Monday, June 30, 2014

Nick Edmonds — If Banks Don't Lend Reserves, What Do They Lend?


Confusing money (accounting entries) with money things, like cash. Again, generalizing from a special case and a limited one at that.
The fact is that a loan does not have to a loan of anything. Some loans can easily be treated as being a loan of something, such as a loan of a car. But dollar loans are not in general a loan of something, even if we feel a desperate urge to think of them as such. They are in fact just bilateral agreements to procure accounting entries.

For many purposes, it is fine to think of dollar loans as being loans of money. But we should be careful not to fool ourselves into thinking that is what they actually are, because we need to understand how things work when that interpretation no longer fits.
Reflections on Monetary Economics
If Banks Don't Lend Reserves, What Do They Lend?
Nick Edmonds

When a bank makes a loan and credits a deposit account, it undertakes an obligation to settle in accordance with customer's wishes, by either furnishing cash at the window or clearing a draft on the customer's account, which the bank does either through intra- or inter-bank netting accounts or in the official payments system, as appropriate. Most of these transactions simply involve marking up one account and marking down another account in the accounts of both parties to the transaction.

Money is not only created "out of thin air," but it is also exchanged in thin air.

53 comments:

Dan Kervick said...

Most of these transactions simply involve marking up one account and marking down another account in the accounts of both parties to the transaction.

Well, that might be the case. But if we are talking about interbank clearing, then the accounts that are marked up and marked down are not accounts that either bank controls. In the final analysis, these are accounts held by the bank at the central bank, and the "marking up/marking down" business entails a transfer of assets from one account nbank to another. That is also clearly what happens when the depositor chooses to redeem some or all of the deposit balance in exchange for cash. The bank cancels a portion of its liability to the depositor, and in exchange surrenders to that depositor some of its cash assets.

Tom Hickey said...

Yes, ultimately the bank's capital and the shareholders' equity is at risk. Loans are not "free" to the bank and that's not what creating money out of thin air means in the case of banks. Banks have to clear their obligations in a unit of account that they cannot issue. Only currency sovereigns have that ability since they are the sole (monopoly) issuers of their currencies. Banks have to obtain the state's currency as required to settle obligations incurred, just like other currency users. The advantage they have in this over other users is access to the central bank as lender of last resort.

y said...

banks lend base money.

Ryan Harris said...

While the MMT idea that banks create loans/deposits out of thin air is technically true and helps to illustrate the point, banks must manage their reserve accounts balances in real time and are always subject to collateral requirements along with periodic capital adequacy review.

Whatever you call the units of account the banks must account for the transactions they incur with the rest of the world and if they run out of "money"/reserves/deposits/units of account overnight and overdraft their accounts at the fed more than a couple times during the course of a year, it automatically triggers a review by regulators and they are charged highly punitive rates -- even more punitive than normal discount window borrowing which is punitive compared to interbank borrowing. Similarly if during the course of the day a bank exceeds the nominal cap on their overdraft facility with the fed, they are given punitive rates and eventually their capital adequacy will be investigated to understand why they are unable to maintain adequate reserve balances.

When I read the comments from people after they hear banks make loans and then worry about where to get the "money" afterwards people get the wrong idea, and think that banks aren't held on tight leashes by regulators when they are, in real time, minute by minute.

The Federal Reserve Account Management Guide pretty clearly explains how the banks pledge collateral subject to their periodic capital review. How they maintain their account

Tom Hickey said...

"banks lend base money."

How so? MB is notes and coins in circulation, vault cash and rb at the cb.

M1 is notes and coin in circulation, demand deposits, travelers checks, and other checkable deposits.

Loans create deposits. Banks don't need to have either either rb or vault cash prior to extending a loan. Notes and coin in circulation are irrelevant. Banks only need rb or vault cash after a loan has been made tas may be needed to settle after netting. If the bank doesn't have the required rb in its account at the cb at the end of a period, the deposit "creates" rb through the discount window.

Tom Hickey said...

"When I read the comments from people after they hear banks make loans and then worry about where to get the "money" afterwards people get the wrong idea, and think that banks aren't held on tight leashes by regulators when they are, in real time, minute by minute."

That's the job of the ALM department, which coordinates with the loan department. The loan department alerts ALM to loans in the pipeline so that ALM can ensure the required rb are in the bank's account at the Fed on time so as not to incur a penalty, which is taken as a signal of poor management practice.

But that's in the US. Other countries operate differently. Canada has no reserve requirement, for example.

Warren, who has sat in on examination, makes the point that bank oversight is tight but that regulators are looking at the wrong things.

Dan Kervick said...

Banks don't need to have either either rb or vault cash prior to extending a loan.

Well, in some sense that's true. But if a bank issues a loan to you by crediting $50,000 to your deposit account, and then one second later you say, "I want the $50,000 in cash," they have to give it to you.

Tom Hickey said...

That's true, of course. A bank incurs an obligation when it makes a loan and credits a deposit account that it must deliver on upon demand.

The point, though, is that banks don't seek deposits first and only then lend out other people's money in a process of intermediation between savers and borrowers, which is the basis of loanable funds.

The logic of the operation is that loans create deposits, and then banks deliver on the demand after netting using settlement balances or vault cash. Banks obtain settlement balances either from customer deposits, borrowing from other banks or the money market, using repo at the cb, or resorting to the discount window.

Actually during the crisis Bernanke and Paulson twisted the TBTF's arms to borrow at the discount window whether they needed to or not in order to overcome the stigma so as to melt the liquidity freeze.

y said...

Tom,

"Loans create deposits"

Deposits are loans of base money from depositors to banks. So long as the depositor is lending money to the bank, the bank can do what they want with it. They don't need to keep that money on hand in the form of reserves or cash.

However, if the depositor asks to withdraw the money and the bank can't pay up, then the bank would have defaulted on the loan.

y said...

I think it's accurate to say both that banks lend base money, and that banks don't lend reserves, or rather that they don't need to have reserves on hand to make loans. Reserves are base money which the bank currently has on hand either in its account at the CB or as vault cash. Banks only need enough reserves on hand to meet current demand for withdrawals and payment settlement between banks.

Tom Hickey said...

y, banks don't lend out settlement balances. They borrow settlement balances from other banks in the interbank market, in the money market, from the cb through repo or the discount window, or through taking deposits.

Banks use settlement balances to settle in the payments system and to obtain vault cash to meet window demand. They do not lend out settlement balances in making a loan and crediting a deposit account.

Banks pay their bills by crediting accounts, as they do in the case of loans.

IN the case of settlement of accounts through intra-bank netting, no settlement balances are needed.

y said...
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y said...

Tom,

"They do not lend out settlement balances in making a loan and crediting a deposit account."

When a bank 'credits a deposit account' they are borrowing from the depositor.

If the bank credits $100 to your deposit account, that means the bank is borrowing $100 from you.

The $100 they are borrowing from you is base money.

You don't need to physically have cash which you then give them for this to be the case.

"Banks pay their bills by crediting accounts"

So they pay their bills by borrowing money from depositors.

Tom Hickey said...

When the bank make as loan the person borrowing is the the person to whom the loan is extended. Saying that the bank makes a loan by borrowing the deposit from the depositor is a backwards way to construe it.

When a customer makes a deposit, the depositor is making a loan to the bank from either cash in circulation, which doesn't fall under settlement balances, from another account at the bank, which also doesn't involve settlement balances or from an account at another bank, which may or may not required settlement balances depending on interbank netting. Cash in circulation is part of the monetary base so it could be said that the depositor is lending the bank base money. But this is a relatively small amount of deposits and is declining.

No base money passes from the depositor to the bank other than cash in circulation that is deposited. Settlement balances (bank reserves) only exist within the banking and payments system as vault cash and banks' balances at the cb.

Tom Hickey said...

y, who have you been reading? That sounds bonkers to me.

y said...

Tom,

"When a customer makes a deposit, the depositor is making a loan to the bank"

all bank deposits are a loan from the depositor to the bank.

Tell me what you think the depositor is loaning to the bank?

Neil Wilson said...

You are buying bank liabilities from the bank, much as you would buy a share certificate from the bank if you bought ordinary shares.

The peg to state money works in both directions.

If you draw bank liabilities they are converted into state money. If you deposit state money they are converted into bank liabilities.

Should the bank liabilities lose their peg to the original state (say you're in Scotland and they declare monetary independence), then you will get a conversion back in the new denomination.



Roger Erickson said...

Where have these people BEEN all these decades?

Trying to teach economics?

This is like watching a 10 yr old Luddite discover reality.

"What? You mean it exists?"

Nobody could have predicted this, right?

Ralph Musgrave said...

Ryan Harris starts, “While the MMT idea that banks create loans/deposits out of thin air….”. I have two text books for first year university economics courses written 15 years ago, and they both make that point, thus the above point is not specifically an MMT idea.

Likewise Positive Money and others of a similar persuasion claim the text books get it all wrong on banking. Far as I can see the text books get the above point right.

Tom Hickey said...

When a person makes a loan, the customer gets a credit to a deposit account that includes an obligation to settle that loan according to the terms. The deposit created by the loan is not a loan of base money to the bank. The bank has to get base money as needed to settle drafts on the deposit at its own expense. The profit it makes is on the spread, which only is realized as the loan is paid down.

When depositor makes a deposit not related to a loan, then the depositor is either depositing cash in circulation which is part of base money, or is depositing a draft on the same bank or another bank. The draft is a direction to the appropriate bank to settle the transaction, using settlement balances if required.

Settlement balances are base money. But the customer is not providing base money other than in depositing cash. The bank on which the draft is written has to supply the settlement balances as required after netting. Transactions that are netted don't require settlement in base money. No base money is involved.

Settlement balances in the payments system never leave the payments system other then through the withdrawal of cash at the window that converts vault cash into cash in circulation.

I think that difficultly here is confusing the unit of account as accounting entries and money things and thinking of settlement balances as money things rather than accounting entries.

Clonal said...

Tom,
A "Big Problem" would go away, if the bank could only book profit on a loan after the principal had been repaid, and not (as done today) when a loan is originated. The incentive to make fraudulent loans (liar loans) would be taken away.

Adam1 said...

While I whole heartedly agree that in aggregate a loan creates a deposit I think the wisest operational way to look at it is that you need to disaggregate the process of extending credit from the payment and deposit acceptance processes. If you really understand banking operations you'd notice these are all very different things for an individual bank.

If there was only one monopolistic bank then it's easy to see how a loan creates a deposit! That's the macro view everything else is just accounting and the management of interbank clearing and interbank trading risk (with a central bank, in essence, this is at par and zero risk).

When you go to the bank and ask for a loan; in reality what you are asking for is for a personal payment that exceeds your current ability to pay. The extension of credit is just the banks promise to CLEAR AND SETTLE that payment for you (the payment can be taken at the teller window, printed as a check accepted as a debit card transaction or what ever). How it does it is here nor there - the bank would rather you not even understand how it works (and oddly most bank employees don't even appreciate the details)! Whether it finds new deposits, borrows from the Central Bank (if it exists), issues new bank notes or new bank debt or spends down reserves/capital is also here nor there. Any bank that can't make those operations match up at the end of the day if either insolvent or borrowing at the central banks discount window (assuming it exists). The reason that banks ability to make LOANS CREATE DEPOSITS work is that someone on the other END IS WILLING TO ACCEPT the banks payment in lieu of yours which otherwise never would have occurred!!! It's the ACCEPTANCE of the payment that matters!!!

INDVIDUAL banks want deposits to draw onto their balance sheet CHEAP interbank tradable assets. Issuing new bank notes or any other interbank/system borrowing is more expensive than Central issued reserves (assuming that's a clearing option). Banks want deposits to lower their operating costs (and increase profit)! Not "fund" new loans! Note, that deposits at a minimum are "funding" the transactions of loans already made - PAST tense! Note... base or government money is NOT needed... the only thing needed is an acceptable asset to CLEAR AND SETTLE the transaction (it could be government money accepted at par (or if we get down to the nitty-gritty that doesn't even need to be accepted at par) or it could a bank note accepted at what ever its trading for or could be whatever the individual institutions agree to accept as INTERBANK risk-assets... since any profitable/revenue generating bank assets is risky!!!)

If you clearly and fully understand what I've tried to communicate is that... the extension of credit has nothing to do with the acceptance of deposits. Yes banks WANT DEPOSITS, but that is confusing correlation with causation! Once you disaggregate what's going on (to me) it becomes more clear.

Note, banks create deposits by lending with OR without government money!... they can do this with OR without a Central Bank...

...Banks can extend credit because someone on the other end of the transaction is willing to accept whatever they are offering as payment (for you as the borrower). That payment invariably becomes a deposit somewhere in the financial system. As Minky said, "anyone can create money; the problem is in getting it accepted." For banks the acceptance problem has been overcome! End of story!

Note, is a bank CAN'T get its interbank payments cleared and settled, its like me writing you a bad check! In today's world banks typically don't face those interbank clearing issues but don't confuse interbank clearing processes with loans create deposits! Those are different transaction processes!

y said...
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y said...

Tom,

"The deposit created by the loan is not a loan of base money to the bank"


A bank deposit is a bank debt. The bank owes money to the depositor. That's what a bank deposit means.

When the bank credits $100 to your deposit account, they are saying to you "we owe you $100".

If they paid you immediately, instead of owing you $100, they would pay you with cash. Then they wouldn't owe you $100 any more.

When you take a $100 loan from a bank, the bank credits $100 your account, i.e. they say to you "we owe you $100". They lend you $100, and simultaneously borrow $100 from you, the depositor.

Ryan Harris said...

Good point, Ralph, critics often express frustration about MMT falsely claiming ideas as it's own. It is probably arises in no small part because of reckless off hand blog comments like mine.

I'm not an expert in MMT or PK though that is no excuse.

Tom Hickey said...

When you take a $100 loan from a bank, the bank credits $100 your account, i.e. they say to you "we owe you $100". They lend you $100, and simultaneously borrow $100 from you, the depositor.

I would say that that a bank loan creates an asset (loan) and liability ( deposit) on the bank's balance sheet, and a corresponding asset (deposit) and liability (loan obligation) on the customer's balance sheet. The bank is obligated to provide base money on demand as required for settlement, and the customer is required to provide base money on schedule, either directly by cash or a draft drawn on the bank, indirectly through the payments system through another bank by a draft on that bank.

There is no base money involved in the loan creating a deposit. All that exists at the point of credit extension by marking up accounts through keystrokes is a settlement obligation that may involve base money at some points in the future, e.g., as the loan is drawn down and according to the repayment schedule.

Loans don't create base money and the deposit created by the loan doesn't involve the deposit of base money by either the bank or the customer.

y said...
This comment has been removed by the author.
y said...

"Loans don't create base money"

I understand that.

"a bank loan creates an asset (loan) and liability ( deposit)"

A liability is a debt. When a bank creates a deposit they go into debt to the depositor. This is why I say they borrow money from the depositor.

y said...

to make the process clearer, say it happened as follows:

1. A bank lends you $100. They hand you $100 in cash.

2. You immediately deposit the cash back into the bank (i.e. you lend the cash back to the bank).

3. The result is exactly what would have happened if the bank had just credited your account with a deposit, instead of going through the process of handing you cash and then taking it back again.

Adam1 said...

at y...

"1. A bank lends you $100. They hand you $100 in cash. 2. You immediately deposit the cash back into the bank (i.e. you lend the cash back to the bank)."

You are confusing correlation with causation!

Tom Hickey said...

Loans create deposits means that the bank and customer swap IOU's. The bank's IOU is more negotiable or liquid than a customer's IOU.

Most bank lending involves liquifying collateral. Banks land against capital and customers borrow against collateral in secured lending and against assets that are not protected in bankruptcy in unsecured lending.

No base money involved in creation of "bank credit money," I.e., no government IOU shows up in the transaction other than in the future payment obligations undertaken.

This is the endogenous creation of "bank money" or "credit money." As Adam 1 observes, it may or may not involve state money, which is different from bank money. Use of bank money in bank lending may require a bank to obtain state money, which it does not issue for settlement of its obligation. Banks obtain state money either by borrowing or from capital.

For example, when a customer writes a draft on a deposit account in payment of taxes, the customer's draft is entered on the bank's accounts. This is bank money. The bank is obligated to clear the draft on the customer's account in favor of the Treasury by settling in state money in the payments system in most countries using central banking. Repayment of loans by customers is similar, in that they don't involve state money when the settlement is netted intra-bank, for example, or in free banking.

Only bank money involved in netting. After inter-bank netting, settlement in state money may be required if there is a residual obligation.

Tom Hickey said...

1. A bank lends you $100. They hand you $100 in cash.

2. You immediately deposit the cash back into the bank (i.e. you lend the cash back to the bank).


What actually happens is that a bank extends a loan for 100 and credit a deposit of 100 to the customer's account using keystrokes. Then the bank debits the customer's account for 100 using keystrokes, and the customer receives 100 in cash, satisfying the bank's obligation to the customer. The customer deposits 100 in a deposit account in cash.

The customer has now loaned the bank 100, and the bank records (keystrokes) that as a credit to the customer's account. The bank has 100 in vault cash (transfer of customer asset to bank asset, and the customer has 100 recorded as a deposit in bank money, which is a 100 asset in bank money for the customer and 100 in bank money as a liability of the bank.

This is how it shows up on the customer's statement.

y said...

Adam,

"You are confusing correlation with causation!"

Huh? Please explain.

y said...

Tom,

"Loans create deposits means that the bank and customer swap IOU's. The bank's IOU is more negotiable or liquid than a customer's IOU."

IOU means 'I owe you'. A bank deposit is a debt. It means the bank owes you. What does it owe you? What specific thing does it owe you? What thing settles the debt that it owes you? Base money.

"the customer receives 100 in cash, satisfying the bank's obligation to the customer. The customer deposits 100 in a deposit account in cash. The customer has now loaned the bank 100"

You say that when you deposit $100 in cash and the bank credits a $100 deposit to your account, you have loaned $100 to the bank.

So if the bank just credits a $100 deposit to your account without any cash handling involved, you must also be loaning $100 to the bank. In both cases you have loaned base money to the bank, not some other sort of money.

Tom Hickey said...

What thing settles the debt that it owes you? Base money.

The bank has an obligation to settle iaw the customer's demand. Certain of these demand involves base money, like withdrawing cash at the window and settlement of obligations to the state like taxes that require settlement balances in the state's money. Many if not most transactions today settle through in bank money through netting. Base money never enters into the transaction in netting.

When a loan creates a deposit, bank money is created. Subsequently, the customer may demand that the bank convert this bank money to base money, or not.

y said...

"Many if not most transactions today settle through in bank money through netting. Base money never enters into the transaction in netting".

Netting just means cancelling offsetting debts. If bank A owes $100 in reserves to bank B, and bank B owes $90 in reserves to bank A, bank A simply pays the net $10, and all the debts are cancelled/ paid. The debts are STILL promises to pay reserves however, even though payment only involved a transfer of the net amount owed.

"the customer may demand that the bank convert this bank money to base money, or not"

Bank money is a debt, a promise to pay a specific amount of another form of money - base money. Bank money is redeemed for base money rather than 'converted' into base money. The bank's debt is paid when a deposit is redeemed.

Tom Hickey said...

y, it's clear that we are framing this from different points of view and no amount of discussion is going clear this up. Since we are arguing in terms of different frames, the "facts" are perceived differently. Where I see bank money, you see base money.

y said...

Tom,

do you agree that a bank deposit is a bank debt - that the bank is a debtor and the depositor is a creditor?

Adam1 said...

"You are confusing correlation with causation!"... y said, "Huh? Please explain."

For example... if you go to the bank and request a loan for $100, if its granted you can go and get cash from the teller what your missing is how is that cash "funded". You're assuming its funded with money on deposit but you DO NOT KNOW THAT! It could be funded by a line of credit from another bank, it could have been funded by a bank note it could have been funded by over drawing at the central bank their are lots of options! The extension of credit doesn't mean the extension of deposits it only mean the extension of liabilities and how they are "funded" are day to day banking operations subject to maximum profitability preferences with minimal future risks.

Dan Kervick said...

At the risk of being a jerk, it seems to me that most of this discussion is an illustration of why the question "Do banks led their reserves?" just isn't that significant. y and Tom both seem to be in broad agreement about the operations involved, and the constraints that do and do not affect those operations, but have a disagreement about the logico-semantical characterization of various aspects of those operations.

Tom Hickey said...

do you agree that a bank deposit is a bank debt - that the bank is a debtor and the depositor is a creditor?

I would put in terms of the accounting as I have above. Formalizing it in this way makes the issues clear.

Ordinary language is ambiguous, which is why technical language is used.

In these transactions, the accounting is double-entry in two sets of books.

y said...

Adam,

"You're assuming its funded with money on deposit but you DO NOT KNOW THAT!"

You've misunderstood my point. I'm not assuming that. All I'm saying is that bank deposits are bank debts so the bank is borrowing from the depositor. And I'm saying that the thing they are borrowing is base money. If the depositor calls in the debt, the bank will have to pay base money. I'm saying this is the case even if no cash acually changes hands between depositor and bank when the deposit is originally created.

y said...

Tom,

if you look through bank account terms and conditions, you'll see that many of them include the phrase "our account relationship with you is that of debtor and creditor".

Jose Guilherme said...

Since reserves are deposits of the commercial banks at the Fed (individuals not being allowed to hold deposits at the Fed) then it follows that, by definition, banks can´t lend reserves to the non-bank sector.

The important point to retain is that banks create deposits out of thin air - and deposits are a substantial part of "money".

The other part of "money" - much less substantial - is currency held by the public. Depositors are entitled to ask the bank to convert their deposits into currency - yet generally they prefer not to. However, depositors can´t ask that their deposits be converted into "reserves", because individuals aren´t allowed to hold "reserves" - i.e., deposits at the central bank.

y said...

Like this one:

Bank of America, Deposit Agreement and Disclosures, page 2:

"Our deposit relationship with you is that of debtor and creditor"

https://www.bankofamerica.com/deposits/resources/deposit-agreements.go

y said...

Jose,

reserves include deposits at the central bank and vault cash. So banks can give depositors reserves by giving them cash. However, when they are held by depositors they cease to be bank reserves.

Tom Hickey said...

if you look through bank account terms and conditions, you'll see that many of them include the phrase "our account relationship with you is that of debtor and creditor".

And what that translates as is, "the funds in your bank accounts are not held as a sequestered deposit or in a trust account, even if you deposit cash with us. Our capital is in position of first loss, but if your account exceeds the FDIC guarantee, then your deposit is also at risk in the event the bank becomes insolvent."

That is to say, if you deposit cash (base money), for example, it becomes bank money in your account and over the FDIC limit it is at risk of loss. Many people not only don't realize this but would be shocked to learn it. So it is in the fine print.

y said...

"Our deposit relationship with you is that of debtor and creditor"

translates as "we are borrowing money from you, the creditor, and the money belongs to us until you ask us to pay it back".

Tom Hickey said...

That's true and legally it puts the depositor on notice of being in the position of a creditor, which different from what a lot people think when they deposit money in the bank. They think that the bank is holding their money rather than their money being put at risk, with government taking on some that risk limited by the amount of the guarantee.

Bank money is inherently risky. State money is not.

The risk of holding cash is not that the government will become insolvent but that one will lose the money or be robbed of it. That was a big reason that people used to put money in banks rather than under the mattress or burying it in the yard. BTW, I do know people that bury gold in vaults on their property.

Now banking more a matter of convenience in making payments, and the monetary system is become increasingly a digital payments system where all transactions are entered by keystroking spreadsheets in real time.

Jose Guilherme said...

the monetary system is become increasingly a digital payments system where all transactions are entered by keystroking spreadsheets in real time

Let's hope the process will never be completed and that cash as a means of payment will be preserved.

Otherwise people will lose access to state money - and the government, as well as the banks, will be able to monitor each and every transaction of the common citizen.

An Orwellian nightmare under the guise of "technological progress". The usual suspects (see for instances recent pieces on the subject by K. Rogoff) are already salivating over a possible "abolition of cash".

Tom Hickey said...

As I read it, this is the (dystopian) plan. It will be justified as a way to deny funds to terrorists in order to "make the world a safer place." Who could be against that but terrorists?

y said...

Thanks James! I guess you must be rich, with lucky family name!

y said...

Jose,

"Otherwise people will lose access to state money"

that could be remedied by having central bank accounts available to everyone. Didn't Rogoff also suggest that as a possibility?