Zoltan Jakab & Michael Kumhof — Banks are not intermediaries of loanable funds – and why this matters

Problems in the banking sector played a critical role in triggering and prolonging the Great Recession. Unfortunately, standard macroeconomic models were initially not ready to provide much support in thinking about the role of banks. This has now changed, with many new papers that study the interaction of banks with the macroeconomy. However, as emphasized by Adrian, Colla and Shin (2013), there are many unresolved issues. In our new paper “Banks Are Not Intermediaries of Loanable Funds – And Why This Matters” (Jakab and Kumhof (2015)), we argue that many of them can be traced to the fact that virtually all of the newly developed models are based on the intermediation of loanable funds (ILF) theory of banking. 

In the simple ILF model, bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers. Lending starts with banks collecting deposits of real resources from one agent, and ends with the lending of those resources to another agent. In the real world, however, banks never intermediate real loanable funds, an activity that, correctly understood, can only amount to barter. 

Rather, the key function of banks is the provision of financing, meaning the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor. Specifically, whenever a bank makes a new loan to a non-bank customer X, it creates a new loan entry in the name of customer X on the asset side of its balance sheet, and it simultaneously creates a new and equal-sized deposit entry, also in the name of customer X, on the liability side of its balance sheet. The bank therefore creates its own funding, deposits, through lending. It does so through a pure bookkeeping transaction that involves no real resources, and that acquires its economic significance through the fact that bank deposits are any modern economy’s generally accepted medium of exchange. 

This understanding of the function of banks, which we will refer to as the financing and money creation (FMC) model, has been repeatedly described in publications of the world’s leading central banks—see McLeay, Radia and Thomas (2014a,b) for an excellent summary. What has been challenging is the incorporation of these insights into macroeconomic models....

To summarize, banks are not intermediaries of real loanable funds, they do not collect new deposits from non-bank savers. Instead they provide financing, they create new deposits for their borrowers. This involves the expansion or contraction of gross bookkeeping positions on bank balance sheets, rather than the channelling of real resources through banks. Replacing intermediation of loanable funds models with financing and money creation models is therefore necessary simply in order to correctly represent the role of banks in the macroeconomy. But it also addresses several of the empirical problems of existing banking models.

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Banks are not intermediaries of loanable funds – and why this matters
Zoltan Jakab & Michael Kumhof