Anyone who has taken ECON1000 has probably seen the simple model of how banks create money in a fractional-reserve banking system, and how an increase in reserves creates a multiple expansion of loans and the money supply. An alternative approach, cogently argued in comments here by JKH, says that it is bank capital, not reserves, that plays the crucial role. I think there may be some truth in what JKH says, especially at present, but it is not the whole truth. I'm going to lay out what i believe. Others can either learn from what I say, or try to help me learn where I might be wrong (or maybe even both).
Let's start with the simplest textbook story.
Bank deposits are money, by assumption. Each bank desires to keep (say) 10% reserves against deposits, either to cover liquidity risks, or because it is required to by law, or a bit of both. Bank capital is irrelevant. Start in equilibrium, where reserves are 10% of deposits at every bank. Now assume the central bank does something that causes each bank's reserves to increase by $10. Each bank now has $10 excess (undesired) reserves. In the first round, each bank increases the supply of loans and deposits by $10. It does not increase loans and deposits by $100 immediately, because it anticipates that when the deposit is spent, it will be re-deposited in another bank, so it will lose $10 in reserves. (The textbook story implicitly assumes that each bank is small relative to the whole banking system, and is looking for the Nash equilibrium.) But in aggregate, of course, there is no loss of reserves. If all banks are doing the same thing, each bank finds it gains as many reserves and deposits as it loses (absent a currency drain, of course). So with deposits and reserves both $10 higher than in the original equilibrium, each bank now has $9 excess desired reserves, so it increases loans and deposits again…
In the new equilibrium, deposits (the money supply) expands by 10 times (1/10%) the increase in reserves. That's the simplest textbook story. (OK, I've told it slightly differently from the textbook, by assuming all banks get the extra $10 reserves, rather than just one bank. That helps me think about the symmetric Nash equilibrium.)
Now let me give a totally different theory. It's one I just thought up this morning. Initially it was just a thought-experiment to help get my head clear. But then I wondered if there might be some truth to it after all. I call it the "Loan Officer Theory of Money Supply".
Forget reserves. Banks don't need reserves to make loans; they need loan officers to manage those loans. The desired reserve ratio is probably zero anyway, and doesn't matter. What matters is the ratio of loans to the loan officers who are needed to manage those loans. Assume, given an average turnover and complexity of loans, that one loan officer can manage a $10 million loan portfolio.
Start in equilibrium, with the desired ratio of loans to loan officers. If the central bank increases the supply of reserves, that does nothing to the money supply. The extra reserves just sit there. Banks won't increase loans with the same number of loan officers. But an increase in the number of loan officers, one per bank, would increase loans by $10 million per bank, and would also increase the money supply by $10 million per bank.
It's the supply of loan officers, and the desired ratio of loans to loan officers, that determine the supply of loans and money.
What's wrong with the loan officer theory? Absolutely nothing, provided we make explicit some assumptions. The first assumption is that the banking technology has fixed proportions between loans (the output good) and loan officers (one of the inputs). There is zero substitution between loan officers and other inputs. This means that banks' demand curves for composite other inputs, holding the quantity of loan officers fixed, is perfectly inelastic when loan officers are fully employed. The second assumption is that the market supply curve of loan officers is perfectly inelastic. Given these two assumptions, and change in the price or availability of any other input (like reserves, or capital) will have no effect on the quantity of loans, and so no effect on the money supply.
But if we relax either of those two assumptions, the supply of loan officers to the industry will no longer be the sole determinant of the supply of loans and money. A fall in the price (or increased availability) of other inputs will cause banks to expand loans by using more other inputs per loan officer, or hire more loan officers (pushing up wages along their supply curve) to make more loans.
You can see where I'm going with this. Here's the Bank Capital Theory of Money Supply.
Forget reserves and loan officers. What matters is the ratio of capital to loans. Assume banks desire (or are required by law, or both) to have capital equal to 10% of their loans. Then the money supply is 10 times bank capital. A fall in the price, or increased availability, of reserves (or loan officers) will have no effect on the money supply. But an increase in banks' capital will cause a tenfold increase in loans and the money supply.
Again, this assumes that there are fixed proportions between loans and capital. And it assumes the supply curve of bank capital is perfectly inelastic. Relax either of those two assumptions, and a fall in price or increased availability of other inputs will cause an increase in the supply of loans and money. If banks can vary the loan/capital ratio, by varying the average riskiness of their loan portfolio (at the expense of lower returns or greater loan management costs of course) then the model fails. Or, if banks can all raise more capital, perhaps at a higher price, the model fails.
The Loan Officer and Bank Capital models fail except under extreme assumptions. But that's not surprising. All simple models fail. That doesn't mean they contain no truth. The supply of bank capital, and the supply of loan officers, will affect the supply of loans and the supply of money, other things equal. And perhaps their effect is more important in the current recession than normally. Bank capital is certainly important now, but has been discussed by others. But maybe, just maybe, my Loan Officer model contains more truth than normal as well. If there have been large structural changes in the demand for loans, so that loan management is now much harder to do, and in greater demand than normal, then perhaps the supply of experiences loan officers does matter much more than normal. (Sound plausible, bankers?)
But, but, but. Why all the emphasis on the supply of reserves, if reserves are just one of many inputs? And more importantly, are reserves really an input?
Let me tackle the second question first. Are reserves really an input in the production by banks of loans and money?
Yes, and no. At the level of the individual bank, reserves are certainly an input at the margin; and rational individuals and banks make choices at the margin. At the level of the banking system as a whole, reserves aren't an input (or, are only r% of an input with an r% desired reserve ratio, and I am quite happy to let r go to zero).
Suppose the desired reserve ratio is zero, for simplicity. An individual bank that makes a new $100 loan, by crediting the borrower's chequing account $100, knows that the borrower will spend the loan, and if his cheque is cashed at another bank, the first bank will lose $100 reserves. If it doesn't have $100, it will need to borrow $100 reserves. That's a required input, and that input has a cost. The cost is the interest rate at which it could borrow reserves, or, in an opportunity cost sense, the interest rate at which it could have lent its own reserves. So the interest rate on reserves is a marginal cost of an input to the individual bank, and affects its supply of loans in exactly the same way that the marginal cost of capital and the marginal cost of loan officers affects its supply of loans.
It simply does not matter to the individual bank's decision, in Nash equilibrium, where it chooses its own quantity of loans taking other banks' quantities of loans as given, that there is no loss of reserves to the banking system as a whole. It's maximising its own profits, not those of the whole banking system. It does not internalise the externality of the fact that its reserve loss is another bank's reserve gain.
So the price and availability of reserves matters, at the margin, for an individual bank's decision, in exactly the same way that the cost of loan officers and bank capital matters.
So why do economists concentrate so much on reserves, and downplay or ignore other inputs in the money supply process?
Because reserves can be influenced by policymakers. Other things equal, the price and availability of reserves, capital, loan officers, etc., all influence the money supply and loan supply process. But a central bank's job, when it determines the price and availability of reserves, is to make sure those other things aren't equal. The slope and position of the market supply curves of bank capital and loan officers are what they are. The slope and position of the market supply curve of reserves is whatever the central bank wants it to be. It can make it horizontal, or vertical, or anything in between. It can make it shift left, right, up, down, back and forth, to try to attain whatever objective it wants to attain.
Worthwhile Canadian Initiative 
Winterspeak:
A bank sells $30 million in 10 year notes and uses the funds to make $30 million in commercial loans. Increase in bank loans, no increase in deposits.
A bank sells $30 million in T-bills from its asset portfolio and uses the proceeds to make $30 million in commercial loans. Increase in bank loans, no increase in deposits.
A bank collects om $20 million in bank loans, and uses the proceeds to retire $20 million in 5 year Certificates of Deposits that happen to be coming due. Decrease in bank loans, no decrease in transactions deposits–the ones that count as part of the quantity of money.
A bank collects on $20 million in bank loans and purchases 10 year Treasury notes. Decrease in bank loans, no decrease in deposits.
The bank sells $10 million in new shares of stock, and uses the proceeds to make $10 million in new bank loans. Increase in bank loans, no increase in deposits.
The bank issues $15 million in checkable deposits and finances $15 million in 1 year Treasury bills. Increase in deposits, no increase in bank loans.
The bank collects of $100 million in bank loans, retires $50 million in CDs, purchases $50 million in Treasury bills, and issues $50 million in checkable deposits. Less bank loans, more deposits that serve as money.
The bank retires $10 million in 30 year bonds all coming due with $10 million of newly issued checkable deposits. More deposits that serve as money, no change in bank loans.
It is evident to me that all you care about is the amount of new bank loans, or maybe, total bank credit. What I care about is the amount of deposits used for monetary purposes created by the banking system.
Because the central bank controls the quantity of reserves, it can create an excess demand for reserves if it wants. Because all of the monetary liabilities created by the banks must be kept redeemable with reserves, the central bank can create an excess demand for them as well. (The price of central bank reserves relative to checkable deposits cannot change to clear the market.)
This process doesn’t control the amount of bank loans. Banks could sell 20 year notes and make bank loans if they want. They could sell CD’s which do have a variable price in terms of central bank money because htey don’t have to be redeemed until they come due, and use the proceeds to make loans.
I am not talking about using reserves to control bank lending. I am talking about controlling the quantity of reserves to control the amount of deposits that are utilized as money. These are controllable because they are redeemable.
I have no interest in trying to control lending in the economy. Nominal interest rates should adjust to clear quantity supplied and demanded.
The quantity of money should adjust to control the growth path of nominal expenditure. I am not claiming that there is never any impact on nominal interest rates from changing the quantity of money to control nominal expenditure. It is just that I don’t care what happens to interest rates as part of that process–whether they need to go up or down. That is, whether clearing credit markets require that they rise or fall. Let them change.
Nick,
“A long run horizontal supply curve of reserves, where the BoC sets a fixed rate of interest on reserves regardless of the quantity demanded, is not just empirically false…”
That starts to makes sense to me as long run visualization…
Except I struggle with and question the necessity for the qualifier “regardless of the quantity demand”. Again, if one believes in PK/MMT, the quantity demanded only reflects what is required for banks to meet current reserve requirements. It doesn’t reflect anything having to do with prospective loan expansion, for example. BTW, MMT would not differentiate between the short run and the long run in terms of the nature of such reserve demand. It is a function that relates only to meeting current reserve requirements. If you were to track the supply function over time ex post, it would be a step function of flat curves with steps at announced target changes.
By “architectural dial”, I meant something like distinguishing between the US pre-QE reserve system and the US post-QE reserve system. The supply function must be different now in my view because the Fed is supplying reserves for reasons only partially related to reserve demand and mostly related to the chosen consequence of its own asset expansion (again in my view). The reserve system architecture is different post-QE in terms of the order of magnitude of excess reserves (due to the reason just mentioned) and the fact that the Fed must pay interest at the target lower bound now because of that change in magnitude. That means the Q in the supply function must be completely different relative to the same P, comparing the pre-QE supply function with the post-QE supply function. The supply function has changed because the architecture has changed (maybe there’s a better word than architecture).
NR: Suppose the CB set a fixed exchange rate, and you used fiscal policy to change the quantity of reserves. Whenever the Govt spends reserves go up, and whenever it taxes, reserves go down. I’m sure you realize this. The Govt could choose to run deficits (or surpluses) depending on whether the environment was inflationary or deflationary. If it paid 0 interest on reserves then I don’t see the bias being inflationary or deflationary if fiscal was managed appropriately.
Also, re: supply vs demand, I understand what you mean. We are on the same page now.
Nick,
On the zero reserve requirement issue:
You stated that the reserve requirement wasn’t zero because banks were allowed to have negative balances. That’s true, but they are charged on negative balances, which is equivalent to an overdraft credit line, which is equivalent to borrowing to cover that deficit. Suppose bank A ends up $ 50 million short against a requirement of $ 100 million, and borrows the difference from the central bank. Bank B ends up $ 50 million short against a requirement of zero, and is charged an overdraft rate on the difference. Both banks are short prior to being charged by the central bank. The idea of a requirement of zero would be analogous to a requirement of 100 in that sense. Bank A was “allowed” to be short on its requirement in the same sense as bank B was “allowed” to be short.
No doubt some of this is semantics and definitional differences. I think the important point is that there is a level of balances, zero, that is economically equivalent to a requirement in the sense that there are penalties for not meeting this requirement, the same as there are for a positive reserve requirement system. It may be more accurate to refer to the requirement as one of settlement balances in the case of a system with “zero reserve requirements”. From a PK perspective, the important characteristic of a positive reserve requirement lies in the financial disincentives that discourage deviation from that requirement, not in the value of the stock of reserves per se. Preserving this characteristic alone lies at the core of countries like Canada moving to a zero reserve requirement. In that financial motivation sense, there is such a thing as a zero reserve requirement in a way that is comparable to a positive reserve requirement system.
The following paper from the Bank of Canada is titled “Implementation of Monetary Policy in a Regime with Zero Reserve Requirements”. The paper refers to “zero reserve requirements” frequently in the text. It also uses the phrase “no reserve requirement” on occasion, so there is some ambiguity.
“It is not sufficient for the implementation of monetary policy that the central bank be able to control the supply of settlement balances. It is also necessary for the commercial banks to have a determinate demand for these balances on a daily basis; in other words, to have firm targets each day for the quantity of settlement balances that they desire to hold. Otherwise, if the demand curve shifts erratically, a given supply of balances will produce unpredictable effects on monetary conditions in the economy. In particular, the central bank would not then have an adequate degree of influence over short-term interest rates, which are essentially determined in the market for settlement balances. To ensure that there is a determinate demand for balances, a zero-reserves framework has to contain a set of rules and incentives that motivate the banking system to target zero settlement balances at the central bank.”
From:
Click to access wp97-8.pdf
The idea of “targeting zero” as noted in the paper is the main point I wanted to get across. Zero is a requirement in the sense that anything below zero is penalized. And from an economic perspective, a target/requirement of zero is no different in the nature of its financial motivation and incentive than a reserve requirement of X>o. I don’t think that idea comes across in the phrase “there are no reserve requirements”, although it appears the paper’s author believes that “no reserve requirement” is not inconsistent with “zero reserve requirement”. I think he used the idea of “zero requirement” to reinforce a similar point to what I’m making.
Nick . . . PK horizontal supply of RBs (not that they necessarily believe this is the case all the time . . . I certainly don’t) DOES NOT assume there is no shift up or down in the supply as the cb changes the target rate. It’s just horizontal at whatever the current target is. And when the target is changed, it will be horizontal there. No fixed price model necessary (or desirable, of course).
JKH . . . agree with you on “architectural dial,” I think. My lense for interpreting this is that the demand for rbs is essentially set by how the cb sets its operating procedures for hitting an interest rate target (that is, the supply of RBs), including RR, length of maintenance period for RR, overdraft penalties, interest on rbs, structure of the payments system (such as decentralized (US) or centralized (Canada)). Much more could be said, but see how that goes for now.
Bill: Banks don’t sell debt to make loans. Banks are not vehicles that match those who have money to invest, with those who want to borrow money.
A bank makes the $30M loan. It debits its reserve account and credits a receivable asset ($30M). That loan is then deposited somewhere else. If it’s in the same bank, then the bank credits a liability (deposits) and credits its reserve, for no net change in its reserve position. if the loan is deposited in a different bank, THAT bank credits a liability (deposit) and its reserves. If this second bank ends the day long reserves, and the first bank ends up being short, the second bank will lend the extra to the first bank overnight at the FFR. It is this overnight lending market which makes banks unconstrained by reserves when they lend.
Bank credit is created ex-nihilo via expanding both sides of its balance sheet at the same time. The reserve system connects all deposits, making lending unconstrained except by capital requirements on the supply side, and creditworth demand on the, well, demand side.
“I am not talking about using reserves to control bank lending. I am talking about controlling the quantity of reserves to control the amount of deposits that are utilized as money. These are controllable because they are redeemable.”
Great — let me know when you run across someone who cannot withdraw money from their FDIC insured checking account.
“I have no interest in trying to control lending in the economy. Nominal interest rates should adjust to clear quantity supplied and demanded.”
Some people think so. Tell me, how’s that working out these days?
Loans CREATE deposits. You saying that you are not interested in “controlling lending in the economy” but are interested in “controlling the quantity of reserves to control the amount of deposits that are utilized as money” means you do not understand how this works.
If a bank wants to make a loan, it just makes it (if it is within capital requirements). Making that loan creates a deposit, which is absolutely used and usable as money. (Reserves shuffle about in the background as a convoluted and brittle mechanism to set the interbank overnight lending rate.)
Nick’s post said: “Too much Fed: One standard definition of the money supply is M1. M1 = currency in public hands + demand deposits
The argument is that (chequable) demand deposits can be used as a medium of exchange/means of payment, without first converting them into something else, and so are money. And yes, demand deposits are a form of debt: they are a liability to the bank, and an asset to the public.”
So, “a” money supply can be defined by currency (in public hands) plus currency denominated debt (demand deposits). What about other money supplies? Plus, can that currency denominated debt (demand deposits) be defaulted on?
Bill Woolsey said: “Your example is helps promote the confusion between money and credit. The money is the bank deposits. The credit is the bank loans.”
To me there is more confusion with the money is the bank deposits. Are bank deposits all currency, all currency denominated debt, or a mix?
Nick’s post said: “For the fungible money supply minus currency to be 10 times bank capital, does that mean currency = savings = bank capital so that spending amounts and financial asset amounts depend on changes in currency denominated debt?” You totally lost me there, but the answer is “no”.
So, what can be used as bank capital?
winterspeak said: “If a bank wants to make a loan, it just makes it (if it is within capital requirements). Making that loan creates a deposit, which is absolutely used and usable as money. (Reserves shuffle about in the background as a convoluted and brittle mechanism to set the interbank overnight lending rate.)”
Is this a good example? A bank makes a loan for a no downpayment mortgage (creating currency denominated debt “out of thin air”) and then the builder redeposits it back at the bank.
What happens if the builder just leaves it there vs. cashing it out wanting currency?
Feel free to correct or expand.
NIck: “If the central bank shifts the supply curve of reserves, that will change the interest rate on reserves, and that will shift the supply curve of bank loans, and that will change the interest rate on bank loans, and that will change the quantity demanded of bank loans.”
But in the US, the Fed has increased the supply of reserves enormously, allowing the risk-free (overnight) rate to fall almost to zero, but this hasn’t shifted the supply curve of loans materially, which remain dismally low. Nor has it changed the quantity demanded of bank loans. This has been the situation for some time now — so much to the Fed’s chagrin that Chairman Bernanke has taken to chiding lenders for not lending. However, he cannot force them to do so; nor can he force credit-worthy borrowers to demand loans either. Inquiring minds are asking, what’s up with this then?
tjfxh said: “But in the US, the Fed has increased the supply of reserves enormously, allowing the risk-free (overnight) rate to fall almost to zero, but this hasn’t shifted the supply curve of loans materially, which remain dismally low.”
I believe it depends on creditworthiness.
And, “Nor has it changed the quantity demanded of bank loans.”
If most of the lower and middle class were a stock, would it have not enough (wage) income and too much currency denominated debt already? Other than cheap oil, is there anything in short supply? If there is very little in short supply, why borrow?
And, “However, he cannot force them to do so …”
Well if they can concentrate credit in a few entities that will do what the rich and the fed want (lend to debt enslave the lower and middle class so they can never retire and to prevent price deflation and asset price deflation), they might be able to.
And, “nor can he force credit-worthy borrowers to demand loans either. Inquiring minds are asking, what’s up with this then?”
What if there are not enough qualified borrowers to prevent price deflation?
What if the lower and middle class realize there are about 6 billion people in the world, about 4 billion want jobs, and there are only 3 billion jobs and most goods are not in short supply? Will they realize hourly wage income will be negative in real terms and maybe negative in nominal terms along with no increase in hours? If so, will they finally financially realize it is time to stop going into currency denominated debt? Is the rich and fed’s wealth/income inequality economy with too much currency denominated debt on the lower and middle class starting to stop working?
JKH said: “Capital is allocated based on the risk of unexpected loss. That is why nominal asset amounts are “risk weighted” when determining a required capital allocation. The risk weighting for a (Canadian) residential mortgage is far less than the risk weighting for an equivalent nominal amount of junk bonds. Treasury bills have zero risk weighting. Central bank reserves have zero risk weighting as a commercial bank asset.”
Are there “ways” to get around capital requirements like getting regulators to change risk weightings (or “let the market determine it”) or “offloading” risk to another entity?
And, “Banks are capital constrained in lending, as I’ve defined it, …”
What if a bank buys only treasuries? Any capital constrained limits in lending then?
Would central bank(s) swap reserves for garbage debt to protect bank capital?
Nick,
Another thought on “zero reserve requirements”.
The reserves we’re almost always talking about in the case of banks are settlement balances – i.e. a reserve of settlement balances, as opposed to a reserve of vault cash.
A bank with a reserve requirement of $ 100 million faces opportunity costs above that level and actual costs below that level.
A bank with “no requirement” faces opportunity costs above zero and actual costs below zero.
So “no requirement” is economically equivalent to a requirement of zero.
That applies in the case of Bank of Montreal, for example. But to say that Bank of Montreal has “no reserve requirement” doesn’t distinguish BMO from Nick Rowe, who also has “no reserve requirement”. Better to think of BMO having a “zero reserve requirement” (economically at least), because that doesn’t apply to Nick Rowe. To say that BMO has “no reserve requirement” omits important information about the economics of managing settlement balances.
JKH,
Ignoring the institutional detail that BMO can borrow directly from the CB and Nick can’t, the whole point here is the the fundamental difference between them is how much capital each has. If Nick had as much capital as BMO and could borrow on the interbank market and/or with the CB then he could operate as a bank just as well as BMO.
That’s why capital matters and reserves on hand don’t, as long as the bank has enough capital on hand it can get as much short-term reserves as it desires at the relevant interest rate. That’s why capital is a constraint but reserves held are not.
It’s a function of the bank conducting monetary policy via the policy rate. The bank explicitly stands ready to provide the system as a whole with as much reserves as they want at the policy rate, the banks of course want to hold as little reserves as possible.
Adam,
You’re really up on this stuff. Thanks for the lesson.
you’re being serious or teasing me? I haven’t read all the comments so don’t mean to make an obvious point. (I was only responding to your comment just above).
both
it’s good comment, but completely out of context
you have to go back and read the full exchange between Nick and myself regarding “zero reserve requirement”
it’s a particular point on reserves that’s got nothing to do with capital
nor does my comparison between BMO’s potential interest in reserves/settlement balances, and Nick’s – the comparison is making a point on reserves only
I’m quite aware of the difference between capital and reserves, thanks, but your point is fine
But some of BMO’s liabilities are media of exchange, and none of Nick Rowe’s liabilities are media of exchange. 😉
JKH: But I think I see your point about zero vs no required reserves. Banks need to have settlement balances, whether it be positive or negative. It would be like requiring Nick to have a chequing account at the BMO, but allowing Nick to run an overdraft if he wants. And the Bank of Canada has defined zero as the level of settlement balances at which it switches from paying to collecting interest. It could have defined some other number.
By the way, there’s a semantic question that is muddying the waters here, on what “loans” means. I think of the asset side of banks’ balance sheet as being comprised of reserves plus “loans”. But much of what I think of as “loans” is loans to the government. When BMO buys a Tbill or government bond, I think of that as a loan to the government. Which it is. But my way of talking isn’t the usual way of talking, which restricts the word “loan” to non-securitised loans to private borrowers?
tjxfh: it is quite possible, I think, that right now the bank capital constraint is the relevant one. I did say there was some truth to JKH’s way of thinking, and perhaps especially now. And my post was trying to recognise that truth, as well as recognise the truth in the reserve story (plus the loan officer story).
Nick,
“It could have defined some other number.”
Exactly. That’s really the crux of it.
BTW, it could have defined a negative number as well. It’s an interesting thought process to understand why that could be the case. Put’s required reserves (or settlement balances) in context.
JKH: Yes, and funnily enough I was trying to think through that negative number thought experiment just yesterday.
Winterspeak: fixed exchange rates does make the price level determinate but it doesn’t mean a perfectly elastic supply of reserves at a fixed interest rate. The central bank will need to allow that interest rate to adjust in order to keep the exchange rate fixed.
Nick,
“But my way of talking isn’t the usual way of talking, which restricts the word “loan” to non-securitised loans to private borrowers?”
Yeah, I’m pretty relaxed about all that. I think there may have been a discussion above where Bill Woolsey brought that up, but I wasn’t following it.
I usually think of assets = liabilities plus equity.
A general model for banks would have loans and securities and things on the asset side and deposits and capital on the other side. But you can stretch the idea of a loan as far as you want as far as I’m concerned. I have no problem even if people want to think of a deposits as a loan in a way.
One thing I did find frustrating in the credit crisis was when people were using various types of language to distinguish between credit losses from securities write downs and credit losses in the form of conventional loan losses. The “fast money” securitized stuff came through first; the conventional bank loan losses are coming through now. But it was all due to credit risk.
NICK: Yes, both bank loans and private loans can be on the asset side of the bank balance sheet. Note the difference in how they work though.
1. With private loans, the bank creates a receivable (asset) and a deposit (liability). Its balance sheet is larger. Whatever the loan was spent on gets a bid.
2. When buying Treasuries, the bank is exchanging a reserve (asset) for a Treasury (asset). Its balance sheet is the same size, but the composition on the asset side is different. The Treasury gets a bid.
tjxfh: It’s because reserves do not have anything to do with bank loans. This shoots an enormous hole in monetarist theory. Adam P has a nice synposis on this @6.10
tjxfh: just to recognise the truth in the bank capital story explicitly: if there were a shift in the supply curve of bank capital, for a given supply curve of reserves (and loan officers), as long as those latter two supply curves weren’t vertical, that would indeed cause a shift in banks’ supply curve of money (and loans).
But in normal circumstances, the Bank of Canada could and would offset that effect by shifting the supply curve of reserves in the opposite direction, so it doesn’t matter (much). But it can’t do that when the supply curve of reserves hits the lower bound.
Nick,
“But some of BMO’s liabilities are media of exchange, and none of Nick Rowe’s liabilities are media of exchange. ;)”
Remember the Bowie bonds?
http://en.wikipedia.org/wiki/Bowie_Bonds
That should give you some ideas for liquifying Nick Rowe liabilities 🙂
Winterspeak: “1. With private loans, the bank creates a receivable (asset) and a deposit (liability). Its balance sheet is larger. Whatever the loan was spent on gets a bid.
2. When buying Treasuries, the bank is exchanging a reserve (asset) for a Treasury (asset). Its balance sheet is the same size, but the composition on the asset side is different. The Treasury gets a bid.”
I think the important difference is this:
1. when the bank buys a security from the public, whether it’s a govt or private bond, it pays by cheque, and the seller deposits that cheque in his account (perhaps at a different bank), and the money supply expands.
2. When the bank makes a loan, it directly creates a deposit at the same bank.
3. When the bank buys a new bond directly from the government, then reserves fall, and there is no deposit created.
All these are first round effects, of course, not the final equilibrium.
JKH @7:32
yeah, I wasn’t following the conversation. I certainly wasn’t suggesting you don’t know the difference between reserves and capital or that you didn’t already understand the point I was making. Mainly I just took the chance to phrase the point in a way that it seemed nobody had yet, but you’re right it was more or less out of left field.
Nick: “1. when the bank buys a security from the public, whether it’s a govt or private bond, it pays by cheque, and the seller deposits that cheque in his account (perhaps at a different bank), and the money supply expands.”
Really? Please take me through the balance sheet transactions. Would this be true if, say, the bank buys a computer from IBM? I see a transfer, but I don’t see any new money.
“2. When the bank makes a loan, it directly creates a deposit at the same bank.”
Not necc. The receivable will be with the bank making the loan, but the deposit could be at any bank. Maybe your “first round” is measured in milliseconds? The reserve system gets everyone back into compliance overnight.
“3. When the bank buys a new bond directly from the government, then reserves fall, and there is no deposit created.”
Yup.
Nick and TooMuchFed: I agree with what you both are saying about the financial situation getting in the way of the theory. Lots of folks in the US have been saying that since the Fed started implementing their strategy to increase lending by providing liquidity to the banks. The objection was that this is not really a liquidity problem as much as a solvency issue.
The opposition has been saying all along that the problem is debt deflation. Hence, the solution is not providing liquidity in a liquidity trap, but rather unwinding debt that cannot reasonably be serviced or paid off. This is not happening yet. As a result, the US is stuck with zombie banks, and consumers who are underwater but not yet defaulting are delevering. Under these conditions, households are not contributing to the consumer demand that is needed for recovery, since businesses aren’t going to invest or hire while they have fallow resources (output gap of over 70%). Add to this that banks are returning to prudent standards of lending, and the Fed’s policy is pretty much dead in the water as far as lending goes.
Opponents also observe that the easy money is resulting in reflation of asset prices, which is what the Fed wants, of course. Moreover, the banks are also using the Fed’s “generosity” to recapitalize through very generous spreads and leveraged prop trading, generating systemic risk owing to the moral hazard of TBTF. In addition, this has resulted in a run up in the price of oil (Goldman reportedly has boat loads of oil and it predicting a rise to 93 US). This price rise of a vital commodity with inelastic demand pretty much cancels the fiscal injection of the stimulus package.
Opponents suspect that the Fed could not be so unaware of all this as to think that their liquidity provision would really result in lending, and this is actually a disingenuous way of intentionally trying to reflate assets and recapitalize banks without admitting it. Needless to say, a lot of people don’t like this, which is a big reason for the push to “audit the Fed<” coming from the grassroots and now an unlikely coalition of Austrians and progressives in Congress.
Winterspeak, @12.49.
As you know, balance sheet accounting is not my strong point. Let me give you my underlying vision instead:
If you lend me $10, I give you a bit of paper that says “IOU $10, signed Nick”. I call that bit of paper a bond. I describe what has happened is that I sold you a bond. I can’t see the difference between banks making loans and banks buying bonds, in other words.
NICK: Can you see the difference between banks buying bonds and banks buying an IBM server (both from the private sector)?
Nick: I think that calling your promissory note a “bond” and implying it is a bond in a sense to the way a Treasury is a bond is equivocating on the term “bond.” In the accepted vocabulary of finance, a bond is a (negotiable) interest-bearing debt instrument with a maturity of more than one year. Promissory notes are not bonds in this sense.
As far as how I understand how banks account for bonds versus loans, government bonds are ultimately purchased as assets by charging the bank’s reserve (“deposit”) account at the CB. This has the effect of switching funds from a deposit account to a time account, as it were, with the government acting as the “banks’ bank.” (Can’t remember now whose analogy this is.)
Loans generate deposits. The loan is the (illiquid) asset and the deposit is the (liquid) liability. Most deposit from loans are spent relatively quickly. Therefore, the bank has to commit liquid assets, either by factoring the loan or finding assets elsewhere, e.g., bank reserves. Bank reserves are defined as vault cash and reserves held at the CB. The bank has to provide from vault cash or commit reserves, charging the respective accounts. Most deposits resulting from loan activity are withdrawn by check, so this involves committing reserves at the CB for clearing.
I understand it, the point that the MMT’ers make is that once the transaction is properly analyzed, the accounting is evident. I admit to be being a novice at this, so somebody please correct me if I got it wrong.
TooMuchFed: “Are there “ways” to get around capital requirements like getting regulators to change risk weightings (or “let the market determine it”) or “offloading” risk to another entity?”
This is the issue in the US regarding the rating agencies that “sold” the AAA ratings that made securitization possible.
“Would central bank(s) swap reserves for garbage debt to protect bank capital?”
Look at the Fed’s balance sheet. It’s filled with dreck. That’s where the mountain of excess reserves comes from.
tjfxh: Govt bonds are purchased as assets and paid for by reserves. So, you debit one asset (reserves) and credit another (Govt bond). The balance sheet does not change size, no new money is created, no credit is extended, but the term structure of extant reserves have been changed by some of them moving into a time account (as you say).
Loans generating deposits are totally different to this as they expand balance sheets.
If the bank purchases something from the private sector, then it’s a transaction, and you debit some cash account and credit an asset. The seller debits some asset and credits their cash account. You’ve rearranged assets in the private sector, as there is a transaction, but no new money has been created, and balance sheets stay the same size. This is why I asked Nick about the IBM server vs. the IBM bond (or whatever other privately held asset he wants to ponder)
JKH, Adam P: “Nick has no reserve requirement.”
A philosopher of language would say that this is not a proposition that can be either true or false. Rather, it is a nonsense, since only banks have reserve accounts with the CB. Hence, it makes no sense at all to say that a a non-bank entity has no reserve requirement.
Something similar can be said with mixing up terminology in such a way that implies that what applies in the horizontal relationships of the non-government economy applies in the same way in the vertical relationship between government and non-government. This is one of the key point of MMT, as I understand it, and failing to keep the language straight can result in a ton of confusion.
Winterspeak,
Sorry, I believe that’s not quite correct.
If the IBM server is accounted for as an investment (I believe so), bank assets increase by the value of the server and deposits (new money) increase by the same amount.
If the IBM server is treated as an expense (I don’t believe so), bank equity decreases by the value of the server and deposits (new money) increase by the same amount.
Anyway, that’s the investment and expenditure accounting in general as it relates to the creation of new money.
In this analysis, you have to look at expenditure as an isolated event.
Conversely, revenue has the effect of destroying money. Money is paid from deposit accounts into equity.
Nick said: “I can’t see the difference between banks making loans and banks buying bonds, in other words.”
How about is there a difference between buying a NEWLY issued gov’t bond (expanding the currency denominated debt part of the fungible money supply) vs. buying an existing gov’t bond (which does not)?
Does a bank making a NEWLY issued loan also expand the currency denominated debt part of the fungible money supply?
And. “If you lend me $10, I give you a bit of paper that says “IOU $10, signed Nick”. I call that bit of paper a bond. I describe what has happened is that I sold you a bond.”
If the person gave Nick $10 dollars of currency, can you see that the fungible money supply is the same (currency “went down” by $10 because it was saved and currency denominated debt “went up” by $10)?
I hope this is not too odd of a question but …
What happens if there is a 5% “reserve requirement” (may not be the correct term), and it has to be met with currency (not bank reserves)?
Winterspeak: “NICK: Can you see the difference between banks buying bonds and banks buying an IBM server (both from the private sector)?”
No, I can’t. Not on the balance sheets, anyway. But I bet it makes a big difference to the guys in the IT section.
JKH: Just so I understand you. If I buy a server (as an investment) I debit cash and credit an asset, IBM credits cash and debits inventory. Money has not been destroyed or created (as no credit has been extended or paid down) but it has been transferred.
Is there something different when a bank is the buyer, or am I doing my own accounting wrong?
Oh. I see JKH has already addressed that. I was assuming the IBM server lasts many periods, so is an investment rather than an expense. And they probably look rather different on next year’s income statement.
Too Much Fed, bank reserves = vault cash plus reserves held on deposit at the CB. Generally speaking, “bank reserves” is used to mean the banks deposit account that the CB, but the legal reserve requirement specifies vault cash plus the bank’s reserve account at the CB. Of course, the bank could choose to hold a greater percentage in reserve as a liquidity measure. but they don’t need to, because the CB makes reserves available (at a price) if required.
It is important to remember that bank reserves are a liquidity provision, while bank capital is a solvency provision. Liquidity is a constraint for most firms, but not for banks because the CB as lender of last resort always makes sure that enough reserves are made available. Not so for capital, however. However, in the US the Fed is granted emergency powers to prevent systemic collapse, and it may absorb capital losses by taking bad debt onto its balance sheet. That is what is happening now, in addition to relaxing accounting rules to allow banks to mark to model instead of market instead of market. There has also been no pressure to force off-balance sheet issues that could threaten solvency.
Winterspeak,
“Is there something different when a bank is the buyer?”
Yes. It is completely different. But no different than a loan. I gave the overview above.
Try again.
So we assume the server is accounted for as an investment.
That means it stays on the balance sheet.
So:
Bank cuts cheque “from nothing”.
Bank pays for server.
IBM deposits money in bank (assume same bank; it doesn’t matter).
This is an increase in money supply.
The change in the balance sheet is that the bank has a new asset (real investment) and a new liability (deposit).
There is no change to the bank’s equity account.
Very simple.
No difference between a new loan and the acquisition of any other new asset, financial or real, in terms of new money created, provided that the counter party is not a bank.
(And expenditure has exactly the same effect. This is much more counterintuitive, but very worthwhile to understand if you really want to understand money creation and destruction. If Scott F. is reading, this is just starting to touch on Steve Keen’s circuit modeling area of interest.)
Ye gads. Banks are even more powerful than I had imagined!
So, does this mean that all bank spending which ends up on a balance sheet is merely capital constrained?
Not only that.
It also means spending that doesn’t end up on the balance sheet is merely capital constrained.
If the IBM asset transaction above seems counterintuitive, just remember that the bank has paid for it by issuing it’s own liability. It is “richer” by the amount of its investment, but “poorer” by the amount of its liability.
The same thing in terms of the money effect happens when the bank purchases a note pad, or pays an employee. These are expenses. Expenses are a debit to equity, other things equal. The note pad seller gets new money that he deposits in the bank, the employees get new money in their accounts with the bank, and the bank debits (drops) the value of its equity account. Equity down; new money up.
And the reverse happens when the bank sells an investment (selling an asset destroys money but leaves equity unchanged) or when it receives revenue of any type (equity up; money destroyed).
In the case of expenses and revenue, the trick is to understand that an isolated income statement transaction, assumed on its own, then must flow through to the equity account.
Every piece of revenue at the margin is a gain in equity; every piece of expense at the margin is a reduction in equity.
Loans, financial investments, real investments, and spending on note pads all create new money, at the margin. As well as the reverse.
ALL transactions of ALL type between banks and non-banks create or destroy money at the margin.
Bet you didn’t know this.
🙂
JKH said: “ALL transactions of ALL type between banks and non-banks create or destroy money at the margin.”
Should that be create or destroy currency denominated debt at the margin?
If not, how is currency destroyed?
My mind is boggling. I think I’ve almost turned back into an Austrian.
In the few moments of lucidity that I can muster, I see that the line between banks and the Govt (or, more precisely, any entity that has access to reserve accounts and the Govt) is actually much thinner than I thought. ALL transactions of ALL types between Govt and non-Govt entities create or destroy money at the margin, but I was including “banks” in the non-Govt category. Now it is not so clear to me, and I’m thinking banks are nothing more than Govt currency issuers with some private capital in first loss position.
Talking about underlining, in triplicate, the unimportance of reserves!