Can banks create credit?

In yesterday’s post Do Banks Loan Deposits we very briefly looked at the conventional and popular understanding of how banks provide loans and  stated that this is not how they actually work. So how, in fact, do they provide loans?

Sticking, momentarily, to a 10% fractional reserve requirement (FRR) and a £1000 deposit, the more likely scenario (still not quite correct but we will get there) is as follows.

The bank receives a £1000 deposit. It uses 10% of that – £100 – as the reserve against that deposit and uses the remaining £900 as the 10% reserve against a £9,000  loan! How can it do that? Where is the actual money, yesterday we saw how a £1000 deposit could be multiplied by 10 (given a 10% FRR) but this was through a deposit-loan-redeposit recycling process that reused the same money, in each case there were transfers of FRR reduced existing money.

We need to look at this from a balance sheet perspective in terms of assets and liabilities.

When you take out a loan, you strike a loan agreement with your bank, this is actually a promissory note – agreeing to terms of payment and in return the bank puts the loan in your current (or demand) account.

From your perspective the loan document payment schedule is your liability and the newly loaned amount in your account is your asset.

From the banks perspective, it is the other way around, the loan document is their asset and added to their assets (technically this is a debit to their assets but we will ignore subtle issues of double entry accounting for now)  and the loan amount is their liability added (credited) to the liability side of their balance sheet. (Also this new asset should be worth more than their liability in Net Present Value or Discounted Cash Flow terms, otherwise they would be making no profit from the transaction but we can ignore that too for now).

Most importantly the bank loan department, having set up the loan, now hands over the adminstration of both interest and principal payments from you and loan payments from them over to the relevant accounts department. You will see an increase in your current account of the loan amount but until you use it is, from the bank perspective, an account payable but not yet paid! Yes, you are just a creditor of the bank, like all the other creditors providing utilities, services, goods or demanding salaries, taxes, bond coupons payments and so on. That is there is no actual  transfer of money into your account!

How can this be? Is this an accounting trick? (Some did and still do regard this as quite dubious but we need to understand the operational issues first).

We need to see what happens when you make a payment from your account regardless of whether  it is  either  from cash deposited or from the new loan added to it. Say you are paying all your loan from Bank A to an account holder in Bank B to purchase a car.

Bank A  and Bank B have their own accounts at the Central Bank and need to work out the net transfer between them over a specified period, say a day and this transfer will happen in their central bank accounts.

Bank A sums up all the account demands on Bank B accounts and provides these to Bank B to approve (or bounce) those demands determining the net amount that Bank B owes Bank A. Similarly and in parallel Bank B provides the demands on Bank A in order to determine the net amount  that Bank A owes to Bank B. It is the difference between these that is then transferred. The central bank acts as the clearing house for the banks to settle their balances.

The transfer of your new loan to pay for a car is just a minute part of this daily  clearing and settlement process between banks.So thats how this credit can be created without your bank lacking resources to fulfill its obligation to you.

All these payments are managed in the money we already know as reserves. However, as customers of a bank, we cannot access reserves directly, we can only access bank credit. We can convert this credit to cash in, say, an atm, and a bank can convert deposited cash into reserves but we do not directly  use nor access reserves at all.

So how much reserves are required in these banks accounts at the central bank? Surely at least 10% of credit outstanding? Well no. In the UK there is no fractional reserve requirement! And this applies in various degrees to many other central banks where the government has its own sovereign currency.  So revisiting our momentary example posited at the beginning of this post, no reserves are required and so no deposit is required to create the loan. In other words, loans create deposits!

So the causality of loans and deposits is quite reversed. It is not deposit create loans but the loans create deposits. There is no Money Multiplier. This is the Credit Creation Theory of Bank Loans. The Fractional Reserve Theory of Bank Loans is a fiction. The Loanable Funds doctrine is false.

Now there are a number of important implications of this, all of which will be discussed in future posts.

There are times when a bank does not have sufficient reserves to settle its account with other banks but then there are various means to borrow those reserves such as borrowing from other banks with surplus reserves. We will discuss that shortly.

It would be overreaching to say that banks do not need deposits at all for credit creation, banks need a supply of reserves and  typically the cheapest source for them has been deposits. Again this is a theme I will expand upon shortly.

If we are just a creditor what are our rights when a bank becomes insolvent? If there is no fractional reserve requirement, how does this affect bank liquidity and the threat of bank runs? If banks are not constrained by the money multiplier and deposits, what is to stop them lending an infinite amount of money (and creating inflation)?

If this is how banks work, why do most if not all mainstream macro economists still insist upon the Loanable Funds doctrine. And how does the Credit Creation Theory of Bank Loans affect their macroeconomic models?

If people want to reform banking and they do not understand how it work, should we listen to them? (There are plenty who argue for reform based on the correct understanding, this question, obviously, does not apply to them!)

Finally, I did say I did not want to reinvent the wheel and there is some very good literature on this topic.  Still the themes just mentioned above I do need to specifically explore. The next post will include some decent references to back the claims made in this post.


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