I make no apology for returning to the stories of money creation that have rather dominated this blog for the last few days.
I reflected overnight on the posts by Clive Parry and me yesterday and why they present different views and realised that at its core, the conundrum can be simply summarised.
As all central bankers agree, commercial banks always make loans using newly created money.
And then, as Clive pointed out, banking regulation forces those banks to borrow to cover the loan that they have created as if the funds to make the loan were not newly created money.
What is obvious is that if banks can create money from nothing (and that is a universally true fact and always the funding mechanism for loans made), then banks never need to borrow to cover those loans. And yet, regulation apparently imposes that wholly unnecessary requirement.
The questions to be asked are:
- Why does regulation do that?
- How does it do that?
- Who benefits from it doing so?
- How do they benefit?
- What can be done to resolve this situation, which is obviously absurd?
I am not saying I have answers as yet. What I do know is that the regulatory requirement is obviously absurd.
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“…then banks never need to borrow to cover those loans.”
No, they do. We must be very careful to distinguish the macro from the micro.
When a loan is made a deposit is created. That deposit IS borrowing… just not from the interbank market or other counterparty.
If the borrower spends the money with someone that banks elsewhere then Reserves will move between the two banks.
Clearly, at a macro level there are enough reserves in the system to mean that the bank that can borrow the Reserves it needs IF (and this is key) there is someone willing to lend (a micro question).
The whole purpose of regulation is to ensure that
1) Banks are sufficiently capitalised and liquid to give comfort to lenders to keep depositing with banks
2) To ensure that when this fails to be the case that other banks don’t go down with them.
And as I suggest, the CBRAs provide that loan capacity and the best tool to indicate stress.
The alternatives disguise it
I am not sure what the basis of your argument rather than observation is, Clive. That is my confusion now. Regulation results in your observation, but why?
Waiting until there IS a bank run (which is what a sharp drop in a bank’s CBRA is) is like waiting for the fire alarm to sound and calling the Fire Brigade. Yes, this right…. but more should be done to prevent reaching that situation
Regulation is about taking sensible fire precautions to prevent one starting and, if it does start, to stop it spreading.
But how does the BoE know there is a risk unless it is sigmnalled bvia the CBRA?
And yes, I do know there is weekly bank reporting
But does it really work?
How?
Because banks have to report the capital and liquidity positions (vis a vis requirements) on a continuous basis. If they are breached, regulators move in and sort it out.
If banks lie to regulators then I suppose that CBRA balances might be the first public indication of trouble… but lying to the Regulator at a large bank is virtually impossible given how many people would have to be part of the conspiracy. It could happen – and Vince raises the Barclay/Qatar story but (and I might be wrong) this revolved about whether the money was debt or equity. If equity they were ok; if debt they were in breach of regulation. In fact it was some sort of hybrid that the lawyers have been haggling about since.
Clive
I am working through this again – and think there is much more to the regulation than regulation, per se. But I will have to work it through before sharing the theory.
Richard
Barclay/Qatar was more chicken and egg it seemed to me. The affair portrayed banking as an environment where one literally can pull oneself up by one’s own bootstraps. Useful to some then, those who can envisage it, have access to it and can grasp it. Opaque and of no use to the rest of us, who can only wonder how some can perpetually have fortune seemingly smile on their palaces while we grub around in the dirt outside, clawing at the walls, wondering why we can never get in.
Richard is still getting it wrong, yet still pretends he knows more than the experts!
The fact that banks DO need to borrow to fund the loans is precisely the point being made by numerous people over the last few days and which Richard repeatedly denied.
Maybe as one of the ‘faithful’, he will take on board your knowledge, Clive.
Very clearly banks do nit need to borrow money to lend. That is a fact, now known to be true.
Regulation requires that they do something that is not necessary, at least if all banks had equivalent loans and deposits.
The question is why does regulation require something not necessary? You really don’t understand, I suggest
Lending automatically creates borrowing….. you don’t need to borrow “externally” but when you set up the loan account and credit the borrowers current account you have just “borrowed”…. from the individual you have lent to. The key, of course, is maturity transformation which is both the magic and danger of banking.
Perhaps we need to take care to distinguish between “borrow” and “borrow from the interbank market” and “raise a deposit from an outside depositor”.
With regard to the idea that all we need to do is monitor CBRA accounts to regulate the system this is, I am afraid, a non-starter.
Not a non-starter. It’s clearly a part. We’re going to have to disagree Clive.
I guess the acid test is to look at the development of CBRA balances for SVB and Credit Suisse to see if they were a leading or lagging indicator of trouble…. I suspect that later but I have not looked at that data – indeed, not sure how easily it is available, if at all.
I will ask….i know those who might have the data
Clive
“you don’t need to borrow “externally” but when you set up the loan account and credit the borrowers current account you have just “borrowed”…. from the individual you have lent to”
Please can you go over that again as it has confused me.
An individual borrows from a bank. How then has the bank simultaneously borrowed that money from the indiviudal?
The argument is implicit in the mutual promises to pay.
Clive,
“Lending automatically creates borrowing….. you don’t need to borrow ‘externally’ but when you set up the loan account and credit the borrowers current account you have just ‘borrowed’…. from the individual you have lent to. The key, of course, is maturity transformation which is both the magic and danger of banking”.
There is an extraordinary statement being presented here: “you have just ‘borrowed’…. from the individual you have lent to”.
Now I am going to have to go away and think about that; but much better would be if you could explain that statement, Clive and logically dissect the steps that arrive in an apparent paradox. I am looking for something closer to science, or formal logic than magic here.
John
I am hoping that my explanation, tomorrow if possible, will make this clearer.
Richard
When I place a deposit with a bank they are borrowing from me – when I pass a crisp £10 note over the counter and ask the bank to look after it for me they do not write my name on it and put in the safe. They just stick in a pile with all the other notes and record “I owe Clive £10” …. or “I am borrowing £10 from Clive”
So, when I borrow £10,000 from the bank, they put £10,000 in my current account and also record that I owe them £10,000 repayable in (say) 5 years time.
I am borrowing for 5 years AND lending to the bank but only “on call” (ie. I can move my money out whenever I want).
Therefore, the act of the bank making the loan needs no “external ” borrowing because they are borrowing from me…. or, at least they are until I take my £10,000 and send it to the car dealer who banks elsewhere.
At that point, the bank DOES need to borrow either from (a) a new depositor (b) another bank or (c) the Central bank
Agreed
Thank you, yes. I fully understand that; we all do, there is nothing new or esoteric about it, and it isn’t magic; but in order to use the word borrow here, you embraced it with inverted commas; ‘borrow’. This simply means in plain English – I am using the word borrow in a special sense, that doesn’t quite mean what it may seem to mean. You are thus using the word borrow in two distinct senses.
Indeed it is not really true to say that they are borrowing from the lender: “they do not write my name on it and put in the safe. They just stick in a pile with all the other notes”. Indeed as a member of the public, the depositor is not required to have any idea about what the bank does with their money; their trust may not be based on any personal knowledge of banking. The depositor makes a deposit. All the piles of notes are gathered and lent. Two separate transactions, one personal, one aggregate. What binds them together is the accounting entries alone.
Notice it is quite different when a borrower borrows from the bank. There, you refer to the transactions as personal on both sides of the equation: “I am borrowing for 5 years AND lending to the bank but only ‘on call’ (not sure about the last, at least in all cases of borrowing terms?). But this is merely form, what really matters, again is the double entry. all of it is just a function of double entry, and the time value of money; for the bank, in aggregate.
The problem is solely that the bank is trying to make a profit out of the time value of money, wherever they can acquire money, and make a profit from the borrowing/lending spread; and meet the “call”, when it comes, and fulfil the liquidity rules. The point is it is a dangerous game, and it is becoming a more and more dangerous game; and frankly I am not sure the bankers are equipped to play in a ‘market’ as volatile (short-fused) and unstable as it can now be, and full of more and more possibilities for those who wish and think they can, game the rules: a casino.
Will rates, excess reserves and regulators be enough ammunition in the second quarter of the 21st century for Central Banks and Treasuries to stay ahead? Not, I humbly submit on the current evidence, history and CVs of the incumbents.
Forgive me, I was born in the Humean philosophical tradition; I am a heretical sceptic by nature.
One important point I missed out in my explanation of the logic, was that I was also searching for (but had not properly established), the distinction between the personal and aggregate, that may be found in the strict legal, contractual relationship (and the ramifications) between bank and, on one hand a depositor with the bank; and on the other, a borrower (typically a loan) from the bank.
Many of the most astute monetary thinkers were not just bankers or (more rarely) economists, but lawyers; the great, but too often forgotten H Dunning MacLeod, ‘The Theory and Practice of Banking’, (1856); or in our own day, Christine Desan springs to mind.
Also worth including this from Greenspan
https://www.youtube.com/watch?v=DNCZHAQnfGU
“The is nothing to prevent the federal government relating as much money as it wants to somebody. The question is how do you set up a system that assures that real assets are created which those benefits are employed to purchase”
Indeed
Useful, that, Keith 🙂 I’ll include it!
Bill not sure if this is in your list but it’s important evidence:-
https://www.sciencedirect.com/science/article/pii/S1057521915001477?ref=pdf_download&fr=RR-2&rr=7f18f7e14d8cdd17
Keith, I’ve used it though it hasn’t gone live yet – do you want me to link to you as having been the source of this reminder, and if so, where please?
Yeah, I left it out (and the pamphlet on the subject the English guys did too, I have it here somewhere…) because I didn’t want it to get too techie and so be putting Joe Public off but I suppose now the site’s getting a little recognition and a broader more educated audience is likely to be happening along it wouldn’t hurt to include them – thanks! 🙂
Mr Scofield, the article you cite mentions the use of banking software in a controlled environment to test the various theories of banking. I wonder why this had not been done before.
Nearly a quarter of a century ago I was teaching a course on setting up web interfaces to banking software. This involved three pieces of software, banking software, a server as an intermediary between that and the internet and the web interface that was being built. There was a copy of the first two for each attendee on the course.
I am not sure where the banking software came from but it must have been fairly standard as all our clients were quite happy with us using it to model their own banks. These included several well known names both from the UK and Europe.
Testing the web client consisted of the students setting up various accounts and making transactions between them and then checking that the same transactions were recorded in “their” bank. It would have been quite easy to run an experiment along the lines of the paper.
As an aside we left the issue of security until the end of the course. Not because it is not important but because in practical courses involving computer security there is always someone who manages to lock themself out of the system and thinks it is the instructor’s job to get them back in.
Hi Bill, More than happy for Greenspan quote to be included though not sure where. Somewhere where the Myths of Money Creation are addressed I suppose.
I think it was the MMT podcast with Patricia Pino and Christian Reilly that pointed me towards the quote, so perhaps they should get the credit.
Also please note that “related” in my post should read “created” (damned autocorrect)
Isn’t the heart of Christine Desan’s argument that the existence of stable market capitalism is dependent upon the capitalisation of private sector banks which can only come from government deficit spending?
“The Monetary Structure of Economic Activity: A Constitutional Analysis” Christine Desan 2023.
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4585801
If this is so we need a new word like the use of “hologenomics” in biology to make this monetary structure inter-dependency clear and this will also reveal the congenital idiocy of Market Fundamentalists!
Agreed
Certainly.
History shows that money and banking MUST be a very tightly controlled activity. Leaving to the “market” or “private interests” has always ended in tears.
“And then, as Clive pointed out, banking regulation forces those banks to borrow to cover the loan that they have created as if the funds to make the loan were not newly created money.”
And thus deficit becomes debt. Regulated it is. By design.
Literally money being wasted on the finance sector. Creating inflation.
Best directly allocated to NHS, Pensions, Benefits… A better economic stimulus all round,.
Theory of multipliers.
This is a headache-inducing discussion! Why is banking such an opaque industry? The more you read, the more confusing it all gets, partly because it isn’t clear what is fact and what isn’t.
The questions you ask, Richard, are central to an understanding, but I think Clive answered them in his first comment. Here’s my take:
Banks create money by creating deposits when they lend.
Banks need funding to support this because loans are long term but deposits can be withdrawn on demand or at short notice. (This is often called maturity transformation.)
This puts individual banks at risk of a run if there is a loss of confidence, but as deposits largely stay within the banking system, the system is not at risk. Unless banks lose confidence in each other and stop lending to each other (as happened in the credit crunch).
(Does this still apply when CBRAs are so high? Do banks still lend to each other?)
Central banks are lenders of last resort, ie when other banks or financial institutions won’t lend to support a bank. But they don’t always perform that role. SVB’s business was transferred to HSBC, for example.
Banks were shown to be hugely risky and unstable institutions in 2008. There was much discussion about how to change this and regulate them better, including whether to revive the Chicago Plan from the 1930s (100% reserve backing). Some changes were made. But ultimately, as long as they lend long and have short term liabilities, the risks remain.
In a piece on the banking system in 2017 Martin Wolf said: “Banks are in better shape, on many fronts, than they were a decade ago. But their balance sheets are still not built to survive a big storm. That was true in 2007. It is still true now. Do not believe otherwise.”
He said banks were undercapitalised and their leverage ratios were still too high. I don’t suppose that has changed.
The post Covid rise in interest rates put more pressure on banks. In a letter to the FT in May 2023, Anat Admati, Professor of Finance and Economics at Stanford University, and others, said: “Bank failures in the US, including SVB and First Republic, illustrate the fragility of using deposits and other short-term debt with razor-thin equity funding to make long-term investments. Over an extended period of low interest rates, banks accumulated long-duration, low-yielding assets while paying even lower rates, often zero, on their deposit liabilities. When rates rose, this business model became unsustainable.”
They also said: “The immediate policy challenge and threat to financial stability is not primarily runs and illiquidity but rather the weakness and potential insolvencies of many banks, unless and until nominal rates fall sharply. Longer term, it is essential to reduce the fragility of the system by requiring much more equity.”
In an aside, someone mentioned Richard Werner, who I have come across before. I decided to renew my acquaintance and found this piece by him in the Conversation a good read:
https://theconversation.com/why-central-banks-are-too-powerful-and-have-created-our-inflation-crisis-by-the-banking-expert-who-pioneered-quantitative-easing-201158
He has a challenging view on QE through the Covid crisis. Always good to get a new perspective!!
None of that is disputed – and I wholly get the maturity transformation issue, but the regulation system does not provide answers to the systemic questions that gives rise to. I will address this in the morning.
I wait with bated breath!!
Seriously, this to and fro has made me think more deeply about these things… and that is always good.
Pauline it is easy to see why you are very successful journalist. Excellent comments!
Richard’s work and some of his fine followers lead to my conclusion that the system is far too complicated, and is designed to permit the banks to flourish rather than for the public good. Martin Wolf’s article on cbdc convinced me 2 years ago that we need a major overhaul. Richard’s discussion on it was interesting. For anyone to read it we can put the title in Google get past the paywall :
The time to embrace central bank digital currencies is now
Money must adapt to an era of new technology— but it has to work for society as a whole
MARTIN WOLF
Michael Kumhof has grasped the problem. This does not mean that he, I or anyone need rush off, blindly supporting a new theory. There are puzzles in the separation of money from credit, but the problems with the prevailing orthodoxy are at least as puzzling; and the endemic complacency of banking and central banking practitioners is at least as worrying: because they are running a challengeable system.
The real issue is that there is something badly wrong with the status quo ante and the monetary, regulatory, central banking and commercial banking framework; and there are well established alternative ideas to consider. In 2013 Kumhof wrote on the important issues raised by the Chicago Plan, in “We should seriously consider revisiting ‘The Chicago Plan’ of the 1930s which separates the monetary and credit functions of the banking system”*.
“It is striking that, while Fisher and his fellow economists fully understood the central role of banks in causing economic cycles, financial crises, and excessive debt, in modern macroeconomic theories banks have been almost completely absent for decades. Even recent attempts to remedy this reflect a fundamentally incorrect understanding of banks as intermediaries of pre-existing funds, rather than their critical role as creators of new funds. It is a simple fact that banks create their own funding in the act of lending, an extraordinary privilege not enjoyed by any other type of business. This fact, as well as its implications, seems to elude many modern students of monetary matters. Many also continue to think in terms of the mythical deposit multiplier of economics textbooks, where narrow monetary aggregates are exogenously determined by the central bank, and broad monetary aggregates are endogenously determined as a result. This turns the actual money creation mechanism on its head, and has been refuted in several studies. With this deficient theoretical understanding it is hardly surprising that many of today’s mainstream analyses and proposals amount to little more than tinkering with the plumbing of the existing system, rather than designing an alternative system free of many of the problems we are facing today. In stark contrast, the monetary reformers of the 1930s thought beyond the confines of their existing monetary system, and designed an alternative one……….. The historical experience also supports the view that full government control over money issuance is generally not inflationary or destabilizing. To the contrary, financial crises only became a regular phenomenon after states had given up this sovereign right to private banks. It would be a serious logical mistake to treat the inflationary experiences of the last century as a counterargument to this, because during this period sovereigns have only ever been in charge of creating cash and bank reserves, which represent only a fraction—and in most cases a very small fraction—of the overall money supply. Given that banks were in charge of creating a very large share of the money supply, these experiences would in fact suggest that their activities have been partly responsible for recent inflationary experiences. The German hyperinflation of 1923, as explained by Hjalmar Schacht in “Magie des Geldes” (1967), is precisely consistent with this account”.
Kumhof went on to provide six advantages provided by the Chicago Plan:
1) Preventing banks from creating and destroying their own funds during sentiment-driven credit booms and busts would allow for a much better control of business cycles.
2) 100% reserve backing would completely eliminate the possibility of destabilizing bank runs.
3) Allowing the government to issue money directly at zero interest, rather than forcing it to borrow that same money from banks at interest, would lead to a dramatic reduction in the interest burden on government finances. It would also make net government debt negative, because under the Chicago Plan the government would acquire a very large interest-bearing claim on banks. This claim would be created when banks borrow to pay for their previously non-existent reserve backing.
4) Given that money creation would no longer require simultaneous debt creation, the economy could also see a dramatic reduction of private debts, in our simulation to less than half their previous level. This would evidently contribute to reducing economy-wide financial fragility.
5) The Chicago Plan would generate large longer-term output gains (as Figure 1 illustrates), because lower debt and higher non-inflationary seigniorage revenues would lead to large reductions in real interest rates, distortionary taxes, and credit monitoring costs.
6) Liquidity traps would become a thing of the past, because broad money would be directly under government control while the interest rate controlled by policy would not face a zero lower bound. This would also make it much easier to reduce average inflation to zero.
Discuss. That is what we all come here, to do and to learn.
Ah, the Gold standard, as full reserve banking effectively replicates
It worked so well…..
John Warren – excellent post on Kumhof!
Richard – Kumhof’s words were just as inspiring as yours. I am confused why you conflate the gold standard paradigm shift – moving to fiat money, with the full reserve model.
Your combination harkens back to 1844 which was indeed combined with the gold standard. Of course some persistent people revealed that it was a fake system – there was far more money than gold.
Twells exposed this in 1857 https://archive.org/details/bankcharteractsp00twel/page/8/mode/2up
No, I am not proposing a return to the Gold standard – and really I shouldn’t need to say that, Richard. I was using Kumhof, not in support of Irving Fisher, but to point up the other side of the coin; the flaws in the current system, which are actually well brought out in the contrasts the paper explores. I really thought that would be self-evident.
Sometimes it is better to explore opponents to understand the problems to be overcome (especially when they were in a fix – which they were in 1930), than try to do this while building something completely original, simultaneously. If you look at the financial consequences the Chicago Plan did not like (in itself not for no reason), it is a discussion of some of the problems that impact on the current solutions, with insight. It is not necessary to accept the Chicago Plan conclusions, to benefit from the exploration. Indeed this approach, I believe is often characteristic of exploring testing problems, whether in my own experience or in reviewing the characteristics typical of advancing knowedge in many disciplines.
Apologies
I was way too curt
But I am confused by that approach
The response here
https://positivemoney.org/2014/06/disagree-ann-pettifor/
by Positive Money to a critique of its proposals by Ann Pettifor is a good run-through of the pros and cons of 100% reserve banking. PM’s proposals are slightly different, as they say, but I think the same critique applies. I’m with Ann Pettifor on this.
There is so much confusion around these issues, not least the belief that savings finance investment. Did Kumhof list disadvantages as well as advantages of 100% reserve banking? One would surely be that credit creation was the engine behind industrial growth, and that the turn to using it for speculation rather than investment in the productive economy is part of the explanation for low growth and productivity. Kumhof’s IMF paper made clear that saving does not finance investment, financing and money creation do. I’m not clear how that sits with an enthusiasm for 100% reserve banking.
Ann and I have long agreed on this
My version is here – https://www.taxresearch.org.uk/Blog/2018/05/06/why-positive-money-is-wrong/
I share the confusion you have referred to in your last sentence
I think he may have changed his mind since writing the quoted piece : more recent work implies this.
One of the people who work for me pointed me to this blog and the series of posts on the subject of banking and credit creation and asked me if I would be willing to have a look
Having now read the various posts and comments I feel I ought to comment. For good order, the things Clive Parry has said in his post are mostly correct. The things Richard Murphy has said are almost without exception incorrect.
I will try and be as brief as possible and will simplify some things for brevity.
Let us start with the one thing we can agree on. When a new loan is created by a bank, money in the form of credit is created, with offsetting asset/liability on the balance sheet depending on point of view.
Richard makes his first error by claiming “then banks never need to borrow to cover those loans”. This only applies in the situation that the loaned money never leaves the bank. The moment it does, it becomes a matter of simple accounting. Which I would hope he understands. The bank’s balance sheet (which I hope we can all agree needs to balance) now does not do so, and to cover the shortfall it must borrow from elsewhere. This should be unquestionable – if it did not the bank would be insolvent.
Richard also seems to misunderstand the nature of both CBRA’s and how central banks such as the BoE operate. He alludes to it in his post linked here:
https://www.taxresearch.org.uk/Blog/2024/01/08/have-we-got-banking-regualtion-wrong-in-the-era-of-mass-central-government-money-creation/
But then misses the point. Currently, the BoE operates in a surplus regime where EXCESS reserves (i.e. those not loaned out commercially) are placed back at the BoE at the base rate, which acts as as a floor on interest rates, thus enabling the transmission of monetary policy. The BoE in effect acts as a borrower of last resort. If the floor didn’t exist (or as Richard has argued for, no interest was paid on reserves), short term interest rates would fall or even collapse, monetary policy would be meaningless, the currency would devalue and various other economically terrible things would happen.
What is important to note though is that banks are not forced to place their reserves directly with the BoE. They will place them elsewhere first, assuming they can achieve a better return.
Richard also mention in this post the opposite situation, know as a shortage system. In this case there are minimal reserves and the BoE acts as a lender of last resort, though banks have to collateralize this borrowing with high quality asset such as Gilts (as I believe both Clive and Richard mention).
Going into depth regarding the trade-offs between surplus and shortage regimes is beyond the scope of this comment but I would note that both can effectively control interest rates and liquidity. A surplus regime with excess reserves is not necessary for a functioning economy and can prove damaging in certain ways. It is necessary for QE though. He does say though that banks are now dependent on the BoE for liquidity. This is simply not true in a surplus environment. There is ample excess liquidity and the BoE is forced to mop up ecess liquidity by paying interest on reserves to sterilize the reserves introduced by QE, otherwise rates would fall to zero and as mentioned would lose control of monetary policy.
Let us return to the surplus scenario now. Where Richard makes his next mistake (though his treatment is unclear) are his treatment of CBRAs. They are not homogeneous. By that I mean that they are separate accounts and banks do not have cross claim over them. So if loaned money leaves one bank (A) but arrives in the CBRA of another (B), banks A still has to borrow money from somewhere to balance it’s books, whilst bank B has to lend the same amount.
Now at this point, Richard I am sure will argue that B will lend to A and we are all square. Sometimes this may indeed happen. However, this is not always the case. Bank B might deem bank A a credit risk, or simply has no more credit lines available to trade with bank A (which is very common). At which point bank B places its reserves on account with the BoE or elsewhere.
Bank A still has to borrow. Richard seems to claim that it can simply go to the BoE and borrow from other CBRAs at the same base rate, forgetting the need for collateral. Once you take that into account, borrowing from the BoE (acting as lender of last resort akin to the shortage scenario) is expensive. The bank pays a higher rate as well as having to lend (called a reverse repo) collateral to the BoE.
This in itself is not a huge problem as long as a bank has sufficient assets and credit worthiness. It does require a large pool of assets though, and dramatically limits the amount a bank can lend, disproving in an instant the idea that banks can create unlimited amounts of money. This initial capital takes the form of the usual mix of equity, debt, retained earnings etc.
It is also a good segway into why banks need deposits, where Richard makes another mistake. Firstly, the most simple reason is that deposits are by far the cheapest source of funding for a bank, especially in a surplus regime. With excess money supply in the system retail deposits are one of the few sources of funding which are likely to cost below base rates. This is also a major issue with the surplus system – it punishes savers. However, regulation also plays a part. Basel III mandates that banks hold sufficient liquid assets to manage their liquidity risk. This is known as the liquidity coverage ratio (LCR) and really can only be fulfilled by cash and cash equivalents. So deposits are a necessity almost without exception. In real terms, this amounts to around 10% of outstanding loan balances typically.
One comment i saw on one of the posts by Richard is that deposits are held as a buffer against losses. This is not true except in extremis. When banks take losses on loans, it falls against their own capital first. Depositors don’t take losses until the point of bankruptcy (and even then might not do so). Again, Basel III regulates here: banks also have a capital adequacy ratio (CAR) which is a measure of the amount of loans a bank has made against its (risk weighted) capital. Importantly, this is independent of deposits held at the bank, but it does also serve to limit the ability of a bank to lend.
Richard seems to treat deposits and capital interchangeably, when they are very distinct, but banks need both, neither are free and it is done to maintain financial stability as well as that of banks.
A lack of either can cause a bank to collapse. A lack of liquidity (deposits) caused Lehmans and Northern Rock’s demise. A lack of capital caused other collapses (for example SVB).
One area where is strongly disagree with both Richard and Clive is the idea that banks are getting “free money” from reserves. They are being paid interest on these reserves, and it currently happens to be higher than bond yields, but this is not usually the case. Given these reserves were created when assets in the form of Gilts were exchanged for cash, there has been no net change in banking net assets from QE. Banks weren’t handed free money. They got it in exchange for another interest bearing asset. The complaint seems to be that currently the new asset (cash) yields more than the old one. This very shortsighted view fails to notice various important points. The first has been covered – paying no interest on reserves would force those reserves to seek other higher yielding assets first. Notably Gilts. So all yields would fall dramatically, as well as the currency (as GBP would become a funding currency for overseas assets), as well as an inflationary boom in other financial and non-financial assets. It would be a recipe for high inflation and boom and bust.
Moreover, QE simply wouldn’t work if no interest was paid on reserves. People were not forced to sell their bonds, and for the most part wouldn’t if the asset they are getting instead pays nothing.
The claim then that banks are getting something for free is manifestly false.
To come back to the main thrust: Banks do require both capital and deposits. They don’t create limitless money from nothing (both deposits and capital cost money and both limit credit/loan creation. It is done to promote financial stability, prevent bank failure and also to act as part of the remit of monetary policy given that banks create broad money (China’s banking system is a good example here).
I also see Richard and Clive’s comments regarding regulating via CBRAs. This simply doesn’t work in the way Richard imagines. Banks are not forced to deposit on their CBRA so a bank might appear to have small balance with the BoE but be perfectly healthy having loaned the money elsewhere, or might have large balances but dwarfed by the size of their loan book. Without regulation similar to Basel III you would simply be unable to tell.
I also note another error Richard has made: “The reason why banks are not allowed to fund themselves using overnight funds from central banks is not because this is not possible (it always has been), and nor is that because this should be seen as a last resort, which given the existence of central bank reserve account balances is clearly not the case, but because the pretence is being maintained that the banks must regulate each other through their interbank lending.”
No. If the BoE made un-collateralized loans this would place all the risk of failure on the BoE itself. If the loans are collateralized then you go back to a shortage system and dramatically reduce the ability of banks to lend. In effect it would be reversing QE as either rates are forced higher (thanks to cost of collateral) or massive amounts of new Gilts would need to be issued to make up the shortage caused by QE, again forcing Gilt yields/interest rates higher.
I think I will end it here. I have tried to keep the language simple and not delve into every rabbit hole or tackle every error Richard has made, as there are several more. It is important to note that Richard Murphy’s statements and claims are almost entirely wrong. Banks do need deposits, banks are cannot create credit without limit or for free (given both deposits and capital have a cost) and many of his “solutions” would actually entail removing the BoE’s ability to control monetary policy and cause instability at best, massive economic harm at worst. Turkey actually tried some of the things he suggests – with predictably damaging results.
I have read the above comment with interest. I have also done a little due diligence on the commentator who, as is normal, does not publicly admit who he is, or who he works for or what his qualifications to comment might be. I oftyen wonder why people are so ashamed of what they do that they think it necessary to do this. In this case, however, I think it possible that the person posting might be a person working in a Treasury function in a London bank. I am presuming so.
This does not mean that what they say is credible, of course. For example, they begin by saying that almost everything Clive Party has said on this issue is right and almost everything I say is wrong. That’s amusing, because we agree on just about everything except the role of central bank reserve accounts in regulation. Even on that contentious issues, Clive Parry agrees that CBRAs do not require interest to be paid on all of the balances and that the interest paid on these aggregate balances is free money for our banks. In other words, we have some agreement, even there. The commentator only sees differences. I stress two things from the outset as a result. One if that this person is clearly skilled in trolling. The second is that his post is internally inconsistent.
Then let me address the straw men that the commentator creates within his post. For example, he says I suggest banks can lend without limit. I have never said any such thing. I have instead made clear that they obviously cannot because there are limited credit worthy customers.
Then he claims that I think there is a singular central bank reserve account rather than one for each bank. Given the enormous amount of effort I have expended on explaining the nature of this system over time, that is just absurd, and straightforwardly wrong.
After which he claims that I am wrong to claim that banks view deposits as buffers against losses, or as a form of capital. Straightforwardly, his implied claim that banks do not do this is false as the ordinary, unsecured depositors of Silicon Valley Bank in the USA know only too well. That is exactly what depositors in banks are. They are cheap, unsecured capital, which is exactly how I think banking regulation views them and why depositors do not trust banks without a state guarantee.
Then there is the claim that both Clive and I are wrong to think that banks get free money from QE. First, QE did not create free money. QE was an asset swap put in place to disguise central bank funding of central government. You would think a bank treasurer could work out what they were looking at in QE, but apparently, they cannot. Second, it was that central bank funding of government that created the reserves. QE did not. And third, as a result banks had assets worth about £900 billion transferred to them for no effort on their part and are now being paid maybe £40 billion a year to hold those assets for no good reason. If a bank treasurer cannot identify that as free money I seriously worry about their intellect.
I do so, again, for another reason. This commentator claims early in his 1,800 plus word comment that if the deposit created by the loan that a bank makes is not placed with that bank then its balance sheet cannot balance. It would, he claims, in fact be insolvent. I quietly despair at this level of incompetence, because of course, the only reason why that deposit can be placed in another bank is that funds flowed from the loan creating bank to the deposit taking bank via their central bank reserve accounts. That is where the double entry to ensure that their balance sheets always balance takes place. So, of course the bank making the loan is not insolvent: it now owes the entire value of the deposit held by the deposit taking bank to it via its CBRA. The CBRA creates the loan, and by the way in which interest is then adjusted between the banks by the Bank of England, the oan creating bank is charged fror that loan at base rate. This is the point that Clive’s arguments also miss. But what is clear is that the original loan making bank is not at risk of financial peril as a result of the deposit it created going elsewhere. as this commentator suggests. It would have had a liability for that deposit if it had been made with it: it has a liability to another bank reflected through the CBRA if it is made elsewhere Nor does it now need a loan, as he says. It already has a loan from a UK bank to replace the deposit it has missed out on. All that UK banking regulation says is that this CBRA based loan must be re replaced by another (invariably more expensive) loan, although heaven knows why, which is the whole question I am asking with the points that I raise. If a senior bank treasurer cannot work that out their employer really does need to ask about their competence.
Worse, because this commentator does not comprehend that CBRAs are always the balancing mechanism in interbank relationships, he misses the entire point of the discussion between Clive and myself, which is in whether they are a sufficient mechanism in themselves for interbank loan relationships. I suspect they are, precisely because there is excess liquidity in the system, but this commentator does not understand that.
So, let’s ask why this person is clearly paid sufficient to not understand the job that he does, as is so commonly the case. What is actually apparent within the comment offered are three things. They are:
• He wishes to retain the power structure within UK banking.
• He wishes that this power structure be used to impose excessive interest rates on the UK economy at cost to millions of households and the real, productive, economy of which he is not a part.
• He wishes that his bank benefit from the resulting free money for banks because, no doubt, his bonus is mightily increased as a result.
Given the scale of his basic ignorance and dependence on straw man arguments I can come to no other conclusions.
In that case this was more than 1,800 words posted to make a complete fool of himself. No wonder he sought anonymity.
Wow Richard you gave us two blogs for the price of one 🙂
EDITORS NOTE
I gave this commentator some attention yesterday, and the courtesy of a full reply to their comment, whilst also noting that I suspected that whetever mechanical knowledge they might have of banking regulation they were also a troll.
My suspicion was correct. Two further comments were posted here last night by someone claiming to be the same person as posted the original comment. There were, however, classic troll characteristics:
– They could not spell their name in their email address consistently. However many typos we make, most of us get our names right, unless,of course, we are using a false one.
– The three comments all can from different IP addresses, which is a troll classic.
In addition, the comments only repeated previous accusations whilst repeating the previous evidence of a profound lack of double entry and accounting knowledge.
But, most of all there was the standard Tim Worstall style abuse that I am a retired small firm accountant and blogger with no real achievements who can’t possibly know about anything else as if I could never have learned anything from years of thinking, reading, observing and analysing real world economics. It was all the standard stuff that Worstall and his brainless acolytes like to serve up.
I was left with one thought though. If I really am as useless as they like to suggest, why are they so very, very worried about what I have to say? Could it be either:
1) I am right?
2) They know I am right?
3) They can see all their fantasies slipping away from them?
Whichever is true, Nicholas won’t be back under that identity. However, as there is evidence he might have used others in the past, no doubt he will reappear in another guise. They really are worried.
I think Richard and I agree on quite a lot. The one area where there is great scope for confusion (and one where you challenge him) and that is the use of the word capital. You and I use it in a banking sense – equity capital (CET1 or occasionally hybrid instruments). Richard, as an accountant uses it more broadly to include debt/deposits etc.. I hate his use of the word in its non-banking sense when discussing banking issues – and he knows this.
However, underneath his (in my view) “wrong” use of this word I am confident that he understands the issues.
On the substantive issue you have with me (“free money”) I would say this..
Leaving aside the business of credit provision and focus on the “day-to-day” banking that all of us use – current/savings accounts, payments systems, ATMs, branch network etc.
The current model is that interest is paid on all reserves at Base Rate and banks pay very little interest on current accounts or even savings accounts (for the big clearers). This large spread is the quid pro quo for “free banking” that most of us enjoy, ATMs are stocked with notes that need transporting and looking after, branches need to be operated.
When CBRA balances were £30bn and rates quite high (pre 2008) or when balances were £800bn and rates close to zero (2009 to 2022) this was probably a reasonable trade off.
However in 2023, CBRA balances are £800bn AND rates at 5.25%…. while the cost of running the business is not massively changed. This is the “free money”. Perhaps, the phrase “free money” is over dramatic… but it does capture the fact that banks’ profits have risen sharply as a result for no effort on their part.
In a competitive banking environment one might expect it to be competed away…. but it is oligopolistic and needs dealing with.
Thanks
And noted
Clive,
If the system we have had been well thought before it became the established conventional wisdom (rather than the temporary fix for a specific problem, which it still looks like to me); we should be entitled to expect that that Treasury and BoE, in broad terms, could model just such a problem potentially arising (excess reserves and high interest rates), and see it coming, at least as a contingency which required account to be taken. Did they really think a long unbroken multi-decade period of this new lower bound interest rate regime would endlessly continue; no matter what happened anywhere in the world? Really?
Please also note that the BoE’s use of the LSVJ as an insight into the drivers of reserve demand into the future, had its own inherent difficulties; as they well know: “In the UK context, there are challenges to estimating both the money market rates and level of deposits consistent with the PMRR. Unlike in the US, the UK data does not include a period in which the system moved from ample reserves towards scarcity. Given that the structure of sterling money markets has changed in a prolonged period of ample reserves, and will continue to evolve during QT, we do not know the SONIA-BR spread that is consistent with the PMRR”; and, “The level of deposits at the time reserves approach the PMRR is also very uncertain” (BoE, Bank Overground website; ‘What do we know about the demand for Bank of England reserves?’, 2023).
Here we go, with the use of words. Capital (I quite often fall into Richard’s way of thinking; most businesses have to think that way; and few struggle to make the distinction either, capital is used in different ways wherever it is found; bankers are so precious!); but ‘free banking’? Clive, while I agree with you broadly, you are using ‘free banking’ to describe “current/savings accounts, payments systems, ATMs, branch network etc”. That is a very generous interpretation. In a ‘quid pro quo’ I would expect a quid for the ‘pro quo’.
1. Zero interest on current accounts, plus a growing fee for most accounts.
2. Zero interest on savings, unless pressurised to do so; and it remains a poor return always.
3. Closing branches. They are wiping out the Highlands branch network.
4. Shutting ATMs. Ditto in the Highlands. They are driving everybody away from cash, as much as people are willingly moving digital.
5. We are supposed to trust the Banks and their technology. On what grounds? not their own history.
6. They receive two free lunches. A 100% guarantee on all small deposits they take, and another guarantee because they are too big to fail. How much does that cost us all? Nobody else in business ever has it as easy as that.
7. How much are they currently paying for their banking licence?
That is my list, and that is why I think the banks are in receipt of ‘free banking’. Why do we allow these risk takers to control our money; and leave everyone else, including the government to worry about it. What for? Do we really thin theis model of banking is actually worth the grief (except for the bankers, who seem never to be poor)?
Hi Bill
It was the MMT Podcast from Patricia Pino and Christian Reilly that prompted me to chase down the Greenspan quote. So perhaps they should get the credit.
Also, please not that in my post “related” should read “created”
It was you gave me the nod so perhaps we’ll leave credit with you for now. It’s live on the original page if you want to go see, if it doesn’t show then refresh your browser.
Richard, Kumhof has not changed his mind. He is simply recognizing the insights of two greats of Economics, Keynes and Schumpeter – the created financing comes before the production, income and increased savings.
“Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving.” (Keynes 1939, p. 281).
“[…] in general, the banks hold the key position in the transition from a lower to a higher scale of activity. If they refuse to relax, the growing congestion of the short-term loan market or of the new issue market, as the case may be, will inhibit the improvement, no matter how thrifty the public purpose to be out of their future incomes. […] The investment market can become congested through shortage of cash. It can never become congested through shortage of saving. This is the most fundamental of my conclusions within this field.” (Keynes 1937, p. 222).
“The banker […] is not so much primarily a middleman in the commodity ‘purchasing power’ as a producer of this commodity. […] He is essentially a phenomenon of development. […] He makes possible the carrying out of the new combinations, authorizes people, in the name of society as it were, to form them. He is the ephor of the exchange economy.” (Schumpeter 1912, p. 74)
I am struggling to see why that requires full reserve banking, which denies the way fiat currency works
Fiat currency solves the problem Keynes noted
It does not, I was just answering the question of whether Kumhof was having second thoughts. Bought I think a paradigm shift of some kind would make government investment easier, investment in the people, housing, the environment, infrastructure, education, health … We need to reallocate some resources and that can be very difficult in a non-emergency situation.
Pauline, Michael Hudson supports MMT but he says The Chicago Plan should be part of it.
He responds to the Pettifors of the world by saying the central bank could lend to banks, just the way depositors do, to prevent any shortfall
https://www.youtube.com/watch?v=O_btd7wuslc&t=5754s
Which would not happen
This suggestion is a recipe for economic disaster in the fiat world
Joe, I am beginning to think you really are on the wrong blog
Richard, if you were the PM or Finance Minister, things would be a lot better for the people. I support any blog that moves us down that road!
Progressives do not agree 100%, but they have to stick together.
Besides I have learned a lot over the years from you and many contributors – inlcuding the last few days on this vital topic. 😉
Less recently your work on taxes was amazing – no I am not attending the wrong blog
Joe
Ok
I quite like my recent work on tax too….
Thanks Joe, and Richard for your earlier link.
It seems Michael Hudson is not a fan of central banks. In that section of the video, he talks about banks having a line of credit with the Treasury so they could make loans for productive (not speculative) purposes to creditworthy borrowers.
He says elsewhere: “The Federal Reserve’s job is to prevent the Treasury from spending on social purposes and to keep monetary control and centralized planning in Wall Street and the financial centers to benefit the financial sector and its major clients, not the economy. So I don’t think there should be central banks at all. Every country should have money creation and credit as a public utility and therefore under the Treasury, not the Central Bank. They are the opponents of democracy.”
Banks are far too powerful to make much reform possible though. The post 2008 reforms were watered down by the banking and financial sector lobby, even though the banks (and others) were rescued by governments and central banks.
Pragmatically you are right Pauline
I am not a fan of central banks either (I suspect some have noticed) but they have a regualtory job to do
What they should not be doing is dictating economic polocy, at which they are very bad