No, Banks Produce Non Lend Reserves

This is a reply to an article yesteryear Nick Rowe, "Repeat later me: people cannot as well as practise non 'spend' money", inwards which he states that banks lend reserves. As tin live on guessed from the championship of my article, I disagree. But the deviation inwards sentiment is to a greater extent than nuanced than is suggested yesteryear the title. There is a skilful bargain of disinformation spread nearly banking on the internet, thence I intend this is an of import subject. I give an illustration of how liquidity constraints acquit upon the banking organisation - what matters for banks is the growth of their residuum canvas relative to the overall banking system, as well as non the absolute growth. Although this is fairly theoretical, it touches on the topic of the effectiveness of Quantitative Easing (spoiler: it isn't effective).

Justifying The "Banks Lend Reserves" View

In his article, Nick Rowe appears (justifiably) impatient amongst some of the intelligence of banking that floats roughly on the internet. Although some of this is based on disinformation that is spread yesteryear the "Fractional Reserve Lending is Fraud" crowd, some of it is based on exaggerated misreading of "endogenous money" theory (which is used yesteryear Modern Monetary Theory). Paul Krugman's burst nearly endogenous money appears to live on some other illustration of this frustration.

The key to understanding this sentiment is that nosotros cannot but aspect at aggregate banking organisation behaviour, nosotros demand to aspect at private banks. If in that location was solely a unmarried bank, it would human face upward almost no liquidity constraints. This is similar to but looking at the banking organisation inwards aggregate. But in that location are constraints on private banks, which should demo upward inwards aggregate behaviour.

It makes absolutely no deviation whether banks brand loans inwards the cast of currency or inwards the cast of creating demand deposits. An private banking firm that makes a loan of $100 yesteryear creating a deposit of $100 volition lose $100 of reserves to a minute banking firm when the borrower spends that $100 on a bike, as well as the cycle seller deposits the banking firm check inwards that minute bank. If the cycle seller volition solely create got currency, thence the showtime banking firm swaps $100 inwards reserves for $100 inwards currency, thence lends $100 currency to the borrower, the loss inwards reserves is immediate, rather than delayed yesteryear a twenty-four hr menses or two. But the goal final result is precisely the same. 

Let's cutting to the [mild profanity deleted] chase: banks lend reserves.

In other words, as banks lend, they should await the money to live on transferred to other banks or to cash, which implies a loss of reserves. They cannot completely ignore their liquidity position, different some to a greater extent than extreme positions yous read on the internet, inwards which banks tin but "print" money out of sparse air to comprehend liquidity losses.

Why This Is Literally Incorrect

Since I am inwards wide understanding amongst Modern Modern Theory, it is no surprise that I disagree amongst his disceptation ("banks lend reserves"), when taken extremely literally. And this is non but a interrogation of doctrine, nosotros tin encounter this inwards the data.

Firstly, I volition ignore the number of people withdrawing notes as well as coins ("currency") from banks. Under normal circumstances, changes inwards currency outstanding is non a major number (although in that location are seasonal effects, such as a lot of people taking out cash inwards guild to instruct partying betwixt Christmas as well as New Year's). If nosotros follow Minsky as well as analyse everything as a banking firm (and i should follow Minsky), these transactions tin live on interpreted as depositors transferring their cash to the primal banking firm - notes as well as coins tin live on viewed as a deposit at the primal banking firm inwards bearer form. (I am consolidating the primal banking firm amongst the primal government, which is the right agency to analyse the economy, fifty-fifty if it runs afoul of legalistic analysis of the primal bank.) The solely fourth dimension such withdrawals would affair is during a banking firm run. But inwards the modern era, generalised banking firm runs towards currency inwards sensibly run economies practise non happen, as well as thence it does non acquit upon observed behaviour.

For my example, I volition aspect at the "modern" Canadian banking system, which abolished the archaic required reserve organisation inwards the 1990s. Thus, it makes no feel to beak over "reserves" inwards Canada, rather i tin speak of deposits at the primal banking firm (the Bank of Canada).

As shown above, members of the Canadian Payments Association (which includes the banking system) create got dropped their deposits at the Bank of Canada to inconsequential amounts inwards 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 continue a modest positive residuum at the Bank of Canada, the target is to create got a $0 residuum at the goal of the day. (Note that if in that location is some miscalculation yesteryear a bank's treasury department, it tin borrow from the Bank of Canada to brand upward for whatever small town imbalance. Since such borrowing is at a modest penalization charge per unit of measurement - as well as it is discouraged yesteryear regulators - this is to a greater extent than oftentimes than non avoided.)

Therefore, the disceptation that "banks lend reserves" has to live on incorrect - Canadian banks create got lots of loans outstanding, but they create got no deposits at the Bank of Canada ("reserves").

(An additional request is that modern primal banks usually target* interbank short-term involvement rates. If a banking firm is brusque reserves, it tin ever borrow them inwards the marketplace at that rate, as well as the primal banking firm has no selection but to create them if in that location is a shortage. This is what happened inwards the pre-QE era inwards the United States.)

Banks Lend Against Liquid Assets

Influenza A virus subtype H5N1 to a greater extent than accurate characterisation of the province of affairs is to supplant "banks lend reserves" amongst "banks lend against liquid assets". If nosotros aspect at Canadian Chartered Banks, nosotros encounter that authorities securities (at all levels of government, non but Federal government) are typically nearly 10% of their Canadian dollar assets. (Note that the Canadian banks at nowadays create got large U.S. dollar subsidiaries, but those operations are run on a matched-currency basis. In other words, nosotros tin aspect at the Canadian-dollar denominated assets as well as liabilities inwards isolation.) These holdings provide the liquidity buffer that is used to insure against the loss of deposits. For example, if in that location was a withdrawal moving ridge leaving Bank Influenza A virus subtype H5N1 going to Bank B, this could live on met yesteryear Bank Influenza A virus subtype H5N1 selling authorities bonds as well as Bank B buying them.

If nosotros improve Nick Rowe's text inwards this fashion, in that location does non appear to live on much of a disagreement betwixt us. If in that location is, it is in all likelihood the final result of the fact that I practise non attach especial significance to "money" versus other governmental liabilities (treasury bonds as well as bills). Correspondingly, I attach a greater weight to financial policy (which determines the amount of authorities liabilities outstanding) than to monetary policy (which is the carve upward betwixt the monetary base of operations versus other governmental liabilities).

What Are The Behavioural Constraints?

It is clear that a banking firm cannot run downwards its holdings of governmental securities forever. As a result, I volition at nowadays outline what is the practical throttle for banking firm lending based on liquidity considerations (that is, ignoring banking firm upper-case missive of the alphabet constraints as well as borrower demand, both of which matter).

The province of affairs inwards the US is to a greater extent than complicated yesteryear the carve upward betwixt large money centre banks as well as the smaller banks. This creates structural imbalances betwixt sub-sectors of the banking system. So I volition beak over a province of affairs similar to that inwards Canada, where the banking scene is dominated yesteryear a modest number of players.

Imagine that in that location are 5 banks, as well as each has a 20% marketplace percentage inwards both banking firm deposits as well as lending (and for simplicity, in that location is no shadow banking system). The size of each bank's residuum canvas is a squeamish circular $100.

If i banking firm increases its loan mass yesteryear $10, nosotros await that:

• $2 would rest as a deposit at the same bank; and
• $2 would live on transferred to each of the other banks.

Therefore, if yous handgrip all else equal, it would demand to heighten $8 to comprehend the $10 inwards novel loans.

Of course, non everything else is equal. It volition have deposits from novel loans made yesteryear other banks. Since the other banks create got 80% of the marketplace percentage of total loans, that tin live on a lot.

If every banking firm increases its loan mass yesteryear $10, thence each banking firm would "lose" $8 of the novel deposits, but it would gain $2 from each of the other banks, netting out to no meshwork transfers betwixt the banks.

Therefore, all residuum sheets expand equally, as well as in that location is no demand to divulge "reserves" to finance that expansion. But the ratio of liquid property holdings relative to the total size of the residuum canvas would drop, as well as thence it is probable that the banks would demand to heighten their liquidity (somehow) to continue that ratio close target levels. But this is relatively small; if liquid assets are 10% of the residuum sheet, the banks would solely demand to heighten nearly $1 (1% of the residuum sheet) inwards guild to continue the liquid property ratio constant. If nosotros are inwards a province amongst required reserves, the primal banking firm would create got to create those reserves, which is a modest fraction of the increment inwards loans.

The key for a bank's liquidity seat is its deposit marketplace percentage versus its peers, too as its charge per unit of measurement of growth relative to the average. Influenza A virus subtype H5N1 banking firm that is growing faster than average, or has a smaller marketplace percentage of deposits than average, volition goal upward amongst a demand to heighten money inwards guild to finance its residuum canvas expansion. (Losses to "shadow banks" is an of import outcome inwards recent decades.) This financing tin either live on done via equity or bond (term deposit) issuance, or inwards the money markets. But as nosotros saw inwards the concluding cycle, financial institutions that financed their expansion using the money markets were vulnerable to runs yesteryear institutional investors. As a result, regulators frown upon expansion strategies that are non funded amongst deposits. (And if yous are a credit analyst, this is why yous should dislike apace growing financial companies, different equity analysts.)

In summary, liquidity considerations pose solely a express constraint on aggregate credit growth; rather the constraint is on relative residuum canvas expansion inside the banking system.

Relationship To QE

The practical determination of this analysis is that Quantitative Easing (QE) volition create got no impact on the banking system. From the request of sentiment of banks, it is but a modify of resources allotment inside liquid assets, as well as they create got no additional capacity to lend.

If in that location is an impact from QE, it results from provide as well as demand factors inwards the yield curve. I am extremely skeptical that this matters much, at to the lowest degree at the forepart goal of the curve. People toll the brusque goal off of expectations, as well as it is nearly impossible to notice provide as well as demand dynamics. For example, when a primal banking firm announces a surprise charge per unit of measurement hike, marketplace makers modify prices immediately, without whatever demand for securities to modify hands.

Footnote:

* Many economists would object to my phrasing here; what I am referring to is the fact that involvement rates are the target command variable for monetary policy for modern primal banks (excluding those pursuing QE policies). The objective is to purpose this policy variable to guide the economic scheme thence that the inflation target is hit. Since in that location is no guarantee that the primal banking firm volition live on able to forcefulness the interbank charge per unit of measurement to a desired level, I prefer to write that they target the involvement rate.

See Also:

• My article explaining inwards to a greater extent than especial why QE is pointless.
• Are banks special? Yes as well as No. Covers some similar dry reason on the banking system.   
• (UPDATE) Nick Edmonds responds as well as asks "If Banks Do Not Lend Reserves, What Do They Lend?". In it, he discusses the distinctions betwixt different types of lending, such as safety lending.
• (UPDATE) Neil Wilson illustrates the distinction betwixt an 'in specie' (e.g., "full reserve") banking organisation as well as an 'insured' banking system. 

(c) Brian Romanchuk 2014