There’s a considerable backlog of interesting material related to the April, 2012 Krugman/Keen blogosphere debate on banking. Market monetarist Bill Woolsey wrote an intriguing piece on banks and monetary policy, somewhat under the radar to the main discussion. I don’t know if it was prodded by the K/K debate, but it may well have been:
The subject of Woolsey’s post is his explanation of the money multiplier. What caught my eye was not that specific topic, but some of the related description of banking operations he provided as background. The standard textbook multiplier concept as often explained is a highly dubious version of monetary operations and banking. But whether or not one wants to make a case rejecting the concept of the money multiplier is secondary to the main point of my post here, which is the value of Woolsey’s piece for its related descriptive material on banking operations.
Regarding the nature of monetary operations, if I read between the lines, Woolsey may be saying there’s some basic stuff that the post Keynesians think non post Keynesians in general and monetarists in particular don’t know, but in fact they do know:
“Monetarists never argued that the quantity of base money should be fixed. But they did say that it should not be changed to keep any interest rate, including the interbank loan rate, from changing. It was never the case that monetarists were unaware that the Federal Reserve adjusted the quantity of reserves to keep the interest rate on interbank loans at a targeted level. It is rather that they opposed that policy. They favored changing the quantity of base money according to a different principle–keeping some measure of the quantity of money on a targeted growth path…”
No doubt that’s been said before by a monetarist. But it softens the perception that monetarists are somehow unaware that “it’s about price” as far as the Fed is concerned in its modus operandi today. (This is a fact that is not contradicted by the explosion of excess reserves brought about since the financial crisis, since the Fed controls the price of those reserves by deciding what interest rate to pay on balances.)
The most interesting aspect of his post in my view is reflected in the following paragraphs:
“How is it that the quantity of money changes when there is an increase in base money? There is a terribly unrealistic story often told in introductory textbooks. The story starts with a bank having excess reserves. The bank lends those reserves out. The borrower spends the money and the sellers deposit the checks. The checks clear, and the bank that made the loan no longer has the excess reserves, but the bank used by the seller now has the excess reserves. It makes a loan, and so on. Assuming banks’ demand for reserves increases with their supply of deposits, then the amount lent each time is smaller. The initial quantity of excess reserves is “multiplied” into many deposits and many bank loans…
… I often point out to my students that the simple story of banks making loans based upon their existing level of excess reserves is very unrealistic. Do banks put out a sign saying, “excess reserves available today, come get your loans?” In reality, banks set interest rates on both loans and deposits intending to use their deposits to fund their loans. In a growing economy, this generally involves setting interest rates on loans and deposits so that demand for loans from banks is matched by the supply of deposits to banks. The banks then use money market instruments to adjust for any temporary imbalances between the demand for loans and the supply of deposits. Higher loan demand would immediately result in banks selling off government bonds, reducing overnight lending to other banks, or borrowing more overnight from other banks. An increase in the supply of deposits would result in banks buying government bonds, reducing overnight borrowing from other banks, or lending more overnight to other banks…
… It is only when we have a system where banks can use money market instruments to manage their reserves, and banks are funding their loans and securities portfolios with a variety of interest bearing deposits, does a quite different approach to understanding the banking business become reasonable. In particular, changes in the interest rates on money market instruments and the interest rates that banks pay and charge become very important for any reasonable account of the banking business.”
There you have it. Not only does he reject the textbook multiplier story, but he captures the general nature of bank reserve management and asset liability management quite accurately in my view. His high level summary of it compares favorably with similar accounts I can recall seeing on post Keynesian blog posts in general.
He has it right on the general nature of the pricing function across various business lines within a given bank. Commercial bank business lending and deposit business units take their cue on pricing parameters from the bank’s treasury function, which in turn takes its cue from the central bank’s own interest rate management. (Cost of equity capital is also a core input to asset-liability pricing, obviously.) And again he’s right that the textbook story of the multiplier is wrong, or unrealistic, to use his word. I won’t go into Woolsey’s refinement of that story, because it’s secondary to the purpose of this post.
The main point I wanted to emphasize here is reflected in this statement:
“The banks then use money market instruments to adjust for any temporary imbalances between the demand for loans and the supply of deposits”
This is a critical aspect to understanding bank reserve management. It is not a typical focus, at least in much detail, in the post Keynesian blog summaries that I’ve seen, for example. The usual account focuses on the central idea that “loans create deposits”. That idea incorporates the fact that banks don’t require a supply of statutorily required reserves ahead of time in order to create new deposits as described in the textbook multiplier explanation. And that is OK as far as it goes. But that in itself doesn’t really go very far in describing the reserve management process of a commercial bank. So inquiring minds are interested in how this works at an operational level.
“I’ve read all the numbingly repetitive and identical explanations of capital-constrained bank lending, how deposits aren’t, can’t be, lent out. But I’m still confused. If I write a million-dollar check on my account in Bank A and deposit it in Bank B (or roll a wheelbarrow of cash across the street…), what does Bank B do with that million dollars?”
That question is fundamentally germane to real world banking operations, and I suspect a lot of other people are confused about it as well.
Banks run complex money market operations to respond to the net movements in their reserve accounts that result from asset-liability transaction activity in the rest of the organization, including the main loan and deposit book. (Those flows include voluminous amounts of deposits shifting between banks, without any necessary connection to new loan extensions. Such activity results simply from the ongoing use of existing bank money in regular economic activity. It is inherent in the concept of money “velocity”.) Banks adjust their reserve accounts in response to these effects through offsetting transactions in short-term liquid assets and wholesale deposit liabilities. These money market operations are the balance wheel for reserve account disruptions caused by net flows through the main loan and retail deposit banking operations. Effectively, changes in reserve balances that are the result of client initiated activity in loans and deposits are offset by reversing changes in reserve balances initiated in wholesale money markets by the bank itself.
(Note that in today’s environment of chronic system excess reserves, individual banks with outsized excess reserve positions may simply let those balances decline in response to a net reserve outflow. That is a special case of a bank using the ultimate liquid asset (excess reserves) to absorb a net reserve outflow. When a bank already holds excess reserves, those reserves can be viewed as such a liquid asset that is “sold”, in effect, in order to meet a net reserve outflow. If the bank did not hold excess reserves already, it might sell a more conventional liquid asset such as treasury bills for example, in order to offset the net outflow of reserves that occurs otherwise.)
Reserve management might be imagined as simpler in a reconstituted monetary system where the government assumes a much larger, quasi-nationalizing role in operationally funding the banks, and where individual bank liquidity risk is muted as a result. But that’s not the way it works today, in fact. The deposit business is very competitive and the nature of bank liquidity management much complicated as a result. The idea that “loans create deposits” isn’t sufficient to capture the dynamic of deposit gathering in a competitive banking system. Thus, the nature of deposit origination as in “loans create deposits” does not explain the consequent dynamic that competing banks exhibit in attracting and retaining their own desired share of originally created deposits.
Woolsey’s explanation of all this is obviously high level, but it suffices as an important nexus for a coherent story of banking overall. Separate from that, he offers a good deal of additional explanation regarding the monetarist interpretation of the money multiplier. As noted, he rejects the textbook explanation. But he doesn’t dismiss the idea outright. I think I neither agree nor disagree with his interpretation in total at this point. I’ll leave the detail of that analysis as a separate subject for now. But the multiplier idea as it applies to the point of contact between commercial bank money market operations and the central bank reserve system does suggest a more refined interpretation than the crude loan/deposit form found in textbooks, and Woolsey makes a subtle distinction along these lines. And this distinction reflects the importance of money market operations as they facilitate management of net reserve flows that arise from the rest of the banking book. So the interesting aspect of his post in my view is its emphasis on money market operations in this context. And I think this particular aspect should factor more prominently as a general education point for those who are trying to understand how banks work in fact, because there does seem to be some curiosity and confusion about this point.