The argument is straightforward: in the English-speaking world, we no longer live in a world where traditional banking is the main mechanism for allocating credit. Banks may be all over the financial system, but that mainly is because regulatory changes collapsed the traditional distinctions between the various types of financial firms.* The reality is that non-bank finance ("shadow banking") is a dominant factor in shaping outcomes.
Simple ExampleMost bank primers focus on how the amount of deposits is unchanged despite the effect of most customer transactions, other than loans being granted("money creation" of mythology) or paid off.
But as soon as we get to "non-traditional" finance, this becomes murkier.
The easiest example to think of is the act of a bank selling a term deposit to a customer. For example, a customer withdraws $10,000 from a demand deposit account to purchase a $10,000 term deposit (e.g., CD in the US, GIC in Canada).
These term deposits are not included in narrow definitions of money ("M1") by most statistical agencies (?), but might show up in wider monetary aggregates. If we ignore those wide aggregates, the act of converting a demand deposit into a term deposit "destroys money."
Note that the bank is not deeply concerned by this; they are converting one source of funding (a demand deposit) into another (a term deposit). Under normal circumstances, the interest cost is greater, but that is traded off against locking in funding and probably reducing the duration risk of the bank. (Since the duration of assets will typically be longer than liabilities, terming out funding reduces the mismatch.) Banks offer term deposits for a reason.
Although there are obvious legal and operational differences between term deposits and a bond issued by a bank (e.g., eligibility for deposit insurance, put-ability, secondary market, funding cost), from a bank funding perspective, a pool of term deposits resembles a bond issue. This is a hint that bank bond issuance also "destroys money."
Slightly Modified ExampleImagine that a customer of Bank A buys a term deposit issued by Bank B (a situation that I think is more common in the United States).
What happens is that Bank A has an outflow in the payments system, and Bank B an inflow. If nothing else happened that day, Bank A would have to raise funds somehow. The easiest way to do this is to sell a financial asset -- and Bank B would be looking to buy a financial asset. In practice, we do not see such perfect matching, but rather something looking like equilibrium (!) with all buyers/sellers of liquidity matching up orders that clear by the end of the day.
The net result is that a demand deposit is destroyed ("money destroyed"), a "non-money" financial asset shows up on the non-bank aggregate balance sheet, and a financial instrument of some sort has moved from one bank to another.
(Thanks to cultural imperialism of American textbooks, this would be explained as a "reserve transfer." This is the worst possible way to explain what happens, and probably explains why there is considerable bewilderment about bank operations.)
Non-Bank Finance ("Shadow Banking")We now leap to the dreaded "shadow banking." It is a historical accident that term deposits are not considered non-bank finance, but in practice, banks issue debt instruments that are not deposits.
Imagine that Bank A issues $100 million debenture that is conveniently bought solely by entities that held deposits at banks.
- For deposits originally at Bank A, we get a destruction of deposits and issuance of a debt instrument that looks like the term deposit example.
- For deposits elsewhere, there are outflows from other banks (and matching inflows at Bank A). The net result is those deposits are destroyed, and financial assets get re-shuffled from the rest of the banking system to Bank A. (This is the mechanism by which banks build their liquidity position: they steal it from the rest if the system.) This resembles the second example.
The mythology that revolves around bank money creation completely ignores this effect. However, the movement by non-financial firms to hold financial assets that are not deposits forces the banking system to issue securities that are not deposits (bank debentures, money market instruments, securitisations to shrink the balance sheet). Any individual bank will see an ongoing outflow from its customers moving into "shadow bank" assets, and will be forced to issue securities to rebuild liquidity - at the expense of other banks' liquidity positions. As stock-flow consistent models emphasise, the financial assets outstanding have to match up with what is demanded by holders of financial assets (equilibrium again pops up in post-Keynesian theory (!)).
The only way to stop this would be for banks to form a cartel and not issue non-deposit securities. This would force the "law of conservation of deposits" to hold. Nobody would like this, particularly regulators, which is why this does not happen in the real world.
De-Mystifying Deposit LossWith this background out of the way, we can see why arguments that banks need to worry about deposits going to other banks in response to making loans is missing the point.
- For the banking system as a whole, "deposit transfers" are zero sum, and since most banks grow loan books near the average rate (otherwise, regulators get cross), the losses that occur due to "transfers" are negligible.
- There is a massive ongoing outflow of funds towards security holdings, which forces banks to issue debt instruments and securitisations. When housing markets boom in the United States and Canada, residential mortgage-backed security (RMBS) issuance goes through the roof. Any aggregate movement of funds by depositors towards fixed income securities will act as a drain on bank liquidity, which needs to be shored up.
The point is that banks cannot think about their liquidity position solely in terms of new loan origination; they need to react to the portfolio allocation decisions of customers, and shift their funding strategy to match.
Any discussion of real-world banking has to take into account actual conditions, which is where non-banks mainly hold non-deposit fixed income assets. Once we do this, we realise that building a mythology around banks is silly.
* In Canada, this was the "four pillar" system: chartered banks, insurance companies, trust companies, and investment dealers. Now, the megabanks do almost all of these activities under the umbrella of a single holding company (bank "corporations" are in fact a jumble of thousands of corporations, some of which are operating companies). Although there is a wistfulness for the "good old days," there is no way we can go back to that type of system without a total sea change in how we regulate the economy. Currently, entire professions are built around evading the economic intent of the law. Unless that ethos changes, trying to rebuild the pillar structure would fail.
(c) Brian Romanchuk 2019