
                      However, in my Bank A/B example, no “reserves” are linked to the deposit. Or are they? I have understood up until yesterday (until I began reading this interesting post… and now I am confused) that within a given time lag (two weeks in the US), Bank B, all other things equal, will have to obtain “reserves” equivalent to a fraction of the deposit value. Bank B will have several alternatives to do so, including: by borrowing “reserves” from another bank (a bank with an excess “reserves” position), or by borrowing the reserves directly from the CB.
                      Bank A, on the other hand, I understood will not have to worry about obtaining reserves. It no longer has a customer deposit, although the original loan will indeed remain on its books, as will the liability with Bank B. Behind this thinking is my understanding that reserves are only required for customer deposits.
                      I know I am missing something… can you help or point me in the direction of a simple text with T accounts that clearly explains this for the layman?

                      the problem your having is you think deposits have to be “linked” to the reserves. they don’t. reserves are needed for settling payments and meeting reserve requirements. that’s it. in the case of a new loan creating a deposit which is then transferred to another bank. the deposit is transferred through changes in the respective bank’s reserve account. hence why they need a “checking account” with the central bank. see below

                      central bank bank A bank B
                      A L A L A L
                      _______________________ ___________________________ ________________________
                      | +loan | +deposit |
                      | | |
                      | | |
                      |
                      |
                      |
                      |

                      central bank bank A bank B
                      A L A L A L
                      _______________________ ___________________________ ________________________
                      | -bank A reserves +loan | +deposit + reserves | +deposit
                      | +bank B reserves -reserves | -deposit |

                    • Alex Seferian says:

                      Thank you Nathan

            • Oops, please excuse the typo, and hat tip to Ramanan for the Bill Mitchell quote.

            • Jose Guilherme says:

              At the micro level it would seem there can arise two very different situations:

              First, a bank makes a loan. It debits a loan and credits a deposit.

              Second, a bank receives a transfer of funds from another bank. It debits reserves and credits a deposit.

              In this second situation the bank does get “a source of funds…to ensure that its role in the settlement process is not compromised” (Bill Mitchell).

              Not so in the first situation, however.

            • Tom,

              “Taxes don’t fund anything.”

              “Taxes go into the dustbin”.

              “Deposits don’t fund loans. ”

              “Taxes and bonds do not finance government spending. ”

              “Foreigners don’t fund the government. ”

              “Current account deficit is not financed.”

              “Governments in gold standard borrow. Governments in floating exchange do not borrow. ”

              “Tax payments by cash are shredded”.

              “We don’t owe China anything except a bank statement”.

              Did I miss anything?

  11. Alex Seferian says:

    Thanks for this interesting post. This is the first time I comment in this very good website.

    I follow the bit about “loans create deposits”, but get lost with part of the rest.

    You write: “Without further action, the lending bank has lost reserves and the deposit bank has gained reserves. They may both seek to normalize these respective reserve positions, other things equal.”

    I ask: what is there to “normalize” at this stage? If one isolates the transaction that you mention, the deposit bank, because it has the deposit, is the bank that is required to have the reserves, and in order to meet the Fed’s reserve requirement. The lending bank does not need the specific reserves linked to the deposit in your example. It may need reserves for other deposits, but insofar as your example is concerned, and at the point in time you are making the comment, both banks are indeed “normalized”.

    In fact, the “normalization” has occurred automatically as you point out beforehand in your post: “The duplication gets resolved and eliminated when the deposit issuing bank clears the cheque back to the lending bank and receives a reserve balance credit in exchange, at which point the lending bank sheds both reserve balances and its payment liability.” Again, this to me implies that the situation is “normalized”.

    If what I write above is correct, then it seems to me that it does not follow that “deposits fund loans” because of the life cycle of loans and deposits. There is indeed a life cycle of sorts, but having deposits are not a “must have” for the banks to ever lend. I don’t even think they are a “nice to have” (although I do see the logic one of the commentators makes about deposits bringing in additional business for banks).

    To better explain this last point, assume Bank X that obtains a deposit without having had to extend first a loan, and Bank Y that has no such deposit. Which of the two banks will be in a better position to extend a new loan to a new credit worthy customer that one day shows up? If you believe that the answer is (as I do): both will be in the same position, then it can’t possibly follow that “deposits fund loans”. Moreover, I don’t understand why the fact that a loan has a life cycle would make one’s opinion on this change.

    What am I missing?

    • This transaction is in real time – it has nothing to do with required reserves, which are imposed later, with a time lag.

      The reference to reserves here is about their use as the means of payment and settlement for interbank clearing transactions.

      The lending bank is temporarily in a deficit reserve position – the deposit taking bank in a surplus reserve position – at the margin in each case – because the deficit bank has paid reserves to the surplus bank in the clearings in order to make payment for the cheque/draft.

      So “normalization” refers to their respective objectives of “squaring” their reserve positions back to the prior position before this transaction.

      The deficit bank does this by attracting new funding and the surplus bank does this by lending into the market – and in both cases I’m assuming the money market is used for this purpose – because the money market is the established market for short term liquidity adjustments by banks and non-banks.

      • Alex Seferian says:

        Regarding “required reserves”, I am aware that a bank that is short of “reserves” has a time lag to obtain them, and it can do so by either borrowing these “reserves” directly from the Fed, or from the interbank market. When you write: “The reference to reserves here is about their use as the means of payment and settlement for interbank clearing transactions.”, do you mean clearing transactions that do not have to ultimately do with the reserve requirements?
        When else may banks seek to lend or borrow reserves if it is not to ultimately adjust their position to conform to the Fed’s reserve requirements? I know that each time the Fed credits an account as a result of government spending, for example, “reserves” are created. I also know that “reserves” are taken back when the government taxes. Banks end up as a result of these sorts of transactions with reserve balances or overdrafts, and because reserves yield very little, banks will always strive to have just enough to meet the reserve requirement. I must be still missing something because given what I say, there is no “normalization” issue in your example. I am not an economist, so could you please better explain this, or point me in the right direction so I can learn more about the basics? I thought that “reserves” is just a fancy name for money held at or created by the Federal “Reserve” Bank, and it all boils down to “reserve requirements” when talking about “reserves”.

  12. This explanation is tortured and excessively complex. Banks don’t fund their loans with deposits. They attract deposits so they can obtain the least expensive source for settling payments. Obtaining deposits has nothing to do with “funding” loans and everything to do with helping banks acquire funds so they can settle payments for their customers.

    • I was going to ask a question about exactly your comment. My comment is that I am confused by the “deposits fund loans” meme. I thought that “loanable funds” was a myth like the money multiplier.

  13. Dan K,

    http://monetaryrealism.com/loans-create-deposits-in-context/#comment-15805

    Good analysis, including:

    “On the strict initial usage, it is slightly strange to say that banks seek to attract deposits to fund – or in any case acquire clearing balances to make payments for – the account balances created by their lending. Since a deposit is a liability there is no sense in which simply acquiring a new liability helps the bank make any payments, and no bank would ever want to attract a liability alone, if it didn’t come in exchange for an asset. What the bank wants to get is the asset that came with the liability: the money in either physical cash form or reserve balance form that the depositor supplied in exchange for the deposit account balance.”

    I agree it is SLIGHTLY strange – but the language of “fund” here is intended to be used in the sense of its normal banking application to the rest of the balance sheet. The language of “fund” is used in the sense of the flow of funds at the macro level and of asset liability management at the bank level (as well as treasury operations at the bank level). So the language is already established, macro and micro. This is the point Joseph L. made earlier that I agreed with.

    It’s not intended to conflict with the reserve settlement point you and several others have made. I said in the post, the ultimate purpose of the reserve account is to ensure that a bank balance sheet is in balance, more or less. Of course, it’s also to enable payments to and from other banks, but the reason those payments have to be made is in order to achieve intended balance in the rest of the balance sheet. The reserve accounting is an accounting mechanism for that balance. So it’s the asset liability strategy for the rest of the balance sheet that’s driving the functional, operational necessity for settlement through the reserve account.

    One other reason I’ve used the word “fund” here is to emphasize the role of deposits in plugging liquidity “gaps” when one deposit leaves a bank and another one comes back in. And of course, those gaps start opening up as soon as the deposit that was created by the loan has been withdrawn to move to another bank. Attracting a new deposit then closes a gap in the non-reserve part of the balance sheet – which again is the purpose of asset-liability management – and which will be reflected in operational settlement through the reserve account. The reserve management function ends up tracking the effectiveness of asset-liability management in effect.

    The post in part is intended to describe the nature of the connection between the operational management of the reserve account and the broader asset liability management function. You don’t read too much about the latter in blogs. This post is just an introduction to that. And “fund” is normal language in that context (as is “finance” in the case of longer term liabilities and equity).

    The purpose is not to achieve absolute congruence with what might be considered a perfect description using the separate operational language of reserve account management. (Keep in mind as well that the language of ‘loans creates deposits’ also does not involve the reserve account.) It is to move a higher overview of what’s going on at the level of bank asset liability management, which ends up having its own effect on movements at the reserve account level .

    That said, I’m not sure there’s a true conflict in the way in which the word “fund” is used. Banks don’t lend reserves (to non banks) and they don’t borrow reserves (from non banks). So deposits don’t “fund” the reserves that are actually used in the flow of interbank payment and settlement. (Athough in the sense of asset-liability management, the word can be applied in the sense of funding a required stock of reserves where that exists – because that is an asset on the balance sheet.

    And while the overall description may appear “tortured and excessively complex” to some (others), that might be partly attributable to the fact that I’m attempting to explain something that is broader in descriptive scope than just the operational management of the reserve account – in a language that is generally congruent with the language that is used in an actual banking environment that includes both asset liability management and reserve management alongside each other. And those functions don’t generally get terribly confused by each other’s language. So I see no reason why the blogosphere need become confused either.

  14. “So I see no reason why the blogosphere need become confused either.”

    Judging by what have been reading today on other blogs and FaceBook, it aleady has. That just not the way most people understand “fund.” So taken out of context of flow of funds and sources and uses as Joseph pointe out, that is, taken
    just as “deposits fund loans,” it is already confusing. For example, people ordinarily think “fund from revenue” in contrast to “finance by borrowing.” In this sense, attracting deposits “finances” reserve acquisition by borrowing from customers.

    I am not complaining about the use of technical terms. I understand that folks have to understand the technical language because it is precise. Jes’ sayin’ that it doesn’t seem to be clear to a number of people I encountered today that read the post and commented on it elsewhere.

    It’s sort of like “debit” and “credit.” Some people don’t get this terminology, so I generally say “mark up” or mark down.” Maybe not pretty, but people understand it even if they know nothing of accounting.

    • Cullen Roche says:

      Well, you know something’s wrong when MMTers are lecturing other people on how best to use terminology. Just kidding.

      Maybe we should just all start talking in Chinese to one another. We’ll probably end up at the same dead end economic conclusions from policy makers either way. After all, all of us heterodox guys are basically screaming into an empty hole when it comes to influencing policy anyhow. :-)

      • I would hope that we are all trying to work together to develop a presentation that is clear, concise and precise. MR, MMT, and MCT agree more than disagree and also agree that a lot of what we are mutually trying to accomplish is alleviating ignorance based a misunderstanding of monetary economics. Winning the debate the mainstream rather than scoring points against each other is important, not only for advancing knowledge but also wrt fact-based policy making. We are all adversely affected as long as the austerians remain dominant, and now it’s just a matter of degree between the two political parties.

    • interesting, thanks

      I do think you appreciate that the intended message of the post ideally shouldn’t revolve around the term itself – its really about how the functioning of the reserve account relates to a lot of things going on in the rest of the institution, including an active liquidity management and asset-liability management function, etc., particularly when you consider bank strategies in a competitive environment

      So its quite unfortunate this one word is getting in the way – and maybe unfortunate that I captured it in the phrase “deposits fund loans”, although that is entirely natural to me based on experience

      (and as I explained in the post this is intended to be representative of a flow of funds perspective, and not comprehensive in describing the entire balance sheet mix of such things, which also involves debt and equity, and issues relating to commingling rather than specific micro linking of deposit to loan, etc. – there’s a lot more granular detail and additional differentiation behind the simple and simplified ‘deposits fund loans’)

      But this language is congruent with flow of funds language, and with asset liability management, and with what are often referred to as “money market funding operations” in banks etc. etc. So I’m not making this up.

      But neither are you, I know.

      The point about funding relating to revenue is interesting – because flow of funds accounting is designed specifically to move past the revenue source and into the realm of ‘asset swaps’

      And its interesting to me also because the last time this came up for me personally was an off-line conversation with Philip Diehl – when we were attempting to clarify our mutual communication on the issue of seigniorage accounting as it related to the platinum coin – and it became clear that our respective uses of the word ‘fund’ was not quite the same

      that said, I know this use of it that you’re referring to as well

      • Right, I am not arguing about the technical precision but rather the framing. In most people’s mind to fund means to pay for and implies exchange. So a Krugman will read “Loans create deposits and deposits fund loans” as saying what he is saying, namely that for every borrower there is a saver and vice versa, so ISLM holds. Others will understand that it means that banks loan out savings.

        Then what happens is you have to explain that’s not what you mean, and no one seems to get it because it goes over their heads because a frame has been reinforced in their minds. Experience shows that this happens all the time with MMT, for example, because the absolute size of the deficit is not the issue, they think that MMT economists are saying that government can just spend, spend, spend, which, of course, is not being claimed at all.

        Randy wrote a series recently on paying more attention to the framing, since he has realized that it’s about more than being technically correct if one is to be rhetorically persuasive enough to make a difference.

        So if it is one word that appears to be a stumbling block, maybe that is sending a signal about the communication.

        • Krugman seems to be completely missing the ‘loans create deposits’ dynamic

          How anybody of his powers of observation can’t see this is beyond me

          He moves right into ‘deposits fund loans’, and the way he does it is in the form a bit of a subset of what I’ve described – e.g a depositor transfers money from one bank to another and the second bank makes a (near zero risk) money market loan and the first borrows money in the money market – or he says the second bank will leave it in reserves – these were the sort of arguments he was making in the recent Say’s Law thing

          in saying this, he’s kind of implying that banks need capital to make loans indirectly, but its awfully fuzzy in the way he describe it

          what he completely misses is how these balance sheets are created in the first place, which is essentially by ‘loans create deposits’

          its as if he’s making an odd kind of fallacy of composition error, and I can’t understand why he doesn’t get this piece of the whole thing

          • May be he is thinking , “Deposits fund loans that fund further deposits,” i.e. lending on.

          • Dan Kervick says:

            Krugman’s picture, however, was utterly standard in old school Economics textbooks – at least if I recall correctly. When I was an undergraduate, we learned that a bank that brought in $X dollars in deposits during a given period was then permitted to “lend out” a fraction of that that quantity in accordance with whatever the required reserve ratio was. If the ratio was 1/10, then the bank could loan out 9/10 of the $X. The banks that received the loaned-out funds as deposits could then loan out 9/10 of that total, or 81/100 of the original, etc. We then used the formula for the sum of an infinite geometrical series to calculate the total amount of money that could be created by the initial deposit of $X dollars – which in this particular case comes out to be $10X. This picture was presented along a certain amount of sermonizing about the social value of saving money in banks and making the money supply grow.

            In subsequent life I learned that picture was wrong in two stages. The first stage was the recognition that the required reserve ratio didn’t refer to the portion of money the bank “brought in”, that it could “lend out”, but the proportion between the money held as reserves and the total amount of the banks deposit liabilities. So even if the bank acquired no new reserves after getting the $X, and all of its new deposit accounts during that period were created in the process of making loans, that bank would be able to create new deposit balances totaling $10X dollars, not 9/10ths of $X. Also, I realized that banks didn’t exactly lend “out” money that ended up in other banks. They issued IOUs in the form of deposit balances, only a portion of which were redeemed as withdrawals or had checks written against them.

            The second stage, when I read the MMTers and endogenous money folks, was learning that the bank didn’t even have to get the $X before creating the $10X in deposit balances. They could create the deposit balance by making a loan, and then get any reserves they needed. Since for a normal and healthy bank, there are always various ready sources of these reserves and their supply is almost infinitely elastic, then all they cared about was the various prices they would have to pay for them.

            The moral of this new story, it seemed to me, is that all the work of constraining lending and preserving financial stability came on the side of the bank’s own ability to price assets correctly and to accurate measure the expected value of the promissory notes they received from borrowers in exchange for expanding their liabilities by giving the borrower a deposit balance. There is no constraining anchor mooring them to their current reserve balance. Nor does the size of the reserve balance exert some sort of “push” or “pull” on loan generation – only changes in the price do that. This means that if bankers are not rational, competent, economically omniscient and institutionally responsible agents, then regulating credit markets in order to preserve financial stability requires a lot more than the kinds of reserve management operations that are typically classified as “monetary policy”.

    • You can see it as a transitive chain.

      The deposit you create always matches the loan you create until the loan in annihilated. They are just connected by a load of ‘intra banking system’ loans and offsets.

      Not sure that model is any clearer though.

  15. I agree the clearest approach could be to use the same terms as bankers apparently use ( ie deposits fund loans) but to always flag up the fact that the word is being used with a certain meaning. I guess so many crucial words have several meanings that this is a recurring issue. For instance in common usage “investment” often means simply making a swap between pre-existing assets and not investment in the economic sense. It is a pest to have to always have a footnote but that is perhaps the least confusing option.

    • Dan Kervick says:

      Yes, that seems right. I have been browsing around and noticed the ubiquity of the banking terminology of liabilities as “sources of funds” and assets as “uses of funds”. This seems like strange language to me, but given how common it is, I guess the only thing is to adapt to it and learn to speak this terminology.

      But on why it is odd: Suppose a bank loses a legal case and is ordered to pay $1 million to the claimant by April 1st; or suppose it is fined $1 million by government regulators and ordered to pay by May 1st. Until those payments are made, the binding legal requirements that they are to be paid constitute liabilities of the bank. But nobody would speak of these liabilities as “sources of funds”. They are claims on funds, not sources of them. But most of a bank’s liabilities are liabilities they voluntarily issued in exchange for assets – and sometimes the asset is just cash. I would say that when a banker speaks of certain liabilities as a source of funds, what the banker means is that the asset they acquired in exchange for those liabilities is a a source of funds. The thing that is labelled a “deposit” and that goes on liability side of the bank’s balance sheet isn’t the cash in their safe that the depositor deposited. That’s an asset. The liability is the IOU of the bank to the depositor represented by the numerical balance in the depositor’s account.

      The same goes for assets. Suppose I own a bond that delivers coupon payments to me every few months for some amount of time until the principal is paid at maturity. That asset represents funds coming in, and would thus seem to be a source of funds. But when the banker says the asset is a “use of funds”, what they seem to mean is that they used funds to acquire the asset.

      • Equity is a source of funds.

        A sudden legal liability of $ 1 million is a conversion of equity to that liability.

        The liability is the newly categorized source of funds until it is paid off.

        Until the claimant takes payment, he is funding the bank – he has an asset receivable.

        So the liability is a source of funds in the sense of comparison against the counterfactual – in which the claim was immediately paid off in cash.

        • same idea more generally when a demand deposit is converted to a term deposit at the same bank, for example

        • Jose Guilherme says:

          “So the liability is a source of funds”

          yes. But in that case the funds came from a third party – whereas when a bank autonomously decides to debit a loan and credit a deposit it is creating its own source of funds.

          The two situations cannot and should not be seen as equivalent, IMO.

          • right – not equivalent in terms of the gross flow of funds movements

            but same net funding effect as losing the demand deposit and attracting a new term deposit from outside

            and same funding description in terms of comparable final balance sheets

            • Jose Guilherme says:

              In your example there was a decrease in equity and an increase in liabilities. So the net effect on “sources of funds” was zero.

              When a bank receives a deposit transfer from another bank, there is both an increase in “sources of funds” (new liability) and an increase in “uses of funds” (new asset : reserves).

              Following the same logic, when a bank grants a new loan there is also an increase in “uses of funds” (new loan) and in “sources of funds” (new deposit).

              But in this case the bank cannot make payments until it finds a “real” source of funds – either from another commercial bank (+ reserves, + deposit) or from the central bank (+ reserves, + advance from NCB).

              So the 3 situations are different from one another.

      • Source of funds a;;ears to mean where the entry originated that appears on the liability side and use of funds is where the entry originated on the asset side, with no causality involved.

        I think that confusion arises in that deposits fund loans seems to be making a causal assertion that goes beyond the intention. The intention is to assert an accounting relationship and the misinterpretation is to take “deposits fund loans” as entailing that deposits are needed to create loans as a necessary condition in a causal chain. The implication then is that deposits are being lent out.

      • “Yes, that seems right. I have been browsing around and noticed the ubiquity of the banking terminology of liabilities as “sources of funds” and assets as “uses of funds”.

        Dan,

        That isn’t accurate.

        Sale of assets is also a source of funds.

        You can’t equate assets to uses and liabilities to sources.

        So for example, reduction in liabilities is a use of funds.

    • This play in the means of investment is used all the time to justify reducing taxes on the “job creators” so as not to “crowd out” investment. The presumption is that “investment” always means firm spending on capital goods, whereas most “investment” by the wealthy is financial investment that shows up in portfolios and constitutes saving. Debunking this sophistry has been impossible so far.

    • P.S.

      And they’re all not talking about funding reserves – because banks don’t lend reserves (to non-banks) and they don’t borrow reserves (from non-banks). So they’re talking about funding something else – like loans, for example.

    • Cullen Roche says:

      You’re the banking expert and its clear the term is consistent in the field of banking so we might as well stay consistent in our use of it. We will just need to be clear in our conversations with laypeople about its use. Thanks, JKH.

  16. Other systems have been proposed, in which central banks intervene in some way to adjust the landscape of competitive liability management (e.g. the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the MMT Mosler plan)

    I don’t think it’s fair to mention the Chicago Plan in one breath with the Mosler plan. The Mosler Plan, whether politically or operationally workable or not, is clearly rooted in an endogenous money view of modern finance, i.e. a ‘loans create deposits’ world. The Chicago Plan, on the other hand, proposes a top down system in which the central bank creates new deposits at a predetermined growth rate, which has the – intended or unintended – side effect of delegating all endogenous activity to shadow banking system. In any case it isn’t compatible with ‘loans create (reservable) deposits’.

    To me these are essentially incompatible views of the world as they disagree on a very fundamental level about what drives or at least who, and in which way, controls economic activity at the margin. All money supply adherents have an inherently paternalistic view of how the world works.

    In the same sense, I’m not sure it’s helpful bring ‘loans create deposits’ and ‘deposits fund loans’ together in way you’ve been doing above. I can see that you’re trying to tie in the accounting over all levels to demonstrate how they all fit together logically with competitive banking and the rest of the economy. On the other hand, but maybe this is just my own bias, I find you run the danger of losing the, to me all important, macro/micro distinction.

    • “not sure it’s helpful bring ‘loans create deposits’ and ‘deposits fund loans’ together … run the danger of losing the… macro/micro distinction.

      “Loans create deposits and deposits funds loans” seems to conflate a micro-transitive (causal) relationship of the keystrokes entering loans necessitating a corresponding deposit entry with a macro-intransitive (non-causal) entry in the flow of funds statement that is not connected with any particular loan. Putting the two together appears to suggest to some people that there is mutuality between the two.

      I also have to say that I am not so completely clear on this meaning of “funding” as to be able to explain it to someone else and be sure I am accurately representing JKH’s position. Admittedly this is out of my field, but I am lot more knowledgeable about this than many others, and I am actually trying hard to get it straight.

      • I thought this post clearly brought out ….

        “that ‘deposits fund loans’ is as true as ‘loans create deposits’ and that there is no contradiction between these two things.”

        “I also have to say that I am not so completely clear on this meaning of “funding” as to be able to explain it to someone else …”

        Ask yourself “Do CDs fund bank loans?”, for if you think that deposits don’t fund loans, you should also conclude that CDs don’t fund loans to avoid self-contradiction and be self-consistent.

      • Also think you own a bank and have some customer deposits. Sooner or later the deposits will fly and you will be all alone and have to find people to get deposits. Do they automatically give you their deposits without you doing some marketing? Aren’t you looking for funding?

        • No, I would looking for people to borrow from i.e., for financing. Deposits are customer loans to the bank. If I where looking for funding I’d be looking for equity.

          • Tom,

            But that is your terminology. The common terminology is funding.

            My point was however different. If you tell people loans create deposits, they think it is wrong because they ask “since banks look for deposits and can create them, why do bankers look for deposits”. The term funding is not the one that gets them confused.

            • Wrong, Ramanan. You clearly work in banking and not in business. This is distinction is basic to business. Any borrowing means to finance, and to pay for with revenue, new investment (equity) or from savings is the meaning of fund. These terms have different meanings in different contexts and the predominant context is that of business rather than banking and finance. And ask anyone in these parts how that purchase their vehicle. Most likely, they will say that they paid the down from savings and financed the balance. Admittedly this American English. I don’t know about elsewhere.

              • Tom,

                We are talking banks here. The language “funding” is universal.

                In your example a purchase of something was financed partly by cash and partly by borrowing.

                I have used such language 100s of times.

                That is nothing inconsistent with what I said.

                In fact in your example, there is “net borrowing” – a deficit. So I finance the net borrowing by sale of assets (i.e., cash here) and by incurring liabilities.

                But what you say doesn’t prove that the phrase “funding” is inaccurate.

                In fact a bank is not financing a deficit (meaning expenditure less income) in our discussions.

                • cc: @JKH

                • Ramanan, we talking being understood. I’m fine with the technical terminology of banking. What I am saying is that I am already seeing misunderstanding arising from “deposits fund loans” among people who are pretty well versed in economics but find the use of “fund” confusing. Example from a recent comment: “deposits fund loans” makes it sound like banks get deposits from somewhere and then put them into a borrowers account, thereby “lending them out”. But that doesn’t really make much sense, does it?

                  • Tom,

                    The statement “deposits fund loans” doesn’t imply that deposits create loans.

                    In fact although loans make deposits, banks need to have a reasonably clear idea about their funding and have a plan for funding needs and whether they will be met or not.

                    One example – in the Euro Area troubles around 2011, banks weren’t sure if they will be able to fund themselves well. (Cost of funding were rising etc) So they reduced some lending. Beyond a certain point, funding is not available. Of course there were other reasons but this was also a reason.

                    So there is an element of truth to deposits helping create loans. In the extreme, think of a bank thinking that it won’t be able to fund itself in the next year. It will not lend.

                    • “The statement “deposits fund loans” doesn’t imply that deposits create loans.”

                      You know that and I know that, but some people think that JKH doesn’t.

                    • Just inform those people that they can’t read, Tom.

                      I haven’t seen anybody here suggest that.

                    • ““The statement “deposits fund loans” doesn’t imply that deposits create loans.”

                      You know that and I know that, but some people think that JKH doesn’t.”

                      Tom,

                      Didn’t get the impression. People are asking good engaging questions I would say.

                  • Here is one article on the issue – exactly one month before the 3yr LTRO announcement.

                    http://www.euromoney.com/Article/2929899/Funding-freeze-pushes-banks-closer-to-the-edge.html?single=true

    • There’s no question that ‘loans create deposits’ is the endogenous money building block and the source of growth for the banking system – micro and macro. There shouldn’t be any confusion about that (although there are wrinkles around the edges such as quantitative easing).

      But it’s also the case that individual banks in a competitive banking system compete for deposits. And in that sense, banks want to attract new deposits when they lose old ones. And there should be a reasonable way of describing that, which is essentially describing the dynamics of the system ex the growth impulses of ‘loans create deposits’.

      Using the language of flow of funds accounting and bankers’ own descriptions seems to me to be a reasonable way of doing it.

      As I said in the post, the cleanest way of dealing with these things is to start at the top level of the banking system as a whole. Clearly, loans create deposits at the system level.

      And although the system doesn’t need new deposits to fund loans, individual banks that lose them through competition sometimes do.

      Including Chicago and Mosler in the same sentence (Mosler was qualified BTW) is making a statement about how both these proposals have an effect on banking liability management.

      The Chicago Plan creates new reserves and deposits on the books of the banking system as a result of the debt jubilee component (I’m referring to the recent IMF version).

      The part of the Mosler plan I was referring to provides unlimited government funding to banks, eliminating their use of the interbank market, as far as I understand it.

      Both of those things affect bank liability management, although in different ways as you say. However, they are both significant transformations of the existing way of bank liability management. And the other elements of Mosler’s proposals are as well.

      But my take on the Chicago Plan was that it actually doesn’t eliminate an endogenous money process:

      http://monetaryrealism.com/banking-in-the-abstract-the-chicago-plan/

      • JKH
        There’s no question that ‘loans create deposits’ is the endogenous money building block and the source of growth for the banking system – micro and macro. There shouldn’t be any confusion about that (although there are wrinkles around the edges such as quantitative easing).
        But it’s also the case that individual banks in a competitive banking system compete for deposits. And in that sense, banks want to attract new deposits when they lose old ones. And there should be a reasonable way of describing that, which is essentially describing the dynamics of the system ex the growth impulses of ‘loans create deposits’.

        And although the system doesn’t need new deposits to fund loans, individual banks that lose them through competition sometimes do.

        I fully agree. I was merely trying to point out that loans create deposits is a macro statement whereas deposits fund loans is a micro statement and that these lines of reasoning should be kept separate.

        The part of the Mosler plan I was referring to provides unlimited government funding to banks, eliminating their use of the interbank market, as far as I understand it.

        My point was that this is a micro limitation, i.e. has no quantitative impact on the macro level, at least in theory. It’s a qualitative rearrangement of the underlying architecture.

        But my take on the Chicago Plan was that it actually doesn’t eliminate an endogenous money process:

        I’m sorry, I read you as saying that the original intention of the Chicago Plan may well have been to eliminate endogenous money or whatever it was they thought had to be corrected, but that reserve accounting and CB logic permit nothing but endogenous money.

        I remember somebody in the comments (Ramanan?) pointing out that by your logic it wouldn’t matter whether the plan were implemented as full reserve or 0 reserve banking because the logic remains the same. But I’m quite certain the authors of the original plan wouldn’t agree with that! I mean, Milton was Mr. money growth rule in person. You proved by your own logic that their plan could not be implemented in the way they envisioned. That’s at least a position I would agree with.

        But personally, I’d recommend 1’000% reserve banking. Think of how wealthy it would make us ;-).

  17. My probably messed up way of seeing this was to imagine conventional banking as an extreme version of shadow bank maturity transformation. A totally stable shadow bank (with just credit risk rather than liquidity risk) would sell 10year bonds to fund 10year loans. A more typical shadow bank would sell 30day bonds to fund 10year loans and so have liquidity risk since in order to roll over the funding of the loan it would have to sell a new tranche of bonds every thirty days to pay the holders of the previous set of maturing 30day bonds. A conventional bank takes that to the extreme of using “instant maturity bonds” aka deposits. The funding “roll over” is constant, instant and unnoticed since money is money. Nevertheless an outflow of deposits is the same as a shadow bank not being able to sell enough 30day bonds whilst having 10year loans on its books.
    Seen in that way, deposits funding loans seems no weirder than saying 30day debt securities fund shadow bank loans. Surely no one would see that as weird.

  18. Reverend Moon says:

    “it’s also the case that individual banks in a competitive banking system compete for deposits”

    Couldn’t some confusion be eliminated by saying banks compete for reserves as opposed to deposits. Isn’t a deposit simply an obligation that the bank make a payment (in reserve balances) on your behalf on demand in exchange for the reserve that is the cash you deposit or the reserve that follows the deposit when it is transferred from another bank. After netting isn’t everything settled in reserves (or new bank liabilities) as opposed to deposits. What is a deposit and why do banks want them? Banks are trying to buy reserves with their own deposits as opposed to attracting deposits. As long as it is understood that deposits are the liability issued to attract reserves as opposed to the asset transferred from another bank isn’t the confusion mostly eliminated?

    Banks are competing to issue deposits not to attract them. Or I could be totally out to lunch. This comment is more question (isn’t this a less confusing and also accurate way to describe the same thing?) than assertion.

    • yes exactly. i was just going to write that. banks aren’t looking for deposits. if a deposit was canceled ( think like jews after the holocaust) the bank doesn’t suddenly need deposits, their net worth just goes up. what the bank is looking for is maintaining sufficient reserves by holding onto deposits and sometimes attracting more. the flow of funds language is fine, but i think it would be less confusing to say banks care about their reserve positions and deposits are often the cheapest way of acquiring reserves.

      • I suppose though, if everything netted out perfectly then no reserves would ever be needed. Even as things are, deposits dwarf reserves. As such I’m not sure it is so clear to say banks are competing for reserves rather than for deposits.
        In the free banking era in the USA when there was no central bank, I guess there were no reserves and yet banking muddled through, sort of.

        • Stone,

          There is some logic to saying that banks compete so as to prevent their reserve position at the central bank from growing deeply in overdraft.

          So in the extremis if a bank doesn’t look for deposits or other sources of funding,
          then it doesn’t have reserves of course but its highly indebted to the central bank. So to reverse this, it has to attract funds. That type of argument.

          Your situation implicitly assumes that banks are already competing.

    • “Couldn’t some confusion be eliminated by saying banks compete for reserves as opposed to deposits”

      Partly true but not fully because banks do compete for deposits whatever the reason.

      Take for example Australia. Its banks also look for “offshore funding” – although much of it is for longer term funds such as via bonds. The international payments have little to do with the Australian banks’ settlement balances at the RBA. So they are also looking for funding from nonresidents but in domestic currency.

    • Probably better to say that banks compete for customers. Banks want to attract customers for a lot of reasons other than just deposits.

      First you offer the toaster, and then work on keeping the customer for life. There are a lot of services that banks sell their customers. Toasters and fee checking is a come on.

  19. Reverend Moon says:

    I don’t understand what you’re saying , sorry. Can you please be more specific about what you are trying to say? It reads to me like you’re saying banks keep deposit accounts at other banks. Is that what you mean?

    • Yep for international transactions in two currencies, there is no central bank and banks do keep accounts with each other. Of course if few banks are involved in the legs following some flows, a central bank or both central banks may get involved incidentally but that is not the same thing as domestic transactions involving two banks.

      • Reverend Moon says:

        A distinction without a difference. Just like my original post I suppose.

        I was trying to convey how the deposit is not the only moving part (balance sheet adjustment) in a transaction that moves my deposit from bank A to bank B.

  20. Reverend Moon says:

    previous comment directed @Ramanan about competing for deposits etc.

  21. Tom,

    In case you missed it, I linked to numerous major public institutional users of the language of funding in banking, including the ECB, IMF, New York Fed, and others:

    http://monetaryrealism.com/loans-create-deposits-in-context/#comment-15821

    One of the more illustrative links is from the Australian bankers’ association, where the language of funding absolutely permeates a survey of ‘bank funding’. The use is unambiguously dense in its application across all liabilities and equity:

    http://www.bankers.asn.au/Banks-in-Australia/Facts—Figures/Bank-Funding

    Sometimes I have to pinch myself in this sort of discussion. If any standard usage of language should be relevant to MMT, it should be that of banking – not the world apart from banking.

    And the point here is that this usage is in no way inconsistent with endogenous money creation or whether you think the multiplier works or doesn’t work. In particular, it doesn’t ‘defile’ endogenous money any more than it would some fictitious money multiplier world (like in textbooks).

    The language of funding can co-exist with whatever language is appropriate to illustrate the particular aspect of endogenous money creation.

    There is more than just the reserve management perspective in banking. There are a whole lot of people that are busy in banks aside from the guy who’s running the reserve account. And all of these functions offer legitimate perspectives on banking. The best idea I can think of is to strike a balance in describing how banks work by considering the full scope of what’s going on in the institution. And that includes a bunch of people with various funding responsibilities who let the reserve manager do his job while they do theirs.

    • JKH, I am not arguing that. I am just saying that I see confusion arising in several places on the same day as the post. If that is OK with you, so be it.

      • Jose Guilherme says:

        The problem of confusion is there, no doubt.

        For instance, the language of “funding” is implicit in the following passage from well-known Professor Karl Whelan:

        “People sometimes think that individual banks are somehow able to take in
        $100 and then make an additional $900 in loans from this, creating funds
        out of nowhere.

        This would be fraud—lending funds you don’t have. That is not what happens…

        In each case, banks lend 90 percent of their deposits and retain the rest. They don’t lend out amounts above those provided to them by depositors, which is their role as financial intermediaries.

        When a person deposits $100 in cash in a bank, that bank can lend at most
        an additional $100. However, the fact that we have a fractional-reserve
        system means that with a reserve requirement of 10 percent, reserves of
        $100 are consistent with total deposits of $1000″.

        This is the sort of confusion that should be avoided – right?

  22. Ramanan
    Tom,
    The statement “deposits fund loans” doesn’t imply that deposits create loans.
    In fact although loans make deposits, banks need to have a reasonably clear idea about their funding and have a plan for funding needs and whether they will be met or not.
    One example – in the Euro Area troubles around 2011, banks weren’t sure if they will be able to fund themselves well. (Cost of funding were rising etc) So they reduced some lending. Beyond a certain point, funding is not available. Of course there were other reasons but this was also a reason.
    So there is an element of truth to deposits helping create loans. In the extreme, think of a bank thinking that it won’t be able to fund itself in the next year. It will not lend.

    your language is very obfuscatory here. banks make money on the spread between the cost of their liabilities and return on their assets. clearly if the cost of their liabilities rises substantially (as in the eurozone case) some assets become uneconomic. that is clearly a price effect, not a quantity effect.

    • “your language is very obfuscatory here”

      No not really. Again it is not just about price. If spreads rise – they can rise for sometime till the market freezes. The bank cannot raise funds because of the freeze.

      So typically interbank rates – such as Euribor have a value and this needn’t be high. But that fails to convey that some banks are unable to borrow.

      • Ramanan
        “your language is very obfuscatory here”
        No not really. Again it is not just about price. If spreads rise – they can rise for sometime till the market freezes. The bank cannot raise funds because of the freeze.
        So typically interbank rates – such as Euribor have a value and this needn’t be high. But that fails to convey that some banks are unable to borrow.

        i was not making a point about the market freezing. I was talking about the specific case you brought up (reduced lending because of the cost of liabilities rising). the eurozone banking system is obviously a special case. in fact, I’d say it’s the exception that proves the rule.

        • Point being not the cost of liabilities rising themselves but the rising costs leading to a freeze soon in the future. I did specify that beyond a certain point funding is not available.

          The short term money market can freeze at Euribor at 4%. But that that doesn’t mean that 4.25% was uneconomical. It just means funding is not available. So a freeze can occur before the price point where is it uneconomical.

  23. OK, let me put his in the simplest terms I can.

    Say I am asked to explain your position to someone that has no knowledge of banking and probably thinks that banks loan out deposits.

    I begin with “loans create deposits, and deposits fund loans” but that doesn’t imply that banks loan out deposits. Banks create a loan by marking up a loan (asset) account and also a deposit (liability) account — net zero on the bank’s books, and the bank doesn’t need to have either funds on deposit or reserves in its reserve account to do this. It’s just making a couple of entries on the bank’s spreadsheet after the loan papers are signed and approved.

    Then the person interrupts and asks, then why do loans need to be funded after than are made if not before? What does that mean?

    What is your simple answer as clearly and briefly as possible, so I get this right when trying to explain your position.

    Thanks.

    • Tom,

      For starters, I’m not going to answer a question that’s positioned as a follow up to what amounts to a mischaracterization (yours) of what is explained in the post. That’s known as a straw man.

      I described two different ways in which a loan could be made, and one of them does not involve crediting the borrower’s deposit account with the lender. Please read the post again. Then maybe restructure the question you want me to answer.

    • Alternatively, point out exactly where you think I said something that leads people to think that I said that deposits create loans.

      • JKH, I did not imply that you said that deposits create loans. I am trying to figure out how to explain in a few words what “deposits fund loans” means. At this point, I am saying I am not sure I can accurately state what JKH’s position on this is.

  24. Ramanan
    People are asking good engaging questions I would say.

    Not talking about here. People are talking elsewhere and I am not sure I understand this well enough to say JKH means this by “deposits fund loans” other than that he definitely does not mean that deposits create loans, or that it is necessary for banks to have deposits to make loans. Some think that is what he is saying and other who have read the post don’t know what he is saying. Maybe it is clear to people in banking and finance, but it is apparently not clear to others.

    • Oh, and another person who read the post thought that the meaning was that deposits are needed to fund reserves for settlement.

    • Tom,

      I can give a simple example (which I’ve already given) that bypasses your set-up.

      The general banking and flow of funds description of a GIVEN bank balance sheet is that liabilities and equity fund assets. Within that broad overview, one could suggest as an example that deposits fund loans, since those are the two broadest categories. In fact, in banking, funding tends to be directed internally into a central treasury unit for ‘risk processing’ and sent out the other side as funding for specific asset categories. That’s goes to more granular detail on how banks compartmentalize funding categories internally. But the general idea is still that the RHS of the balance sheet funds the LHS. This is the way that the term is used in banking.

      And I can tell you that a retail deposit business manager for example in charge of a program for ramping up on a given category of fixed deposits doesn’t care a hoot about what’s happening to the reserve account. He more likely cares about the overall balance sheet effect in terms of providing funding for some asset category that his senior executive may also be responsible for as part of the overall retail banking operations. The general idea for bank strategy is asset-liability association – not reserve account effect.

      I’ve already noted a simple example. The bank loses a deposit. It requires a new one. That’s got absolutely nothing to do with ‘creating assets’. The assets that require funding in this case are pre-existing. And you can translate that simple story to actual business strategies for categories of funding as per the previous description.

      I’ve written a post here on how banks look at funding and how that relates to the economics idea of endogenous money. I’ve been in the comments. I’m running out of ways to describe this for purposes of responding as it relates to this post in particular. I suspect many of the people you refer to are MMT followers who’ve gotten their banking education from MMT. Quite frankly, MMT is somewhat of a reserve-obsessed school of thought, with little reference to actual banking operations apart from reserves. I can’t control how people think about banking as a result of that particular education focus. MMT makes a good point about endogenous money, but there’s more to banking than that point. I’ve been holding back most of what I know about it, but hope to write more about it in future.

      • Thanks, JKH. This sums up my understanding and confirms what I had understood you to mean:

        “The general banking and flow of funds description of a GIVEN bank balance sheet is that liabilities and equity fund assets. Within that broad overview, one could suggest as an example that deposits fund loans, since those are the two broadest categories. In fact, in banking, funding tends to be directed internally into a central treasury unit for ‘risk processing’ and sent out the other side as funding for specific asset categories. That’s goes to more granular detail on how banks compartmentalize funding categories internally. But the general idea is still that the RHS of the balance sheet funds the LHS. This is the way that the term is used in banking.”

        Clearly stated and to the point. Got it.

      • Another way of integrating the language is to say that once a loan has created a deposit – on the same bank balance sheet for example – the deposit is funding the loan by association. If the bank loses the deposit, it may compete for and attract a replacement deposit. And that deposit is now funding the loan by association. In the same way, but more generally,the RHS of the balance sheet (liabilities and equity) funds the LHS.

        That is the way the language is used both in banking and in the macroeconomic flow of funds – and that is the way in which the bank is managed from an asset-liability management perspective, where categories of liabilities and equity are associated by risk characteristic with categories of assets – without any reference to the role of the reserve account. And this doesn’t contradict ‘loans create deposits’.

        And the claim that a deposit funds a loan doesn’t mean that the loan could not have created the deposit. Funding is an association of a liability or equity with an asset – within the balance sheet or for the balance sheet as a whole. Some have the preconceived notion that a deposit funding a loan or the RHS funding the LHS must imply something different than loans create deposits. And that’s just a preconceived bias in the meaning of the language – which is what the post is about really.

      • Also, a question for the philosopher, perhaps:

        If one doesn’t know how the word “fund” is used comprehensively across the banking industry (and by institutions such as the IMF, ECB, and the Fed), and if the subject is banking, then how can one possibly even claim to understand the meaning of the word “fund”?

        • Merrriam-Webster: Definition of FUND noun
          1
          a : a sum of money or other resources whose principal or interest is set apart for a specific objective

          b : money on deposit on which checks or drafts can be drawn —usually used in plural

          c : capital

          d plural : the stock of the British national debt —usually used with the

          2
          : an available quantity of material or intangible resources :supply

          3
          plural : available pecuniary resources

          4
          : an organization administering a special fund

          Definition of FUND transitive verb
          1
          a : to make provision of resources for discharging the interest or principal of

          b : to provide funds for

          2
          : to place in a fund : accumulate

          3
          : to convert into a debt that is payable either at a distant date or at no definite date and that bears a fixed interest


          I don’t find a technical meaning of fund listed in the dictionary “in the sense it is used across the banking industry.” Most people look to a dictionary to determine possible meaning. For this reason, if a term is used technically it must be carefully specified in the contest of use and the definition adhered to.

          I don’t think it is surprising that most people don’t understand this technical meaning of “fund,” and I suspect that includes most economists, which is why many people don’t follow what you are saying or misunderstand it. I suspect that Krugman is in this boat, too.

          • Tom,

            I’m aware of the dictionary omission, although there is an exception or two to that sort of exclusion, I think, depending on the dictionary. But I take your point there. And that is obviously something that requires updating based on the real world evidence of usage. It’s definitely not the role of a dictionary to exclude real world usage of language as employed by major institutional bodies such as the IMF or various central banks and bankers associations.

            But if you’re saying that (among other economists) MMT economists are also not aware of the standard use of the term “funding” or “fund” in banking, as exhibited densely and undeniably in a sampling of papers and articles from the IMF, ECB, the Fed, Bloomberg, and Wiki – well, I find that a bit rich. And I suspect that many of the people who you have found to be confused are actually followers of MMT, and the MMT economists have had every opportunity to clarify the standard use of the term “funding” or “fund” in banking for its followers, if it chose to do so. I have already noted that MMT ventures very little outside the reserve account when it comes to an explanation of banking. But is MMT aware of this usage in the real world as evidenced in the links I provided? Obviously it is. So I really don’t think you want to use that argument in the case of MMT economists, and by implication, its followers, unless its followers have been shielded from the real world use of the term “funding” or “fund” in the same industry that MMT just happens to criticize constantly for other reasons. And I expect ten thousand newspaper articles on business and finance have used or implied the industry standard meaning as well.

            On the other hand, if MMT economists are deliberately objecting to this use of the term “funding” or “fund” by the entire banking industry, its regulators, its media followers, and its Wiki interpreters, for its own reasons, then I can understand that. It wouldn’t be the first time that MMT has rejected standard financial terminology in banking or other financial settings. The national accounts definition of government saving comes to mind – a definition that is standard in the equations from which the sector financial balances equations are derived, without contradiction of meaning, and which is consistent with comprehensive and uniform usage of the same term in flow of funds accounting for all sectors of the economy, without contradiction of meaning, and which in no way is an impediment of any substance to understanding the idea of net financial assets, for example, without contradiction of meaning. Or the standard classification of taxes as government revenue – which in fact has nothing to do with and does not contradict the simple point that tax payments involve a charge to bank reserves or that saving from a basis of a balance sheet cumulative deficit simply reduces that cumulative deficit, without contradiction of the generally accepted meaning of saving. So I can understand the confusion in that sort of context – and perhaps that played a minor role in why I wrote the post – although putting the idea of ‘loans create deposits’ into a real banking world context was more the constructive motivation.

            So here again is the sample list for anybody who is interested in how the term is standardized – in the real world of banking – i.e. the widespread use of the term ‘funding’ in banking (‘to fund’ is the verb):

            http://www.ecb.int/pub/pdf/other/eubanksfundingstructurespolicies0905en.pdf

            http://www.kpmg.com/AU/en/IssuesAndInsights/ArticlesPublications/Documents/The-future-of-Australian-bank-funding.pdf

            http://www.bankers.asn.au/Banks-in-Australia/Facts—Figures/Bank-Funding

            http://en.wikipedia.org/wiki/Wholesale_funding

            http://www.newyorkfed.org/research/conference/2012/bank_funding.html

            http://www.imf.org/external/pubs/ft/wp/2012/wp1229.pdf

            http://www.imf.org/external/pubs/ft/wp/2013/wp1330.pdf

            http://www.bloomberg.com/news/2013-02-20/spanish-banks-to-face-continued-funding-challenges-moody-s-says.html

            • I have no idea whether MMT economists understand “fund” that way, but I would surmise they do, since they read widely in banking and finance, which I don’t think that many mainstream economists do. Obviously, most other folks don’t either, including, I would surmise, some people you are trying to reach.

              I am just saying that if one wishes to communicate clearly and not be misunderstood by those not familiar with the terminology of one’s field, then one has to explain how one’s use of the term is different from ordinary uses, and also technical uses in other fields. Generally, speaking bankers and financial types are not interested in outreach, so the terms are jargon of the field that only those in the field understand. I’ve said the same thing to the MMT economists about obscure terms they use to, so I am not picking on you. :)

              The idea of “funding” the asset side with the liability side is not the way that most people understand the term fund, when what is doing the funding on the RHS is liabilities and not equity. Its not intuitive, so its a special use that most people are likely not going to figure out on their own and to which they need to be alerted. In other words, I don’t think that “loans create deposits, and deposit fund loans” is useful as a slogan standing by itself.

              For example I gave your explanation to someone trying to understand this who responded, JKH is just confusing people.

              I am passing this along because it seems to me it is adversely affecting your cause. Do with it what you like.

              • The trouble about talking about the man on the street is one can arbitrarily assume any level of understanding, background and interpretation. It would be better if you don’t “appeal to layman” and discuss this as Tom Hickey yourself.

                • If you were following the conversation closely Ramanan, you would have noticed that I said that I was not sure I understood JKH’s position clearly enough to others with whom I was in conversation elsewhere who had read the post and were confused on the meaning. I did two things. First, I alerted JKH to the fact that I had encountered confusion among others, and secondly, that I was not completely clear on his position myself, so would he please clarify it for me in a few words that I could use in simple explanation to non-bankers-financial types-accountants, like myself, which he kindly did. If I did not make myself clear about that, I am now.

              • Cullen Roche says:

                MMT is a great example of how some complex things shouldn’t be dumbed down so far that the interpretation is totally misconstrued. Just look at how people interpret the idea of the govt “destroying” and “creating” money within MMT. Easily understood metaphors like “pay your taxes in cash and the IRS shreds it” are totally counterproductive. Not just because no one pays their taxes in cash, but because the whole destruction part is a misinterpretation of the way the actual flow of funds through the money system works. You end up with a whole bunch of people who literally think that the govt creates every dollar in the economy and that banks don’t even create money but just send it into some govt shredding machine.

                Some of this stuff is very complex. It’s very high level. Dumbing it down too much is counterproductive.

                • There’s a happy medium. The people that are considered the great expositors communicated complex ideas in a way that non-specialists can access adequately to use.

                  If the intent is communication only among specialists, no problem. It’s a choice, and if one chooses to extend one’s reach, then that challenges one’s communication skills. The choice involves scope. The wiser the scope, the similar the message needs to be. At certain point, the message gets diluted so much that signal is suppressed by noise.

                  There is usually a wider range between ultra-high grade signal that only the highly trained can receive and signal lost to noise. Where one positions oneself along this range is a choice depending on a variety of factors including reach of influence. Generally people who are blogging are aiming at a fairly extended scope, but not always. It’s a matter of positioning as the say in M&A.

                  And for the record, I criticized the shredding metaphor as unhelpful quite a while ago.

  25. ““Loans create deposits’ is an operation in endogenous money. And where central banks impose a level of required reserves based on deposits, the timing of the demand for and supply of reserves in respect of such a requirement follows the creation of the deposit – it does not precede it.”

    Does it have to be that way? What if there are excess central bank reserves? Aren’t the excess central bank reserves of today waiting to be converted to required central bank reserves?

    • Fair point, particularly in the current environment.

      But even with excess reserves, the timing of what is categorized as required reserves does follow the creation of the deposit – and so does the timing of what is demanded or needed in the way of required reserves.

      If an individual bank happens to hold excess reserves ahead of that timing, then it doesn’t have to go and find them when the requirement becomes binding.

      In theory, the same possibility holds in any environment for an individual bank, whatever the system setting for excess reserves (i.e. QE or not). An individual bank can choose to hoard excess reserves ahead of the imposition of a reserve requirement – it just has to compete against other banks to accumulate those reserves. There’s no real reason for it to do so, but its possible.

      • “If an individual bank happens to hold excess reserves ahead of that timing, then it doesn’t have to go and find them when the requirement becomes binding.”

        OK. Plus, it seems to me right now that most banks have excess central bank reserves. If so, is the fed trying to encourage private debt creation (new demand deposits and new loans) because they think there is a shortage of medium of account (MOA) and medium of exchange (MOE)?

        I’m assuming MOA = MOE = currency plus demand deposits.

        • not clear to me what they’re trying to do

          I think they do a pretty good job of communicating how they’re doing what they’re doing – just not why

          And I think they believe they have to do something – and its just a question of what they can do within their scope of responsibility – because they have no responsibility for fiscal policy

          • It seems pretty clear to me. Whenever there is price deflation and/or negative real GDP, it is an aggregate demand shock. The fed thinks aggregate demand shocks are cured by more debt (MOA and MOE) because aggregate demand shocks cause entities to start saving in the MOA/MOE. So the fed lowers interest rates to create more debt (MOA/MOE) that gets spent (especially housing and refinancings). When the fed hits the zero bound, debt is not being created the way it has in the past to “cure” price deflation and/or negative real GDP. The fed then goes “crying” to congress to create more debt to attempt to “cure” price deflation and/or negative real GDP.

  26. “Some interpretations of the ‘loans create deposits’ meme overreach in their desired meaning. The contention arises occasionally that ‘loans create deposits’ means banks don’t need deposits to fund loans. This is entirely false. This is the point that requires emphasis in this essay.”

    What about new stock and new bonds that are sold for bank capital? Doesn’t the bank get currency and/or demand deposits in return?

    • Best way to think about that is that for the system as a whole, issuance of debt or equity destroys bank deposits – RHS of the system balance sheet includes conversion of deposits to debt or equity. Equity is classified as capital.

      • Sorry, I don’t get that one at all. Let’s say I have saved $1,000 as a demand deposit (checking account). I then buy a new bank bond. Why would it be destroyed? Wouldn’t the bank’s account just get marked up? I’m asking because with a 10% capital requirement my $1,000 that was saved as a demand deposit could become $10,000 in new demand deposits (capital multiplier).

        Next, run the scenario where I saved $1,000 in currency then bought the new bank bond with the $1,000 in currency. How would $1,000 in currency be destroyed?

        • The demand deposit is changed into a bond

          It’s entirely a RHS operation. One liability vanished and another is put in its place.

          When one of those conversions happens the bank immediately gets a boost to its LHS ‘loan potential’ and an equivalent RHS boost to its ‘deposit potential’ depending upon the regulatory capital ratio.

        • $1000 in cash is nothing more than a receipt for liabilities at the central bank.

          So when you buy a bank bond with cash there is actually two transactions. The first is a standard deposit to the bank in cash. Depositing cash expands a private bank’s balance sheet automatically.

          From the bank’s point of view:

          DR Cash in vault (LHS) CR Deposit Liabilities (RHS)

          Then there is a conversion:

          DR Deposit Liabilities (RHS)
          CR Bond Liabilities (RHS).

          And then if you are running an expanded balance sheet model you get the balance sheet expansion based on the regulatory capital ratio.

          DR Loan Potential (LHS), CR Deposit Potential (RHS).

          • I’ll need to think about that one. Is a bank issuing new bonds or new stock different than another type of business issuing new bonds or new stock?

  27. “Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes.”

    Let’s call the term deposit a CD. I like to think of a CD as a demand deposit that pays interest at a fixed rate (not a variable rate like an interest paying checking account) over a set period of time. Thoughts?

    • no, its not a demand deposit

      the holder must wait to maturity to get paid – unless there are early redemption features by design

      its the waiting that makes it not demand

      • My wording is not good there. The wait to maturity part is right. I’m trying to get around to the idea that the demand deposit is “held” by the bank. That means the velocity of the demand deposit (MOA/MOE) in the real economy is zero. I believe that adding to a checking account, savings account, and/or CD is saving in the MOA/MOE, whereas a lot of other economists would not say that because of what I consider the flawed “money multiplier”.

  28. I’m going to try to simplify this. “Borrowing” from a bank or bank-like entity is different than borrowing from a friend. When borrowing from a bank or bank-like entity, a NEW demand deposit is created out of thin air, and a NEW loan is created out of thin air. The demand deposit gets a central bank reserve requirement “attached” to it, and the loan gets a capital requirement “attached” to it. More thoughts?

    • not bad

      the bank is a currency issuer within its own sphere of money issuing

      the friend is not

      “attached” is actually a very good word to use in the way you have

      • I’d say the bank is a demand deposit issuer.

        With a bank or bank-like entity, MOA/MOE can be multiplied.

        With a friend, MOA/MOE can’t be multiplied (for every $1 of MOA/MOE debt, there is $1 of MOA/MOE saved). Some people would probably call this “loanable funds”.

  29. “From an operational perspective, banks do not “lend reserves” to their non-bank customers.”

    Banks lend central bank reserves in the fed funds market.

    With non-bank customers, banks “lend” “against” central bank reserves, meaning the central bank reserve requirement becomes a central bank reserve multiplier for demand deposits.

    Sound good?

  30. There is more than just the reserve management perspective in banking. There are a whole lot of people that are busy in banks aside from the guy who’s running the reserve account. And all of these functions offer legitimate perspectives on banking. The best idea I can think of is to strike a balance in describing how banks work by considering the full scope of what’s going on in the institution. And that includes a bunch of people with various funding responsibilities who let the reserve manager do his job while they do theirs.

    So fighting over who gets most deposits / customers / market share keeps bankers busy. And I’ve understood that reserved deposits are a preferred type of liability under current arrangements and that transformation of liabilites will change the total amount of reservable deposits without affecting the total size of banks’ balance sheets. But why is this important for a macroeconomist? Assumably, the general idea behind competitive banking is that it enables funds (here we go again) to be allocated efficiently. In retrospect, that hasn’t panned out particularly well, so alternative models are most definitely called for.

    One line of thinking is geared towards rationing credit – as a whole or in parts, e.g. by limiting access to the reserve system. But again, from an endogenous money / Minskyian point of view, any type of credit rationing is confusing quantitative for qualitative management. As argued above, ‘market discipline’, at least when it’s understood as self regulating, is not sufficient to keep systemic risk in check.

  31. Like the posts about saving and investment, this is a noble effort. Backed hard!

  32. The monetary system and the financial system are constructions of double entry accounting. It has been this way for a long time. This did not start in 1971. The fact that there was gold serving as a fixed value backstop for certain monetary assets shouldn’t obscure the fact that a monetary system is a fiat construction at its foundation. Gold at one time was a hard constraint on the behavior of the monetary authorities. But the authorities will inevitably create paradigms of operational constraint and guidelines in any monetary system.

    Interesting point.

    The way I think about this is that there is no ultimate operational restraint on the activities of any sovereign, by definition of “sovereign”. Under a gold standard, the government sets itself a set of rules to follow, just like it does under a fiat system, but (evidently) nothing prevents if from changing those rules as and when it feels that it needs to; hence, e.g., the regular suspension of the gold standard during war-time. The hard constraint of the gold standard could only ever be hard in relative terms. It was not totally solid.

    The point is that the government can follow whatever set of rules it damn well pleases, but it does not follow that all sets of rules are equally good or equally sustainable. A particular set of rules is chosen because of the quality of the outcomes that are expected to obtain under them. If we are going to pick a particular government policy, we’re not going to do so simply because it is operationally possible. By fiat, anything can be made to be operationally possible. Another metric is needed.

    • thanks, I’m very much in synch with that

      As an unusual example, perhaps, I think Mosler’s zero interest rate policy amounts to a fixed rate constraint that would be very fragile in the context you’ve described

      • Yes, I think you’re right. A similar thought occured to me when I read Scott Fullwiler’s recent posts on sustainability at NEP. Say that the nominal interest rate is set to zero percent. So you lose one degree of freedom from your system, but you require that to control debt accumulation over time. Someone might respond by noting that the economy is probably growing faster than that zero percent, so it’s not problem. But of course, only the nominal rate is set to zero. The real rate is not pinned down–deflations are possible–and something else must be found to determine the rate of inflation.

        • yeah, I think that idea of zero rates is a huge operational and strategic risk in the sense you describe – i.e. in the sense of the risk that it would self-implode as a sustainable policy and vaporize the credibility of the fiscal/monetary authority in that particular respect – plus all sorts of yield curve speculation of that happening – just like betting against an unsustainable currency peg

          BTW – this is also an idea more generally I hold very strongly wrt NGDP targeting of any type – which I think is absolutely off the table as a prospective policy – its just far too fixed as a combined target for the real rate/inflation rate mix of nominal growth – doesn’t give the central bank enough flexibility around the edges for the behavior of the components – unless you start changing the target more frequently – which amounts caving on the idea entirely – and I think this is why you see more sensible moves in this direction with more flexible ideas like the Evans rule

          bottom line is that central banks and/or Treasurys and/or governments are run by human beings that need the flexibility of reasonable zones for judgement without being overly bound by fixed targets that can’t adjust appropriately to the risk of dramatically changing conditions

        • Non-starter: Mosler Plan. Requires unlimited and uncollateralized lines of credit by the central bank to the banks. Only possible if they were nationalized.

          • I believe another part of Mosler’s plan actually does assume unlimited Fed lending without collateralization?

            But I think his argument for proposing that feature implicitly assumes that dropping collateralization requirements would have no net effect on the risk management and risk exposure of banks – so that collateral that would have been pledged normally would still be owned by the bank in Mosler’s presumed counterfactual – and that assumption is questionable, IMO – meaning that the bank ends up exposing the taxpayer to greater risk without such an assumption

            In any event, the point you make strays dangerously close to including some real world assumptions about the nature of risk management, IMO

            :)

  33. Tom,

    Regarding my cause that you refer to, my personal mission statement has an explicit clause in it that I negotiated with myself, whereby I’m not expected to be the Mother Teresa of bestowing gifts of financial understanding on others who get to obtain that understanding without effort of thinking or research. That goes in particular for random opinions for which I have absolutely no information on how the opinion giver has analyzed what he’s been given.

    In terms of a constructive ideas for the prototype confused person in this case, what I can do at this point is suggest the following course of action for such a person:

    a) Research – go to the links I provided to Tom several times and familiarize yourself with how the banking industry uses the term “funding”

    b) Reading and thinking – go back to the post and try to get a feel for what the asset-liability management function I described does in bank, quite separate from reserve management

    c) Thinking and synthesis – try to make the connection between reserve management and asset-liability management in the context of the general message of the post

    Tom, I appreciate the fact that you attempt to be an objective communicator and serve as a constructive bridge for reaching mutual understanding – I do. But do you really believe I wrote this post in an attempt to get everybody in the world to understand it within a day of being exposed to it? The post is there. I’ve now suggested additional steps those who might be interested in it. I’m not defining who is supposed to read it or what level of understanding they might be expected to achieve. And I’m certainly not saying that I’ve done a perfect job of explaining what I’ve attempted to describe.

    BTW, Tom, I don’t believe you know my “cause” is, or what my idea of a target audience for that ‘cause’ is. I’m not out there trying to convince the world that the government should stop issuing bonds. I’m not running a dumbed-down marketing campaign for the masses. I have respect for all levels of knowledge on a particular issue, provided anybody that engages with me has the same. So you shouldn’t presume to define any cause of mine as a point of relativity against your cause. And you haven’t seen anything yet about what my real cause may end up being.

    Anyway, that’s a bit of a rant, but in fact I do appreciate the fact that you make effort to bridge communication gaps like this.

    • JKH, I took your “cause” to be explaining banking and financial concepts and operations to people who do not already understand them through working in the field and showing how they are relevant to economics through monetary economics. If you are talking in particular to people already in the field and familiar with the use of terms there, then I got that wrong.

  34. JKH, I made a comment to one of yours on the repost of this article at pragcap. I don’t disagree with what you say, however, I like to restate everything in a much more pendantic format which works for me and which helps me avoid confusion about what is going on regarding “deposits funding loans.” You comment have simple example of banks A, B, and C:

    http://pragcap.com/loans-create-deposits-in-context/comment-page-1#comment-138482

      • JKH, great points. Thanks for your reply. I hadn’t thought about the cause and effect like that. And of course I should have mentioned risks… but you did a much better job of cataloging those than I could have managed. I guess my main point really is that for the novice, sometimes the language can get confusing. I’m more or less used to it now, but sometimes the “insider” uses a kind of shorthand, wherein the movement of the backing reserves is assumed. This confused me before I was used to it, and that’s why I so much appreciated Scott Fullwiler’s write up in his “Krugman’s Flashing Neon Sign” article wherein he used example simplified balance sheets drawn out, with all the assets and liabilities clearly identified — so we novices didn’t have to decipher the shorthand — we could clearly see the reserves moving around as well. A lot of questions that come up on pragcap are at this novice level, and I enjoy jumping in and answering the simple ones, having gone through the pain of figuring it all out myself. Even some of the more “advanced” posters have gotten confused on this stuff. Even Cullen has gotten confused on it (he blamed it on too much wine). ;)

        • Always keeping in mind the asset-liability pair helps keep me from making too many mistakes.

        • OK, Tom.

          Yes, Scott is very good at laying out the accounting tables in detail.

          I know the accounting, but find constructing the tables boring, so I tend to summarize it at a high level in words – which probably loses people. Unfortunate – its become a preferred habit of mine.

  35. As a slightly meta-comment, what’s weird is, if you don’t have deposits funding loans, how can you have uses equals sources? But if you don’t have uses equals sources, how can you claim to stock-flow consistency? Or am I missing something?

    • sources equal uses as a tracking of flows for a given balance sheet

      its forced by double entry bookkeeping

      deposit increases are sources and loan increases are uses

      deposit decreases are uses and loan decreases are sources

      but all of that is a subset of sources and uses through all asset and liability and equity categories

      RHS net sources = LHS net uses, if the balance sheet grows

      and vice versa

      but cumulatively, RHS is funding (i.e. is the souce of funds for) the LHS

      deposits funding loans is only a subset of all possibilities

      • Right, deposits fund loans, but of course there’s other stuff going on. That’s not total uses of funds nor total sources.

        I suppose what I’m saying is that if deposits don’t fund loans, then the financial sector’s asset acquisition is greater than its sources of funding. But if you have sources != uses for the financial sector, then surely you have sources != uses for the whole economy, at least for arbitrary financial sector activity.

        To me, sources of funds equals uses or asset acquisition means that uses of resources must equal sources of resources. Otherwise, something impossible is happening, and nothing impossible can happen. (I think that this could also be called “common sense.” :-))

        So the accounting here reflects reality, considered as a binding constraint on any entity’s activity, and derives its authority from that: nothing will come from nothing, as King Lear observed.

    • just noticed I used the phrase ‘deposits fund loans’ exactly 4 times in the post

      perhaps a slight overreaction to that

      • I think some confusion resulted when at least a few people took away from the post, deposits create loans and deposits fund loans, and started questioning the meaning based on their understanding of “fund.”

  36. OK, now that I think that I understand what you are saying, there is point that is still not clear to me about that.

    A bank makes a loan, which increases its assets as a receivable. It makes a corresponding deposit that increases its liabilities as a payable. The deposit withdrawn, canceling the payable, which means liability side decreases and the asset side remains the same. The question is then, what is the corresponding entry that keeps the books in balance.

    What is the requirement that a new entry on the liability side to keep the books in balance. Is it just an accounting rule of DBA that bank regs require following, or is there something else going on? I am assuming it is just following the rule to keep the LHS and RHS in balance.

    In other words, what does that newly acquired liability to replace the old one actually do that is described as “funding”? From what I understand, I am assuming this is just following the rule to keep the LHS and RHS in balance.

    • what are you talking about? when a deposit is withdrawn, either their reserve account at the central bank is debited or they have a drain of cash. both assets and liabilities decrease in tandem.

      I still think that it’s much more intuitive to say that banks attract and maintain deposits in order to make payments.

      • Cullen Roche says:

        Most people will easily understand the concept of banking by simply describing banking as a spread business. Banks make a profit by running a payment system that is profitable for them as long as their liabilities are less expensive than their assets. The least expensive form of liability for a bank (and often a profitable one) is a bank deposit.

        If we’re going to “dumb it down” that’s about as far as we should go in my opinion.

    • Simple example, in attempt to make the point as simply as possible:

      Set aside capital requirements.

      ‘Create’ a new bank by making a loan and crediting a deposit.

      So loans create deposits in this sense.

      The starting reserve position is zero.

      Now – the language issue – banking AND the Fed macro flow of funds says that the deposit is a source of funds and the loan is a use of funds. That is a FACT on the use of language in the real banking world and in the scope of Fed economic analysis.

      The question is whether the other FACT that the loan has created the deposit is somehow inconsistent with the language that the deposit is funding the loan.

      I say it’s not inconsistent, as follows:

      Suppose the deposit leaves the bank.

      Then the loan is offset by a short position in reserves – which becomes an overnight loan from the Fed. The balance sheet is matched.

      From a viable banking point of view, that situation is not acceptable. Banks are not expected to rely on the Fed in a chronic way. I made that point in the post, and it is generally accepted. Banks are expected to match their balance sheets without reliance on the Fed.

      So the banker would say the bank is short of funding for the loan it still has on the books. It’s temporarily surviving with Fed support, but that can’t last for long if it wants to remain in business.

      So the bank attracts a new deposit from another bank.

      And the loan is now funded again, and the reserve position is back to zero.

      From a logical standpoint, the fact that losing the deposit created a shortfall in funding from the banker’s viable banking perspective means the original deposit was funding the loan. And now the new deposit is funding the loan.

      And all of what I just described is consistent with language use in banking and in macro flow of funds accounting. And it doesn’t contradict the fact that the original deposit was created by the original loan when you understand the meaning of the language of funding – as distinct from the language of creation.

      There need be no reason for conflict between (say) a PK use of the language of creation and the banker’s real world use of the language of funding, provided you understand the meaning of each. There is no reason for ‘loans create deposits’ to be threatened in this sense, which appears to me to be the implicit reason for some of the reaction to the post. As I said, the post only uses ‘deposits fund loans’ 4 times, which doesn’t surprise me, because the entire idea was to link ‘loans create deposits’ with how the banking world views its own operations in asset-liability management and funding activities. And I’ve included a good deal of material in the post describing banking operations from a high level. So it’s a reconciliation of two perspectives – not a denial of ‘loans create deposits’ at all. No threat. But if the academics simply want to bury their heads in the sand and view all this as a threat, there’s not much more I can do about it. And if they’re not threatened, then there’s no reason not to open up to the consideration of how banks actually manage their affairs in the real world, including the common language they use to describe what they’re doing. Reserve management is only one function, and it works in seamless co-ordination with many others in the bank, including funding operations in their totality.

      • Seems to me that in your example a new deposit is funding repayment of the cb’s loan of reserves that the deposit withdrawal occasioned.

        Original position
        loan | deposit 1

        Step 1
        cb loan | deposit 1 withdrawal

        Step 2
        reserve transfer | deposit 2

        Step 3
        reserve transfer cancels cb loan on asset side | deposit 2

        Final position
        loan | deposit 2

        • What I don’t understand further about this is that according to the accounting, there is a deposit on the RHS that brought with it reserves, which are a bank asset at the cb. So on the books, there the loan AND the reserve balance added by the new deposit on the asset side and only the new deposit on the liability side. That seems to make the LHS larger than the RHS, unless the reserve balance is added to equity, but that doesn’t seem right. What am I not seeing here in the accounting steps?

          • what are you talking about? extending a loan doesn’t have any effect on reserve balances until a deposit is withdrawn.

            if bank a makes a loan for 100 dollars it has an asset (the loan) and a liability (the deposit in the amount of 100 dollars. if the deposit is withdrawn the bank’s reserve account is debited 100 dollars so then it has 100 less reserves and 100 more in a loan with the liability side as it was beforehand

            • JKH: “Suppose the deposit leaves the bank.
              Then the loan is offset by a short position in reserves – which becomes an overnight loan from the Fed. The balance sheet is matched.”

              JKH goes on to say that the bank is not going to leave that Fed loan on the books. So it attracts a deposit that involves a credit to it reserves account and pays off the Fed. Now it has the loan, funded the withdrawal with reserves, either cash at the window in the interbank system, and a new deposit.

              It seems to me that the new deposit brought in the reserve balance needed to pay down the Fed loan that the bank did not want to carry in its reserve account.

              This is what I am talking about.

              Now the bank has the original loan (asset), a new deposit (liability) and a new positive balance in its reserve account (asset).

              What am I missing here?

              • reserves are the exogenous mirror of an endogenous balance sheet

                Does that mean that rb are not bank assets? I thought they were bank assets.

                • It means that the reserve position of the bank considered in isolation is a net asset as a nominal structure – and that the rest of the balance sheet in isolation is an equal sized net liability as a nominal structure. Put them together and you get a nominal structure that is matched. Their equivalent size in isolation means they offset each other in this sense – or that the reserve position reflects the inverse nominal mismatch position of the rest of the balance sheet. Apart from required reserves, the purpose of asset-liability management at the most general level is to get the non-reserve part of the balance sheet to a nominally matched profile – in the sense of liabilities and equity funding assets.

              • you completely forgot about the fed loan. if the bank attracts a deposit

                Tom Hickey
                JKH: “Suppose the deposit leaves the bank.
                Then the loan is offset by a short position in reserves – which becomes an overnight loan from the Fed. The balance sheet is matched.”
                JKH goes on to say that the bank is not going to leave that Fed loan on the books. So it attracts a deposit that involves a credit to it reserves account and pays off the Fed. Now it has the loan, funded the withdrawal with reserves, either cash at the window in the interbank system, and a new deposit.
                It seems to me that the new deposit brought in the reserve balance needed to pay down the Fed loan that the bank did not want to carry in its reserve account.
                This is what I am talking about.
                Now the bank has the original loan (asset), a new deposit (liability) and a new positive balance in its reserve account (asset).
                What am I missing here?

                what’s the issue? the bank made a loan. that expanded the asset side by the size of the loan and the liability side by the size of the loan. the deposit was then withdrawn which caused an increase liabilities owed to the fed (or another bank, it doesn’t matter) equal to the size of the deposit. then the bank attracted a deposit from another bank. that expanded it’s liabilities by the size of the deposit and it’s assets in the form of a positive credit in it’s reserve account. it then paid off the loan which led to a debiting of the bank’s reserve account. at the end of this whole process it has the original loan on the asset side of it’s balance sheet and the new deposit on the liability side.

                there is no issue. just follow the accounting through to the end. use T accounts if it helps.

        • banks don’t lend reserves (to non-banks)

          banks don’t borrow reserves (from non-banks)

          in particular, they don’t borrow reserves by issuing deposit liabilities

          so the deposit doesn’t fund the repayment of reserves

          the deposit funds the loan

          reserves are the exogenous mirror of an endogenous balance sheet

          • OK, apparently I am not correctly understanding the reserve accounting. What does the correct version of the accounting look like on the bank’s BS and how is this reflected in reserve account at the Fed? There has to be a correspondance but I apparently am not seeing it.

      • Jose Guilherme says:

        Create two banks instead of one. Call them Bank A and Bank B.

        Both make a loan and create a deposit. Call them loan A, deposit A and loan B, deposit B.

        Then deposit A leaves for bank B and deposit B leaves for Bank A. Each bank gets an overnight loan from the Fed, because each bank needs reserves to make the transfer.

        The transfers are made and the banks repay the advance of reserves from the Fed (forget about interest costs; assume there weren’t any)..

        The balance sheets are now the following:

        Bank A:
        Asset – Loan A
        Liability – deposit B

        Bank B:
        Asset – loan B
        Liability – deposit A

        According to the flow of funds accounts. deposit B is “funding” loan A and deposit A is “funding” loan B.

        Yet both deposits were created “out of thin air”.

        Now: how are you going to explain this situation to an intelligent, non-economist observer (say, an engineer)? Do deposits “fund” loans? Or don’t they?

        • exactly as explained above

          its the same scenario

          the criss crossing of deposits is irrelevant

          btw, there’s no Fed advance required in either case

          • Jose Guilherme says:

            “btw, there’s no Fed advance required in either case”

            There was an advance (overnight loan) , in your own story:

            “Suppose the deposit leaves the bank.

            Then the loan is offset by a short position in reserves – which becomes an overnight loan from the Fed…”

            • My example assumed an overnight Fed advance in stating the circumstances – i.e. that the bank couldn’t attract another deposit during the day.

              Your example stated:

              “Each bank gets an overnight loan from the Fed, because each bank needs reserves to make the transfer.”

              I read your example as the deposits criss crossing simultaneously – i.e. during the day – in which case the cheques (I assumed cheques) clear simultaneously one bank against the other overnight and there is no net reserve impact and no requirement for an advance.

              My example assumes “failure” to attract a new deposit in the same day. Yours by construction assumes “success”. Either way, the objective of attracting a new deposit remains similar.

              Yours in effect assumes the objective is met “by accident” – which indeed is the way that it often happens given the gross amount of payment flows between banks on a daily basis, just with the back and forth of commercial transactions and the resulting deposit shift between banks at the demand deposit level. So a lot of it nets out from a net reserve effect perspective.

              Btw, when I said “in either case”, I meant in the case of either bank in your example – not in the case of either your example or mine.

              • Jose Guilherme says:

                My two bank example was meant to illustrate a situation where ALL deposits (in the banking sector taken as a whole) are created by loans.

                From a macro perspective, under said situation the banking sector’s “uses of funds” (acquisition of assets/loans) automatically provide and create their own “sources of funds” (new deposits).

                This is a characteristic – a privilege – that doesn’t exist in the non bank sector.

                The non bank system has to find (that is, to actively look after) its sources of funds from outside the system. Unlike banks, it does not automatically create the “sources” by the very act of acquiring assets. Funding in the non bank sector is therefore fundamentally different from “funding” in the banking sector.

                But are ALL deposits really created by loans? The answer to this question should be settled empirically – but, to my knowledge, no empirical studies have ever been undertaken to address the subject.

                However, we should admit that – conceptually – if even one small percentage of all the deposits in the banks has, at its remote origin, the pre-existing savings of the private sector (instead of bank loans) then the money multiplier model might be right.

                And the PK economists would therefore be wrong – or, to put it more diplomatically, not entirely right. :)

                To recap:

                If ALL the deposits on the banking sector’s books result from loans created by the banks then the expression “funding by deposits” would make no macroeconomic sense for the financial sector taken as a whole. Under that situation, the buying of assets automatically provides the funding for said buying, making a travesty of the very notion of funding.

                However, if not ALL deposits are a consequence of the loan-providing activity of banks then the money multiplier model may well have an empirical basis. To quote (neoclassical) Karl Whelan, banks would not be just creating funds “out of nowhere” (the funds would be fractionally based on the clients’ savings).

                In any case, we can’t have it both ways.

                • Good summary.

                  Original funding is definitely different in banking, as you describe.

                  And yes, there is an ‘original privilege’.

                  But competing for different forms (‘transformed forms’) of existing funding is not quite as different. There is still bank competition for desired liability forms ‘post-original-creation’.

                  Not all deposits are created by loans, because the banking system can create deposits by acquiring securities. Also, I’ve written that it is inevitable that QE has created deposits for which the offset is excess reserves. But what’s really created both the deposits and the reserves in QE is the Fed’s acquisition of bonds originally held in non-bank portfolios.

                  I’m not sure I understand your point on the money multiplier. Financial intermediation is somewhat separate analytically from expenditure and income. But it seems it must have its logical start as grease for the wheels of expenditure and income in a non-barter economy. Is that close?

                  I sort of get your idea of ‘funding as a whole’. My use of the term focuses more on the micro turbulence of individual banks competing for different forms of liabilities that in large part are themselves transformed through competition from their beginnings as original endogenous demand deposit creations.

                  • Jose Guilherme says:

                    “Not all deposits are created by loans, because the banking system can create deposits by acquiring securities. Also, I’ve written that it is inevitable that QE has created deposits…”.

                    Two interesting points.

                    Say Apple pays its employee Mr. A in Apple shares.

                    Then Mr. A sells the shares to a bank B.

                    Bank B’s accounting entries will be: DR Apple shares CR Mr. A’s deposit.

                    In this case the deposit (aka “money”) wasn’t created out of thin air by the banking sector. It was created out of the savings (unspent income) of Mr.A.

                    And in the case of deposit creation as a consequence of QE it’s important to underline that the banks only played a passive role in the whole process.

                    When the Fed buys bonds from the private sector, there will be a debit to bank reserves and a credit to client deposits. And, on the Fed’s books, a debit to bonds and a credit to commercial bank deposits. But the initiative was always at the hands of the Fed. Quite unlike the normal practice of banks, in which they decide to acquire assets (loans, securities, real estate, you name it) and automatically credit deposit accounts to “fund” those acquisitions.

                    In QE, the NCB rules the roost. Money (as opposed to just base money) creation becomes a prerrogative of the Fed.

                    • Good points.

                      More generally, deposit creation and destruction can occur within the funding side of banking, quite apart from the asset channel.

                      The funding side includes the equity account.

                      And that includes dividends as ‘anti-funding’.

                      Bank A could pay a cash dividend, which creates a deposit directly.

                      Or it could pay a stock dividend, which creates a liquid asset that can be ‘monetized’ as in your example.

                      Agree on QE – I’m amazed at how this seems to have been overlooked in general – that the banks are not the original source of QE bonds – and that there is a significant banking system liability effect as a result of the non-bank source of most of the bonds. The banks are acting as dealers/agents/brokers in the QE bond sales to the Fed – not as principals – but the payment for the bonds does affect the balance sheet size of the banking system through reserves and deposits.

                      This can only be reconciled by running a plausible counterfactual – it can’t be done by simple time series analysis of the system balance sheet as its evolved – due to deleveraging otherwise – which I think is why the basic point has been missed.

                      I’ve seen nobody focus on the banking system liability impact of QE (as opposed to the reserve impact) – as it might have affected depositor behavior more specifically from there. QE analysis seems floating in the clouds for the most part.

                • “However, we should admit that – conceptually – if even one small percentage of all the deposits in the banks has, at its remote origin, the pre-existing savings of the private sector (instead of bank loans) then the money multiplier model might be right”

                  Jose, that is a very strange claim.

                  • Jose Guilherme says:

                    The money multiplier textbook example always starts with the proverbial guy or girl who deposits $100 and in the end the banking system has created $1000 or $10,000 in deposits through a constrained process of credit extension.

                    You can reinterpret all this as an instance of the “savings precede investments” syndrome.

                    Whereas PK economists say that investments create savings. And show the loans create deposits mechanism as evidence of this.

                    But if a fraction of all outstanding loans (call them “investments”) is matched on the banks’ books by deposits that originally resulted from savings; and if banks are condemned to compete for deposits (“funding”) some of which resulted from savings – then one might say that some investments are really “financed” by savings.

                    • Yes investment creates saving. And investment is financed by both borrowing and saving. So investment is not limited by saving in existence. Nothing wrong there with PKE. For example you can find a lot on PKE papers on how retained earning finances quite a large fraction of investment for corporations.

                      Also one has to be careful – although residential home loans are financed out of banks, banks finance only a small fraction of investment (as in “fixed capital formation”) for corporations. So banks do initial finance as opposed to final finance. You can find such discussions in Davidson or Circuit Theory.

      • I think Tom is asking a slightly different question.
        re:””What is the requirement that a new entry on the liability side to keep the books in balance. Is it just an accounting rule of DBA that bank regs require following,”
        Let’s say we’re in Canada where there is no reserve requirement. When the 100 deposit leaves (for Bank B), and assuming there are no more transactions at the Bank, why does the Bank need to “fund the loan” (replace the deposit)?

        • Yes, that is something that I’m not clear about either.

          • Since no one answered, and I think this is the heart of your question (and the reserve accounting was a diversion; because as JKH said the reserve accounting is just a mirror of what is happening on the balance sheet).
            Tom, I think the answer is Bank B will not extend you credit for nothing in return, so you either have to “formally” buy a deposit from them (and pay them interest), or similarly through an interbank market, or by getting retail deposits. Private bank money is credit.

          • PS I left this comment on the mirror thread. Not sure if this mental picture helps you or not. http://pragcap.com/loans-create-deposits-in-context/comment-page-1#comment-138408

          • I understood Tom to be saying later on that he was somewhat clearer on the accounting.

            But regarding this:

            “Let’s say we’re in Canada where there is no reserve requirement. When the 100 deposit leaves (for Bank B), and assuming there are no more transactions at the Bank, why does the Bank need to “fund the loan” (replace the deposit)?”

            The assumption is that the central bank expects that private sector banks will not demonstrate chronic reliance on central bank funding. Such chronic reliance sort of contradicts the premise of a private sector banking system in the first place. In a sense, its the stigma issue operating at the overarching level of institutional structure.

            So a bank that experiences a shortfall in funding (e.g. a deposit that leaves that is not immediately replaced), with a consequent shortfall in the reserve account, and a consequent reliance on central bank funding – is expected to reverse all of that in short order. In other words, in a zero reserve requirement system, the bank is expected to operate in such a way that assets = liabilities + equity – but without much in the way of assets that are central bank liabilities (i.e. reserves) or liabilities that are central bank assets (i.e. advances). So banks look to replace funding that rolls over or deposits that they lose on that basis.

            • Oilfield Trash says:

              JKH

              So, from your example the Securitization of banking assets would also fund loans and be part of a balance sheet management strategy?

              • Absolutely – securitization is a factor in balance sheet management strategy, in terms of liquidity risk management and capital management.

                Assets can be securitized at either the time of origination, or after they’ve been on the bank balance sheet for a while. In the first case, there may be a short term inventorying of assets on the bank balance sheet, temporarily funded, pending moving them off balance sheet. In the second case, assets are moved off after a longer period of being funded on balance sheet. In both cases, it frees up the bank from having to fund them on balance sheet for a longer period of time – and uses less capital (if any, depending on any residual credit support provision) and less funding capacity (some forms of funding for banks are a relatively scarce resource, depending on how potential lenders/depositors view the credit risk of the bank for a given form of funding).

                • Oilfield Trash says:

                  JKH

                  Ok, but is not it correct that prior to finial securitization these assets can be pushed off balance sheet to some SPV arrangement?

                  • I’m not sure. My assumption has been that an SPV is generally structured to be a holder of (and usually an end holder of) securitized assets. Maybe that’s not right, or maybe there’s at least more flexibility in the structure of the securitization pipeline. It’s been a while since I looked at SPV structures.

                  • Securitization is the whole process and it is difficult to associate one single event to it. So to securitize, a bank will move the assets to the SPV and issue securities which is purchased by the bank first. The securities are then either sold to investors or retained partially/fully in its balance sheet.

                    So the combined entity bank+SPV has the loans and the ABS in its balance sheet and in a simple world, deposits and the ABS in its liabilities. When it is sold to outside investors, the bank has less deposits in liabilities and less ABS in assets.

                    So one can say that initially the funding was via deposits and after the sale to outside investors via the ABS.

                    Of course when retained, the deposits continue to fund the combined entity.

                    In in a more complicated world such as Europe, banks use the ABS as collateral to get funding from their NCB because of deposit flight etc.

                    In the United States, a lot of loans such as residential loans are sold to the GSEs. In that case there is no funding because there is a clean sale. Since it is no longer in the balance sheet, there isn’t a funding really. In other cases such as subprime, banks form SPVs like above.

                    • right, thanks

                      I misstated above

                      the SPV holds assets in non-securitized form; issues in securitized form

                      (maybe there are hybrid exceptions)

                      complex trust and servicing arrangements, etc.

            • I was referring to the genesis comment, Tom Hickey February 21, 2013 at 5:30 pm.
              Yes, he was clearer on the accounting later, Tom Hickey February 21, 2013 at 8:35 pm., but I think at the root he was asking about “why banks operate so asset=liabilities” or in my rephrasing of his example “if assets!=liabilities, why make asset=liabilities?”. Your answer is “the bank is expected to operate in such a way that assets = liabilities + equity”. My non-banking-language answer for Tom is “bank money is credit; when a deposit leaves, you don’t get credit for free you have to pay for”, and then I would add your other point “nobody likes a bank that mooches off the central bank (because that borrowing is very cheap, which may give you an unfair advantage and is meant for emergencies only; besides it’s called private banking for a reason.)”.
              But, regardless I agree with everything you say! Tom, have I helped or made things worse?

              • typo: “you don’t get credit for free you have to pay for it”

              • “Tom, have I helped or made things worse?”

                Absolutely helpful, jt26. Thanks to you and JKH for bearing with me and breaking it out. I think I have a handle on it now. Good examples, too.

            • The operational function of a deposit leaving a regulated entity means that you end up with a shortage at the central bank and somebody else ends up with a surplus.

              That is resolved by those reserve account entities with a surplus lending the money to those with a deficit – which they will do because otherwise they won’t make any money on those assets.

              In other words if a depositor leaves bank A for bank B then, until there is some other movement in the system, bank B becomes the new depositor in Bank A. So nobody ever leaves. They just change chairs.

              There is never any central bank involvement per se unless the inter bank reserve lending system is FUBAR or the central bank has engineered a systemic shortage.

              One of the alternative models that Warren puts forward is to ban inter bank lending of bank reserves and do it all via the central bank. ie they charge an overdraft fee and pay deposit interest (or leave it all at zero).

      • Cullen Roche says:

        This is actually a very simple to understand example JKH. I’d expect that even most lay people can understand that. I’d run with that when there’s confusion in the future.

  37. JKH, forget about the accounting questions. Nathan cleared that up.

    Sorry to be dense but I was doing the T accounts in my head and left out a key step in the reserve accounting.

  38. Reverend Moon says:

    @JKH

    Thank you for being so generous with your time and expertise (Ramanan also). It took me a while but, I finally get what you mean about deposits funding loans and what are reserves. I had to laugh at myself when i finally got what you so patiently had been getting at.

    “reserves are the exogenous mirror of an endogenous balance sheet”

    • OK!

      Glad it’s making more sense to you now.

      I should add that I put this post together much more quickly than usual – even though it attempts to bite off a lot – in terms of communicating what really is a single idea surrounded by a lot of complexity – which is the relationship of reserves to the rest of what’s going on in the bank. And that idea involves both abstraction about what money is, and interconnections across numerous different banking operations – not that easy to get across. It’s also the first time I’ve attempted to put something together on this. So all of that means I can probably improve on the explanation of it in the future, which may have had something (not all) to do with some of the difficulties in getting it understood this time.

    • Thanks to Ramanan also.

    • Second that. Many thanks for taking the time to break this down.

  39. “deposits fund loans”

    What does the model look like if there is just the central bank and one commercial bank?

    • “What does the model look like if there is just the central bank and one commercial bank?”

      Good question! But too hypothetical.

      If one assumes a single commercial bank in a closed economy, assuming its liabilities are acceptable, it doesn’t need to worry about its liabilities. It can simply pay no interest for example.

      Even in that world however, its customers may refuse to accept its liabilities or demand central bank notes in exchange for deposits and if this is large scale can create troubles for the bank so things are not so simple if questions about the bank are raised. But it will be too big to let fail and there will be all sorts of political economy issues. It may need to be broken into several banks for example and we have the real world.

    • This is a strange and wild but interesting configuration. Some rough ideas:

      The first issue is the relationship between the government and the bank. It may be that the bank is just a nationalized extension of the government. Or it may be that the bank is a private sector institution in some way.

      If this is a nationalized bank, then the operations are fairly straightforward. The government sets pricing across the balance sheet and can conduct monetary policy directly that way. There is no reserve account for interbank payment purposes because there is no private sector competition in banking. There might be something like a QE reserve account capacity if the government for some reason chooses to buy back debt it has issued (if it issues debt), or deficit spend directly through bank deposit accounts – i.e. whereby the government in effect expands the money supply with deficits, and the balance sheet might show some accounting entry as an internal transfer of funds from the bank to the government proper.

      If this is a private sector institution (in some way), it’s a very strange arrangement overall. As a bank, it would appear to have monopoly pricing power in the sense that there is no banking system competition. The only pricing competition might come from outside the banking system. Monetary policy is a challenge. One possible arrangement is for the government to issue debt in order to set the yield curve for interest rates. Assuming the debt is auctioned, the market then determines interest rates apart from banking. Some bank liability pricing might have to compete with government bill and bond interest rates – in order to entice depositors to switch from demand deposits into fixed term deposits – which the bank might want to attract in order to hedge interest rate risk on fixed term loans. So there would be some sort of interest rate transmission function along those lines. The reserve account arrangement is as described above for the fully nationalized case. No reserve account is required for purposes of inter-bank clearing and settlement of payments, although possibly something like it to allow the government the option to spend without borrowing. But the whole arrangement is pretty strange, due to the apparent monopoly pricing power of this institution otherwise.

      In terms of the ‘loans create deposits’ and ‘deposits fund loans’ duality, that remains in place. The ‘loans create deposits’ characteristic is straight forward. And the ‘deposits fund loans’ characteristic remains in place. First, from a pure language point of view in terms of flow of funds accounting, the idea that a loan creates a deposit and that the deposit represents funding for the loan is not a contradiction. The deposit hasn’t materialized ‘from nowhere’ and ‘created the loan’ as a matter of causality. That’s not what ‘deposits fund loans’ means. Furthermore, a deposit also represents funding in the operational sense that the bank in either case described above may choose to persuade a depositor to convert from a demand deposit to a fixed deposit – through pricing enticement – as a result of having made a fixed rate loan that ideally should be matched in terms of interest margin sensitivity. Although there is no systemic inter-bank competition for deposits, there is a competition for the minds of depositors in choosing a particular form of deposit that may better suit the overall configuration of the bank’s asset-liability book. And deposits fund loans in that sense of active liability management.

      • Looks like I didn’t get it right the first try again. Let’s say there is a gov’t that issues gov’t debt at auction, a central bank, and one commercial bank that creates private debt (demand deposits and loans) and is a private sector institution. I might add the commercial bank can buy gov’t debt later.

        “No reserve account is required for purposes of inter-bank clearing and settlement of payments,”

        Exactly, the demand deposits have a velocity in the real economy as entities use them, but the central bank reserves have zero velocity in the real economy and zero velocity in the commercial bank/banking system. They just sit there in their account. Let’s assume there is a 10% central bank reserve requirement for the demand deposits the commercial bank creates, the commercial bank/banking system is at its limit for central bank reserves, and there is some currency circulating. Next, some entity enters the commercial bank and wants a mortgage. The commercial bank says OK. The loan is created with some capital “attached”. The demand deposit is created with some central bank reserves that need to be “attached”. There aren’t any. At some time, the overnight rate starts to rise. The central bank can lower the central bank reserve requirement to “regain” control of the overnight rate or sell central bank reserves to the commercial bank to “regain” control of the overnight rate. The second option lowers the profits of the commercial bank. If the central bank does nothing, the overnight rate will rise until some entity decides to deposit some currency to benefit from the higher overnight, interest rate. The central bank has given up control of the overnight rate to currency holders.

        How does all that sound?

        The point of this is to separate debt production from inter-bank clearing/settlement of payments.

        • Another interesting point – required reserves for a single bank system – which is also quite weird.

          The problem is that the bank has nowhere to go to bid for reserves – other than the central bank, which has to inject them anyway in order to allow banks in any system to meet their requirement.

          The odd thing about this case is that the single bank ‘is’ the banking system.

          So the idea of required reserves is simply that of a tax. They serve no purpose in interbank clearing and settlement functionality – because there is no clearing and settlement with just one bank.

          So you can have required reserves – which the central bank must inject – and which will act as a tax on bank interest margins, assuming the central bank pays a 0 per cent rate on required reserves.

          Looks to me like there are two possibilities for the determination of interest rates:

          a) The market controls them via Treasury bond auctions, as described earlier

          b) If the government doesn’t borrow, the commercial bank controls interest rates as a matter of monopoly power administered pricing – but this is also very weird.

          That’s just my first very quick reaction; may require more thought.

          Interesting stuff you’re raising here.

          • Since RR are not required operationally, as the Canadian experience shows, this would suggest that any RR > O constitutes a tax? Seems so.

            • That’s right.

              There is the ancilliary argument that RR can be a useful buffer against daylight overdrafts and collateral requirements for daylight overdrafts – when you have a normal interbank clearing function. So in that sense there may be some ‘value’ or utility for the system in imposing a moderate level of RR. But that argument doesn’t work in the weird case here of 1 bank with no interbank clearing function. The tax characteristic here is even ‘purer’ in that sense.

              But I think you’re basically right.

          • “The problem is that the bank has nowhere to go to bid for reserves – other than the central bank, which has to inject them anyway in order to allow banks in any system to meet their requirement.”

            If there is currency in circulation, couldn’t the bank bid for currency using the overnight rate (raise it so some entity saves and deposits the currency at the bank)?

          • “So the idea of required reserves is simply that of a tax. They serve no purpose in interbank clearing and settlement functionality – because there is no clearing and settlement with just one bank.”

            Couldn’t the central bank use the required central bank reserve percentage to limit debt production? Once this one bank/banking system hits this limit the overnight rate will rise to the point of stopping debt being produced?

  40. When I hear deposits fund loans it is in this sense that I understand it;

    When I go to a bank seeking a loan the only place they look to see if they will say yes is in MY accounts, which includes previous deposits, say from my paychecks. They dont look at their own deposit levels but at the deposit levels I control in my accounts. Its a system wide statement and not a micro statement regarding a particular bank.

    As Ive said to people in discussions before. Banks dont look in their own vaults when deciding whether to make a loan, they look in the borrowers vault.

  41. This probably belongs at http://monetaryrealism.com/krugman-on-says-law/ but I want to keep these in one place.

    I’m going to attempt to discuss the central bank reserves and negative IOR from there. It probably won’t be right the first time.

    Currency = 800 billion. Central bank reserves = 2.2 trillion. Demand deposits = 6.2 trillion. All the currency is circulating, and 4.2 trillion of the demand deposits are circulating. Some people use medium of account (MOA) = currency plus central bank reserves. They see 2.2 trillion “locked up” (or maybe even saved) in the banking system. They want the 2.2 trillion out of the banking system. So they say make IOR negative.

    Let’s start there. First, set IOR at negative 2% for just the central bank reserves. I believe the banks will convert the central bank reserves 1 to 1 to currency (assume they can store the currency). Currency = 3.0 trillion (800 billion and 2.2 trillion in the banking system). Central bank reserves = 0. Demand deposits = 6.2 trillion.

    Next, they say set IOR at negative 2% for central bank reserves AND currency. OK. I believe the banks will set checking account rates, savings account rates, and CD (time deposit) rates at negative 2%. Everybody reacts by taking everything out of the banks. Currency = 7.0 trillion. Central bank reserves = 0. Demand deposits = 0. I don’t believe anything will change much. I see MOA = medium of exchange (MOE) = currency plus demand deposits. At the beginning, there was 800 billion in currency and 4.2 trillion in demand deposits circulating with 2.0 trillion being saved in demand deposits. At the end, there is 5.0 trillion in currency circulating and 2.0 trillion being saved in currency. Others will say currency went up to 7.0 trillion so NGDP should go up. Notice currency went to 7.0 trillion and not 9.2 trillion (800 billion plus 2.2 trillion plus 6.2 trillion). Thoughts?

    • Fedup, my brother used to live in Japan and said that many Japanese people hold lots of household money as paper currency. Apparently you can buy special envelopes with labels such as “holiday”, “electricity” etc. People take their money out of the bank at payday and put it in the envelopes according to what they intend to use it for. Clearly, in Japan, people having piles of paper money in their houses doesn’t lead to inflation.
      A collapse of production and generous lending to anyone who wants to borrow to conduct currency exchange or commodity speculation seems to me the way to get inflation. Those two things can feed back on each other. Commodity price spikes can lead to a collapse in production and so further weaken the value of the currency. It looks to me as though our central banks are targeting 2% inflation via such mechanisms.

      • ” Clearly, in Japan, people having piles of paper money in their houses doesn’t lead to inflation.”

        What??!!! According to Mr Sumner, Japans price level is 100x ours. Thats inflation.

        • Greg, if I’m remembering correctly, Mr. Sumner told me there is no such thing as real aggregate demand (AD), only nominal AD. If so, what do you think of that one?

          • No such thing as real aggregate demand, only nominal?

            I dont know WHAT to think about that.

            So according to Sumner, money is an illusion, we live in a barter world yet there is no real aggregate demand?

      • stone, a collapse of production is a negative real AS shock. A current account adjustment could also cause a negative real AS shock.

        Borrowing MOA/MOE and spending can also cause price inflation.

    • Fed Up,

      I followed you until the last several sentences.

      Here’s my take on the effect of your initial assumptions:

      The banks convert $ 2.2 trillion of excess reserves earning (2) per cent to currency earning 0 per cent. If they convert all excess reserves to currency, this prevents the fed funds rate from dropping to (2) per cent. No bank will lend any additional excess reserves at (2) per cent when they can receive 0 per cent on currency. The banks’ demand for excess reserves becomes inelastic at around the 0 per cent level. So the banks’ currency arbitrage effectively undoes the Fed’s plan for a (2) per cent regime for both IOR and the fed funds rate. That’s why the Fed in effect can’t implement negative IOR under those assumptions.

      If the Fed decrees that currency held by banks also “earns” (2) per cent, then the fed funds rate will drop to (2) per cent. Banks lending fed funds will drive the fed funds rate down to that level, because they will earn more (pay less) on a funds rate that is greater than the (2) per cent they can earn on either reserves or currency. Bank asset-liability management functions examine pricing across the board, and start to drop all interest rates on assets and liabilities accordingly. A bank holding currency or reserves earning (2) per cent will be hard pressed to set its own short term rates higher than (2) per cent for example. Competitive forces will force down interest rates on lending as well.

      However, there’s a further problem if the public can convert their deposits earning (2) per cent to currency earning 0 per cent (I assume that’s your assumption). The arbitrage problem that the Fed faced originally with the banks is now one that they face with the general public instead. Bank depositors will redeem deposits earning (2) per cent for currency earning 0 per cent. The banks will exchange $ 2.2 trillion from their own currency position (have converted from excess reserves) in return for customer deposit redemptions. Customers will additionally redeem the remaining $ 4 trillion of deposits. That requires the Fed to inject $ 4 trillion of reserves into the system – because the banks have to buy the currency from the Fed in order to exchange it with their customers for demand deposits. Combined with initial currency in circulation of $ 800 million, total currency in circulation will now be $ 7 trillion.

      The question then is what form the $ 4 trillion Fed reserve injection takes. Suppose the Fed buys bonds to inject the reserves. Assuming the end sellers of bonds are non-banks, they will end up with new deposits at the banks. But those new deposits will earn (2) per cent. So the new depositors will now redeem their deposits at (2) per cent interest for currency at 0 per cent. And on it goes. The system becomes unstable. Any further attempt by the Fed to inject more reserves by purchasing bonds would produce more deposits and more currency conversion. Accordingly, in order to stop this cycle, the Fed will lend directly to the banks at (2) per cent, instead of buying bonds. This allows the Fed to stabilize the system and maintain a target rate of (2) percent for fed funds. The banks will price their loans at the lower rate structure, and will now be funded entirely by the Fed.

      Good work on your part. Have you seen Sumner or anybody else attempt this sort of analysis?

      • “Have you seen Sumner or anybody else attempt this sort of analysis?” And, “I followed you until the last several sentences.”

        Not that I know of. I think most of the people that want negative IOR are saying MOA = currency plus central bank reserves, MOE = currency, and MOA = the M in MV = PY (nominal GDP). Getting the 2.2 trillion in central bank reserves converted to currency will increase velocity in the real economy and raise NGDP. They want to keep NGDP positive until “something” happens and the economy fixes itself.

        “However, there’s a further problem if the public can convert their deposits earning (2) per cent to currency earning 0 per cent (I assume that’s your assumption).”

        Yep, that is the assumption.

        “The question then is what form the $ 4 trillion Fed reserve injection takes. Suppose the Fed buys bonds to inject the reserves. Assuming the end sellers of bonds are non-banks, they will end up with new deposits at the banks.”

        What if the end sellers are banks? Is it possible for them to lose all of their assets in this “negative IOR bank run”?

      • Will short-term treasury interest rates go into negative territory also?

  42. Stone,

    Regarding your point from above:

    http://monetaryrealism.com/loans-create-deposits-in-context/#comment-16096

    All of these types of analyses that get their motivation from the ‘evils’ of bank endogenous money creation tend to overlook the fact that the banking system we have today does an enormous amount of balance sheet hedging for the type of risk that the Chicago Plan and others purport to provide a solution for.

    (I’ll be doing a post on this at some point.)

    Simple example:

    Today, a bank makes a 5 year fixed rate loan.

    ‘Loans create deposits’ – as usual.

    The usually unstated assumption is that it is a demand deposit that is created in this process – and that is a very reasonable assumption.

    So, from a banking system perspective, a demand deposit has been created.

    But from the lending bank’s perspective, it will typically want to hedge both the liquidity and interest rate risk on its 5 year loan.

    So it goes into the market – wholesale or retail – and attracts a new 5 year fixed rate deposit.

    Meanwhile, the original demand deposit has probably gone out the door to another bank.

    But the new 5 year fixed rate deposit itself has probably been sourced from a depositor who himself has converted his own demand deposit into the new fixed deposit.

    The net result is that the system has a new 5 year fixed rate loan and a new 5 year fixed rate deposit.

    The lending bank has now ‘funded’ its loan in the sense that I’ve used that word. Note that it took specific additional discretionary market action on its part in order to accomplish this – which is why I use the term ‘fund’ in the active sense – and this happens even though the endogenous money process created the ultimate source for the new funding from an overall system balance sheet perspective.

    And the point here regarding Chicago and other such plans is that the bank has just taken steps to hedge its risk position in lending similar to what the Chicago Plan aims to achieve for the asset-liability profile associated with lending overall.

    This goes on all the time in the system that we have.

    The typical meme that points to the ‘evils’ of the endogenous money process is far too simplistic in its criticism in this sense.

    • JKH, so under our current system banks make a ten year loan at say 5% and then subsequently hedge that by selling a ten year debt security at say 4%. Those interest rates are not a reflection of a scarcity of money but rather of competition with treasury interest rates and perception of credit risk. Expansion of credit is entirely at the discretion of the banks and borrowers and the setting of interest rates by the central bank. It is not in anyway entrusted to those with savings. As such credit financing is on a very unequal footing from equity financing where equity financing has to entice those with savings to risk them.

      Perhaps if selling of the debt security had to precede granting of the loan and extra bank reserves were not forthcoming, then credit expansion would be constrained and so equity financing would often get used instead and there would not be credit bubbles and boom and bust cycles?

      It seems to me that under our current system if I want to buy a house I go to the bank and they see that I can spare say $10000 a year and so they make a loan to take that amount from me and that sets the price of housing. If instead credit expansion were constrained because debt securities had to be sold first in order for the bank to be able to loan then things might be quite different. Bank lending would then not be able to induce asset price inflation up to the point where all economic surplus is taken as debt interest.

      Do you agree that if debt securities had to be sold prior to granting the loan then credit expansion and so bank induced asset bubbles would be constrained? I guess the transmission mechanism would be through the price of the debt securities that the banks were trying to sell. Imagine improved technology has enabled everyone to earn twice as much. Under the current system banks would capture much of that as mortgage interest by granting bigger mortgages, pushing up house prices. If instead banks had to first sell debt securities then the choice would be with (potential) savers. They might choose to buy debt securities so as to induce house price inflation or they might decide to fund technology start ups or to spend it any which way. If purchasers of debt securities were not forthcoming then not much lending could be made. It would be a big transfer of power from banks to the population wouldn’t it?

      • “As such credit financing is on a very unequal footing from equity financing where equity financing has to entice those with savings to risk them.”

        This is actually not the case, and its an important point.

        As a very simple example, suppose a bank makes a loan that creates a deposit.

        Then, it decides it wants more capital, so it issues shares.

        From a system perspective, the shares will be paid for with deposits (swapped).

        That’s equity financing without any direct connection to saving.

        This is important because its a clear example of how flow of funds accounting is separate from income accounting.

        As another example, here’s a reverse twist on the above:

        Suppose a corporation generates profit and retains it.

        That shows up as income in national income accounting.

        Now suppose the corporation buys back its own shares in the same amount.

        From a system point of view, bank equity capitalization is reduced and bank deposits are increased.

        In this case, there has been saving, but the ultimate domicile of that saving will be reflected as net worth on the RHS of household balance sheets. In the case of retained earnings, the value gets transmitted indirectly from corporate balance sheets to household balance sheets in the form of the stock market value of retained earnings. In the case of a share buy back, it gets transmitted directly to household net worth, captured on the asset side of those balance sheets by a new deposit. It’s similar to a dividend distribution in that sense.

        This second example is a bit complicated, but the moral of the story is that saving and net worth in the economy doesn’t necessarily connect perfectly to debt or equity capitalization of corporate structures.

        • But the value of shares does not become income until realized, and S is defined as the residual of household income after consumption in a period. I don’t see how that works if the shares are not sold and the gain is not realized as income in the period.

          • Suppose you own stock with a book value of $ 10.

            The company makes a profit of $ 1 and retains it.

            The book value is $ 11.

            That $ 1 of profit becomes part of national income.

            Suppose the market value of your stock at the start is $ 15.

            And at the end the market value is $ 17.

            That just happens to be the way that the stock market values the book value of the company at a point in time – lots of volatility in that.

            Your own net worth (your own equity position) is $ 17.

            The company earned the income of $ 1.

            But the income, because it’s retained, is reflected – along with all other cumulative retained earnings of the company over multiple years – in your net worth – as a result of owning the stock and as a result of how the stock market values the company.

            So the $ 1 income effect of the most recent year is embedded and translated as part of the value of your stock.

            But that value is embedded in the value of all previous year’s income – according to how the market values the total.

            It’s the company’s income – but it’s your wealth.

            If the company buys back your stock at $ 17, it’s an asset swap – your stock for a deposit.

            And if you sell the stock to another bank at$ 17, it’s an asset swap – a deposit for your stock.

            • “If the company buys back your stock at $ 17, it’s an asset swap – your stock for a deposit.
              And if you sell the stock to another bank at$ 17, it’s an asset swap – a deposit for your stock.”

              Yes, but if I hold the stock in my portfolio without selling, over the years my financial wealth increases but it does not affect my income so how does it contribute to S if income is saving plus consumption so that S = I – C?

              In other words, based on the definitions, I don’t see how an unrealized portfolio increase can add to “saving” =def residual of income after consumption. For tax purposes, the income is determined by the realized gain. Are unrealized paper gains to portfolios somehow included in saving? Absent a sale price, how is the unrealized gain figured, e.g., average over the period, close of the period minus beginning of period?

              • Tom,

                Although at an individual level, income is defined differently (for example in the tax returns form), at a national accounts level the definition is different.

                At the national accounts level, it is treated as holding gains or revaluations and so the identity which connects stocks and flows is:

                Change in Net Worth = Saving + Revaluations.

              • Selling your stock has no bearing on national income. It’s an asset swap.

                S was generated once – by the company’s profit when recorded.

                Forget capital gains – they’re not included in national income.

                I commented recently on this issue here:

                http://www.interfluidity.com/v2/3830.html

    • “The lending bank has now ‘funded’ its loan in the sense that I’ve used that word. Note that it took specific additional discretionary market action on its part in order to accomplish this – which is why I use the term ‘fund’ in the active sense – and this happens even though the endogenous money process created the ultimate source for the new funding from an overall system balance sheet perspective.”

      That makes “to fund” clear in the sense of ALM. So the operational meaning is risk hedging?

      • Funding as defined falls within an overarching strategy of asset liability management and risk management.

        If a bank wants 5 year funding, it’s not because its balance sheet is necessarily ‘out of balance’ in the sense of having an offside reserve position.

        It’s because it wants 5 year funding as part of its asset-liability structure – instead of what it has now. And targeting that asset-liability structure reflects risk management for things like liquidity and interest rate risk.

        For example, it can pay off other short term funding when it raises 5 year funds.

        And as an example of that, it may pay off a demand deposit.

        This connects pretty nicely with ‘loans create deposits’.

        ‘Loans create deposits’ for the most part means ‘loans create demand deposits’.

        But banks have no intention of funding their entire balance sheet with demand deposits.

        So they do other types of funding. At the system level, this drains and replaces what would otherwise would be demand deposits.

        In a sense, MMT leaves off at the initial stage of ‘loans create deposits’. That isn’t surprising – since I doubt MMT is greatly interested in explaining how bank asset-liability and risk management works. But it may be why there’s been some difficulty with the idea that funding in this sense is not inconsistent with ‘loans create deposits’.

        • Yes, thanks. I suspect that most non-bankers are not familiar with ALM operations and this is clearing up how banks “fund” assets that are at risk as lonas are.

          I would suppose that large industrial corps that self-finance, like auto companies that extend low-cost loans to customers through their own finance companies, also fund their exposure through ALM operations like this?

          • Not sure if it is 100% Have a look at Ally (used to be GMAC) in US and Canada. They have a bank subsidiary in both. True also for independent credit card issuers; have a look at the annual report for Discover Financial, for e.g. Have a look at the list of FDIC-insured banks (US) or CDIC-insured banks (Canada), you’ll see them along with many retail stores’ finance arms.

          • To paraphrase Friedman/Nixon:

            We’re all AL managers now.

          • ALM is not a single ‘funding operation’ itself. ALM is more of a corporate strategy function that provides overall direction and/or input to the entire mix of funding operations. It’s a ‘super portfolio’ management function, looking at the bank’s entire balance sheet.

            • So I assue then that this overall corporate strategy is then used tactically at desks to make specific operational moves under the coordination of the ALM dept. No need to respond if correct.

              • Roughly – as a blanket statement, that may overstate the intensity of the operational influence – it’s complex in total, involving different operational interfaces with various funding and asset units – some immediate, some remote. But the function has accountability at the most senior level in the sense of coherence of funding strategy across the organization. You know the story about the TBTF banks being too big to manage? This function is right in the middle of that (managing hopefully) as a challenge. It deals directly with the area of greatest complexity in banking. The London Whale fiasco could be considered to be a combined failure of over-delegation of trading authority, risk management, and asset-liability management. ALM would have had a heavy involvement in the internal routing of deposits in that case. One of the things the function does is change interest rates used in transfer pricing across the board –where necessary – whenever there’s a central bank target interest rate change, or a big bond market move for example. Transfer pricing rates are a very strong signal in banking, and are driven by market rates.

                I may do a post on this sometime, but not very soon – it is complicated indeed.

              • Just to repeat something – it occurred to me a few comments back that ‘loans create demand deposits’ may be one way of establishing the connection I’m attempting to make in the post between that and funding. The counterfactual where the entire liability structure of banking consists of demand deposits is a non-starter from an asset-liability management and risk management perspective.

                And there’s an interesting analogy and connection between that idea and the ‘no-bonds’ configuration for deficit financing – but that really is a story for later on.

                • Yes there is a connection of ideas – supposedly because the government creates money that monetary economists seem to think that a nation cannot be considered indebted to foreigners in domestic currency or similar intuitions such as that!

  43. JKH, it seems to me that in your example the bank has created credit that was subsequently used to buy bank equity. Are you saying that that bank loan was expressly made on the condition that it was only to be spent on that bank’s equity? Is it mistaken to think of equity financing coming out of savings? Are you saying that the bulk of equity financing is actually financed at its root by bank lending rather than by saving income?
    My impression was that equity funding tended to be for projects that had a high enterprise risk and required specialist insight. As such those projects were not suitable for bank financing and so banks financed purchases of pre-existing assets (eg mortgages or company leveraged buyouts). So equity financing (for instance of start ups) tended to come from personal savings of investors with specialist knowledge. Are you saying instead that start ups are in fact financed by bank loans? How could that work as doesn’t the enterprise risk mean that repayments will be very hit and miss? My better half was an employee of a start up and it took nine years before they made any money but then they made 30x the start up cost. Isn’t that lumpy return typical and totally unsuited to bank lending?
    Sorry if I am totally missing the point.

    • The deposit created by the loan gets used in the economy. The borrower soon does something with his money. And the money moves around, from depositor to depositor as it travels around the economy.

      In that sense, the deposit and the money created from the original loan gets separated from the loan that gave birth to it.

      But the banking system still includes the deposit originally created (or the same amount of money in some collection of deposits somewhere in the banking system) – other things equal – in the case of this simplified example.

      As an entirely separate decision, the original lending bank may subsequently decides it needs more capital – in order to back additional lending in the future.

      That’s a separate decision from the purpose of the credit already extended.

      So the bank issues new equity, and deposits somewhere in the banking system are used to pay for it.

      From a system perspective, there’s been an equity/deposit swap, changing the funding composition of the banking system, but with the size of the system balance sheet unchanged, other things equal.

      (That assumes the equity is purchased by non-banks.)

  44. If bank loans are made to inflate house prices such that the total value of housing and mortgage loans outstanding changes from say $5T to $10T then servicing that extra $5T of debt is occupying the new deposits is it not? The expansion of mortgage debt has not led to an equivalent expansion of disposable spending money for typical households has it?

    It just seems to me that if we had had constrained bank lending then housing would be much cheaper, banks would be much smaller and people currently employed in banking would have instead been designing funky robots to look after us all. :)

  45. Just as a thought experiment, if all lending required a prior sale of a debt security of the same duration of the loan don’t you think loans would be much more limited? Wouldn’t houses only be bought with shorter term loans and land prices would be lower? If a typical household today spends $300k on housing of which $100k goes to interest would that not change to say $100k paid off in five years rather than thirty years and only $30k going to interest?

  46. JKH, it is fantastic that you go to the trouble of writing these posts but have you ever also considered contributing to the wikipedia banking pages? They do seem to be gradually improving but are still predominantly money multiplier stories.
    http://en.wikipedia.org/wiki/Fractional-reserve_banking

  47. Neil Wilson refers to this post here:

    http://www.3spoken.co.uk/2013/02/the-new-model-bank.html

  48. Reference:

    http://www.cnbc.com/id/100497710

    Basics of Banking: Loans Create a Lot More Than Deposits

  49. Reference:

    http://www.cnbc.com/id/46970418

    What Really Constrains Bank Lending