Justifying The "Banks Lend Reserves" View
In his article, Nick Rowe appears (justifiably) impatient with some of the discussion of banking that floats around on the internet. Although some of this is based on disinformation that is spread by the "Fractional Reserve Lending is Fraud" crowd, some of it is based on exaggerated misreading of "endogenous money" theory (which is used by Modern Monetary Theory). Paul Krugman's outburst about endogenous money appears to be another example of this frustration.
The key to understanding this view is that we cannot just look at aggregate banking system behaviour, we need to look at individual banks. If there was only a single bank, it would face almost no liquidity constraints. This is similar to just looking at the banking system in aggregate. But there are constraints on individual banks, which should show up in aggregate behaviour.
It makes absolutely no difference whether banks make loans in the form of currency or in the form of creating demand deposits. An individual bank that makes a loan of $100 by creating a deposit of $100 will lose $100 of reserves to a second bank when the borrower spends that $100 on a bike, and the bike seller deposits the cheque in that second bank. If the bike seller will only accept currency, so the first bank swaps $100 in reserves for $100 in currency, then lends $100 currency to the borrower, the loss in reserves is immediate, rather than delayed by a day or two. But the end result is exactly the same.
Let's cut to the [mild profanity deleted] chase: banks lend reserves.In other words, as banks lend, they should expect the money to be transferred to other banks or to cash, which implies a loss of reserves. They cannot completely ignore their liquidity position, unlike some more extreme positions you read on the internet, in which banks can just "print" money out of thin air to cover liquidity losses.
Why This Is Literally Incorrect
Since I am in broad agreement with Modern Modern Theory, it is no surprise that I disagree with his statement ("banks lend reserves"), when taken extremely literally. And this is not just a question of doctrine, we can see this in the data.
Firstly, I will ignore the issue of people withdrawing notes and coins ("currency") from banks. Under normal circumstances, changes in currency outstanding is not a major issue (although there are seasonal effects, such as a lot of people taking out cash in order to go partying between Christmas and New Year's). If we follow Minsky and analyse everything as a bank (and one should follow Minsky), these transactions can be interpreted as depositors transferring their cash to the central bank - notes and coins can be viewed as a deposit at the central bank in bearer form. (I am consolidating the central bank with the central government, which is the correct way to analyse the economy, even if it runs afoul of legalistic analysis of the central bank.) The only time such withdrawals would matter is during a bank run. But in the modern era, generalised bank runs towards currency in sensibly run economies do not happen, and so it does not affect observed behaviour.
For my example, I will look at the "modern" Canadian banking system, which abolished the archaic required reserve system in the 1990s. Thus, it makes no sense to discuss "reserves" in Canada, rather one can speak of deposits at the central bank (the Bank of Canada).
As shown above, members of the Canadian Payments Association (which includes the banking system) have dropped their deposits at the Bank of Canada to inconsequential amounts in recent years. (There was a spike during the financial crisis, when nobody trusted private sector short-term debts.) Although such institutions appear to prefer to keep a small positive balance at the Bank of Canada, the target is to have a $0 balance at the end of the day. (Note that if there is some miscalculation by a bank's treasury department, it can borrow from the Bank of Canada to make up for any settlement imbalance. Since such borrowing is at a small penalty rate - and it is discouraged by regulators - this is generally avoided.)
Therefore, the statement that "banks lend reserves" has to be wrong - Canadian banks have lots of loans outstanding, but they have no deposits at the Bank of Canada ("reserves").
(An additional point is that modern central banks normally target* interbank short-term interest rates. If a bank is short reserves, it can always borrow them in the market at that rate, and the central bank has no choice but to create them if there is a shortage. This is what happened in the pre-QE era in the United States.)
Banks Lend Against Liquid Assets
If we amend Nick Rowe's text in this fashion, there does not appear to be much of a disagreement between us. If there is, it is probably the result of the fact that I do not attach particular significance to "money" versus other governmental liabilities (treasury bonds and bills). Correspondingly, I attach a greater weight to fiscal policy (which determines the amount of government liabilities outstanding) than to monetary policy (which is the split between the monetary base versus other governmental liabilities).
What Are The Behavioural Constraints?
It is clear that a bank cannot run down its holdings of governmental securities forever. As a result, I will now outline what is the practical limit for bank lending based on liquidity considerations (that is, ignoring bank capital constraints and borrower demand, both of which matter).
The situation in the United States is more complicated by the split between large money centre banks and the smaller banks. This creates structural imbalances between sub-sectors of the banking system. So I will discuss a situation similar to that in Canada, where the banking scene is dominated by a small number of players.
Imagine that there are five banks, and each has a 20% market share in both bank deposits and lending (and for simplicity, there is no shadow banking system). The size of each bank's balance sheet is a nice round $100.
If one bank increases its loan book by $10, we expect that:
- $2 would remain as a deposit at the same bank; and
- $2 would be transferred to each of the other banks.
Therefore, if you hold all else equal, it would need to raise $8 to cover the $10 in new loans.
Of course, not everything else is equal. It will receive deposits from new loans made by other banks. Since the other banks have 80% of the market share of total loans, that can be a lot.
If every bank increases its loan book by $10, then each bank would "lose" $8 of the new deposits, but it would gain $2 from each of the other banks, netting out to no net transfers between the banks.
Therefore, all balance sheets expand equally, and there is no need to find "reserves" to finance that expansion. But the ratio of liquid asset holdings relative to the total size of the balance sheet would drop, and so it is likely that the banks would need to raise their liquidity (somehow) to keep that ratio near target levels. But this is relatively small; if liquid assets are 10% of the balance sheet, the banks would only need to raise about $1 (1% of the balance sheet) in order to keep the liquid asset ratio constant. If we are in a country with required reserves, the central bank would have to create those reserves, which is a small fraction of the increase in loans.
The key for a bank's liquidity position is its deposit market share versus its peers, as well as its rate of growth relative to the average. A bank that is growing faster than average, or has a smaller market share of deposits than average, will end up with a need to raise money in order to finance its balance sheet expansion. (Losses to "shadow banks" is an important effect in recent decades.) This financing can either be done via equity or bond (term deposit) issuance, or in the money markets. But as we saw in the last cycle, financial institutions that financed their expansion using the money markets were vulnerable to runs by institutional investors. As a result, regulators frown upon expansion strategies that are not funded with deposits. (And if you are a credit analyst, this is why you should dislike rapidly growing financial companies, unlike equity analysts.)
In summary, liquidity considerations pose only a limited constraint on aggregate credit growth; rather the constraint is on relative balance sheet expansion within the banking system.
Relationship To QE
The practical conclusion of this analysis is that Quantitative Easing (QE) will have no impact on the banking system. From the point of view of banks, it is just a change of allocation within liquid assets, and they have no additional capacity to lend.
If there is an impact from QE, it results from supply and demand factors in the yield curve. I am extremely skeptical that this matters much, at least at the front end of the curve. People price the short end off of expectations, and it is nearly impossible to detect supply and demand dynamics. For example, when a central bank announces a surprise rate hike, market makers change prices immediately, without any need for securities to change hands.
* Many economists would object to my phrasing here; what I am referring to is the fact that interest rates are the target control variable for monetary policy for modern central banks (excluding those pursuing QE policies). The objective is to use this policy variable to guide the economy so that the inflation target is hit. Since there is no guarantee that the central bank will be able to force the interbank rate to a desired level, I prefer to write that they target the interest rate.
- My article explaining in more detail why QE is pointless.
- Are banks special? Yes and No. Covers some similar ground on the banking system.
- (UPDATE) Nick Edmonds responds and asks "If Banks Do Not Lend Reserves, What Do They Lend?". In it, he discusses the distinctions between different types of lending, such as security lending.
- (UPDATE) Neil Wilson illustrates the distinction between an 'in specie' (e.g., "full reserve") banking system and an 'insured' banking system.
(c) Brian Romanchuk 2014
There are a number of ways in which QE might have an effect on the economy. In my view, these apply to various degrees, although none is very strong. It should also be borne in mind that some of them have the opposite effect, in that they are deflationary.ReplyDelete
As regards QE and banks, I would tend to agree that creating excess reserves cannot directly lead to additional lending (in fact, I suspect there is a small reflux effect), unless it works through reducing the interbank rate. This won't apply at the ZLB or with interest on reserves.
However, I think there is another angle (unrelated to the lending of reserves issue). Post crisis, some of the main factors inhibiting bank lending were low capitalisation ratios and a high cost of term funding. One of the less controversial effects of QE is that it raises asset prices, including equity and private sector debt. This probably includes that of banks. It is quite possible therefore that QE made it easier for banks to repair their balance sheets than would otherwise be the case. I have no idea how much effect this might have had and I've not attempted to assess it, but it seems to me to be much more likely than the money multiplier type stories.
The purchase of risky assets -qualitative easing - had a big effect due to the stabilisation of asset prices. So that is line with your point. The policies I view as being more ineffective are the continued purchases we see now, when stock markets are at record highs, and spreads near record lows.Delete
The bull market in risky assets could be the result of QE (and the lower term interest rates), but it is also possible that this is just an excuse that has been latched upon by commentators to explain the bull market that would have happened anyway.
I'll admit my focus here has been a little bit more on the UK, but the BoE at least believe that gilt purchases also had knock-on effects on private issue securities (see page 206 in http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb110301.pdf). Obviously, they have some interest in talking up the success of the programme, but I think there are good theoretical grounds why this should be correct (although the extent is very hard to estimate). Interestingly, they don't place much store by the bank lending effect (see page 202 of the same document).Delete
I think I'd tend to agree with you though that the impact is likely to be much less outside of stressed markets.
"But the ratio of liquid asset holdings relative to the total size of the balance sheet would drop, and so it is likely that the banks would need to raise their liquidity (somehow) to keep that ratio near target levels. But this is relatively small; if liquid assets are 10% of the balance sheet, the banks would only need to raise about $1 (1% of the balance sheet) in order to keep the liquid asset ratio constant. If we are in a country with required reserves, the central bank would have to create those reserves, which is a small fraction of the increase in loans."
If the central bank didn't create those reserves, what would happen? Would the interbank interest rate rise? If so, would it keep rising indefinitely until total bank deposits were reduced?
The details would vary in different banking systems, but I will describe what happened in the U.S. (before QE created a huge amount of excess reserves).Delete
The required reserves were calculated based on deposits (of the categories that need reserves) of a prior accounting period (2 weeks earlier?). The banks would then have to hit that reserve target in the current period (although I believe that banks only needed to comply with reserve requirements on a rolling basis, so they could be short reserves in a period as they could make it up in a later period). They would normally attempt to source those reserves in the interbank market (although they could use other money market instruments, but they would just be an alternative to trading reserves).
If the central bank did not create enough required reserves, the banks would presumably bid up the value of reserves to infinity (the effective fed funds rate would be arbitrarily large). Since the Fed wants to keep the effective fed funds rate near its target, it is forced to do open market operations to create those reserves.
The accounting lag means that banks can do nothing other than borrow reserves (or take part in open market operations) to meet reserves requirements in the current period. It is too late to reduce lending/deposits, as that would only take effect in the next period.
This accounting lag made the implementation of "Monetarism" impossible. Although the Fed wanted to have money supply targets, they were forced to adjust interest rates in order to attempt to influence future required reserves; they had no choice but to ratify the previous period's required reserve demand. After doing this for awhile, they gave up.
I am working from memory here. It is likely that this is covered by Warren Mosler, or by other MMT authors. For the discussion of the problems with the implementation of Monetarism, there was a well-known paper written by somebody whose name I have forgotten. I cannot seem to find my copy, unfortunately.
"for the discussion of the problems with the implementation of Monetarism, there was a well-known paper written by somebody whose name I have forgotten."Delete
maybe someone else remembers the name? It would be very useful...
Thanks for the explanation.
A bank that is expanding often gets scale economies that allow it to attract deposits away from smaller weaker competitors.Delete
If the system is short of reserves then the smaller weaker competitors have to run down their loan book (call in loans, stop issuing new ones) to get their deposit drain under control.
So if you have a system where the required reserves are tight, you can end up with an oligopoly very quickly indeed.
And that is what happened in the UK building society sector prior to deregulation.
Bank deposits are loans of base money to banks by depositors. As such, it seems reasonable to say that banks do indeed lend reserves, but they simultaneously borrow reserves from depositors.Delete
When a bank makes a loan and creates a deposit, the loan is a loan of reserves to the borrower, and the deposit is a loan of reserves from the depositor to the bank. As such no reserves actually need to exist at that point.
"So if you have a system where the required reserves are tight, you can end up with an oligopoly very quickly indeed."
My example with only 5 big banks wasn't just a numerical convenience - Canada is already in oligopoly territory. (Although there are some small credit unions, and Caisse Populaires in Quebéc - similar to building societies in the UK. We tend to lose a few of those when the business/housing cycle turns down.)
The paper "Interest Rates and Fiscal Sustainability" by Scott Fullwiler discusses this (I have a link to this paper in my next post). One reference he gives is:Delete
Meulendyke, Ann-Marie. 1998. Financial Markets and Monetary Policy, 2nd Edition. New York: Federal Reserve Bank of New York.
I agree that "banks lend against liquid assets" is a better way to describe bank lending. However, the quality of the liquid assets is an issue that warrants further investigation.ReplyDelete
At first glance, it would appear that all deposits are equal, making all liquid assets identical. After all, money should be money.
In reality, we have two broad groups of borrowers, private and government. Private borrowers are attended by considerable risk but government borrowing is considered extremely safe. Both groups are expected to repay their loans but, historically, governments repay loans by taking on new loans.
With this background in mind, we can see that if the bank loans are to private borrowers, the resulting deposits are more likely to be temporary than if the bank loans are to government. This gives rise to a quality difference in deposits that can only be measured by loan analysis. If the deposits are the result of private loans, then the entire deposit base is subject to private borrowing risk and volatility. If the deposits are the result of government loans, the entire deposit base is subject to government based monetary decisions.
In summary, deposits in banks are the result of both private borrowing and government borrowing with private borrowing and resulting deposits likely to be volatile due to repayment expectations..
As an individual entity, I'd agree that private sector loans are subject to repayment. But on a loan book basis, the amounts outstanding are more stable.Delete
And Governments can run surpluses periodically (particularly sub-sovereigns, like the Canadian Provinces). Also, non-banks want to hold government bonds to stabilise their securities portfolios. (As investors re-discovered the hard way in the financial crisis.) This means that the supply of government bonds available to banks will rise and fall as well.
Say I lend you a $10 note, and you simultaneously lend it back to me. Neither of us needs to have a $10 note on us at the time, for both loans to take place. This doesn't mean that I haven't lent you a $10 note though, does it?
I think "banks don't lend reserves" is contentious because people interpret it as meaning "banks don't lend base money". It might be clearer to say something like "banks lend base money, but they don't need to have base money on hand (i.e. reserves) to make loans."Delete
"Say I lend you a $10 note, and you simultaneously lend it back to me. Neither of us needs to have a $10 note on us at the time, for both loans to take place. This doesn't mean that I haven't lent you a $10 note though, does it?"Delete
We can always make loans which are denominated in (insert country) dollars (as opposed to another unit of account, such as yen) as you state. But these are not "base money" (deposits at the central bank, or state-issued currency) - unless we want to use counterfeit currency.
As long as we are happy with our IOU's, we can use them interchangeably with government defined money, or settlement via the banking system. (The banking system has legal privileges, such as the fact that bank cheques can be used to settle debts.) But if there is a legal dispute, debts normally have to be discharged with "state authorised" money (including bank transfers), unless the contract entered into specifies another settlement mechanism.
To follow up my previous point, this comes up with account receivables. Firms rarely pay cash up front for products and services; they will make the purchase on credit. The supplier can often borrow against such loans ("factoring" or rediscounting), so these loans act as a money market instrument. But my understanding is that these receivables will eventually be discharged via transfers in the banking system.Delete
Therefore, the initial credit creation is done outside the banking system, but it is settled within the banking system.
"We can always make loans which are denominated in (insert country) dollars (as opposed to another unit of account, such as yen) as you state. But these are not "base money" (deposits at the central bank, or state-issued currency) - unless we want to use counterfeit currency."Delete
If a loan is denominated in dollars, is the borrower not ultimately promising to pay the lender cash (or central bank deposits)?
Another of the key MMT points is that we all create money all the time. Every time you pick up an item at the store you've created money. How do you know that. Try walking out of the store with the item, at which point the store will call in their loan and stop you.Delete
You can only walk out of the store with the item when you have swapped that loan you owe to the store for a loan you have outstanding with somebody else that the store also finds acceptable.
We live by exchanging liabilities with each other. Perhaps if we started called them 'favours' rather than debt people would get it?
"If a loan is denominated in dollars, is the borrower not ultimately promising to pay the lender cash (or central bank deposits)?"Delete
In finance, there are things like securities loans, where the repayment is in the form of securities, and people can deposit securities against margin calls. The shadow banking system attempts to minimise the use of formal banking system cash.
But yes, normally, loans are assumed to be paid back by cash - but "cash" does include the use of bank transfers/cheques.(The bank will need to transfer settlement balances ("reserves") if the recipient's account is with another bank, so ultimately "reserves" may be needed.)
The role of legal tender laws is to specify how debts can be discharged. Although gold fans think legal tender laws were implemented to create a monopoly for fiat money, they were actually introduced to protect small traders from powerful interests who tried forcing people to accept commodities to repay debt. (For example, large tobacco farmers would try to dump tobacco on merchants to repay their receivables when there was a glut of tobacco on the market.) That is why there are laws on how loans can be normally discharged.
"Another of the key MMT points is that we all create money all the time. Every time you pick up an item at the store you've created money. How do you know that. Try walking out of the store with the item, at which point the store will call in their loan and stop you.Delete
We live by exchanging liabilities with each other. Perhaps if we started called them 'favours' rather than debt people would get it?"
Agreed. That is one reason I like Minsky's tack of analysing all economic entities as if they were banks, The only thing that separates "banks" from "non-financial" businesses is that the banking system has various legal privileges.
It's important to note the limiting factor - which is the depth and width of the discount window.
If you shape a bank according to that system, then that is the default bank in an economy. Any bank that can lend out at a margin sufficient to cover the cost of it going to the discount window (and having sufficient equity/bank bonds to cover the haircut) can survive.
What happens during an emergency is that banks start to change from their current shape towards the shape dictated by the size and width of the discount window. So they call in loans, push bank bonds, raise equity, increase loan prices, etc to try and stem collapse.
That is the key point that MMT makes and that others misinterpret. Banks can always lend at a price where they can get sufficient clearing reserves from at the discount window to make a profit. And if an economy starts to degrade into crisis, then the discount window will have to change to come to where the banks are (generally it gets wider and deeper as the crisis continues) - or you will get a credit crunch.
And that is what we have seen. So there is no effective control function from running the banks in the current configuration. When the chips are down the system becomes unstable, all the interbank floods to deposits at the central bank and the central bank has to step in to put out the fires by widening and deepening its discount facilities.
So as Mosler says, why not just make the discount window the size and shape you need it to be and leave it there. That way you avoid all the pain during a problem period, when there is clearly no gain to be had at any other time.
Well, bankers only remember that limiting factor during a crisis; my example was more of a steady state growth situation.Delete
Minsky argued it was somewhat of a policy error for the Fed to move to open market operations from its previous policy of supplying reserves via the discount window. This meant that the central bank lost touch with the banking system, and it only finds out what the private sector is up to during a crisis. This relates to Mosler's argument. I thought I wrote about that topic already, but it looks like it was just a planned article.
"If every bank increases its loan book by $10, then each bank would "lose" $8 of the new deposits, but it would gain $2 from each of the other banks, netting out to no net transfers between the banks."
If all 5 Canadian banks sat down at a table together and discussed whether or not they should all increase their loans by 10% across the board, they would not worry about their reserve position (ignoring currency drain etc.). Each bank would gain as much as it lost. But they don't do that. Each Canadian bank makes an individually profit-maximising decision.
If all 35 million Canadians sat down at a table together and discussed whether or not they should all increase their spending by 10% across the board, they would not worry about their incomes (ignoring taxes, imports etc.). Each Canadian's income would rise by 10% too. But they don't do that. Each Canadian person makes an individually utility-maximising decision.
In both cases, we need to look at the constraints on individuals in order to understand their choices, as well look at how those constraints may be very different for the system as a whole. Only if we think that banks operate as a cartel can we say that "banks don't lend reserves".
Hello, thanks for the response.Delete
I wanted to explain my point without using equations, so I gave a couple of simplified cases. I should have possibly written my examples as two extremes: (a) Bank A increases by 10%, and none of the other banks increase their loan book (80% reserve loss) and (b) Bank A increases by 10%, which is the same as the other banks (0% reserve loss). The key is the relative rate of expansion of the balance sheet.
Almost all lending decisions are too small to create an appreciable incremental impact on their balance sheets. (If a home buyer in Vancouver walks into a Schedule 1 bank for a $1 million loan, the bank officer does not have to have an emergency discussion with the Treasury operations team to see if that is possible.) Loans are managed on a book basis.
A well-run bank should have a rough idea whether it is attempting to grow its loan book faster than its deposit book, and the officers should have a rough idea how growth rates are changing across the cycle, which are relatively stable (outside of recessions). A relatively conservative bank would be able to steadily expand its loan book without spending much time worrying about its liquidity position. It's only the high fliers that should be worrying about their liquidity position. Therefore, the liquidity constraint is a relative growth story.
But as I tried to emphasise, my objection to "Banks lend reserves" is largely semantic. An expanding bank just has to make sure it has an adequate ratio of liquid assets - like T-Bills - and it will worry about settlement balances only when the need arises ("lending _against_ liquid assets"). Since Treasury Bills are not normally classified as "money" (although I see a very small distinction between TBills and "money"), they would not be classified as "reserves".
"Only if we think that banks operate as a cartel can we say that "banks don't lend reserves"."Delete
They operate as a cartel in a manner of speaking, because they signal the central bank via their actions.
Banks do not lend reserves. The reserves are backfilled as a consequence of the net transfers.
For funds to move to another bank, the default position is for the target bank to take your place at the originating bank. In other words, by default, to accept the transfer the target bank has to become a creditor of the originating bank.
You simply cannot transfer unless this swap is enabled by the system. Putting a central bank in the way is merely a way of facilitating that swap in a de-risked manner - because everybody trusts the central bank.
Overnight lending is only really required from the central bank when the other banks want to hold reserve deposits at the central bank and therefore send the system short of reserves.
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