Cowdung and Credit Creation

Today is a momentous day for the United Kingdon, as Teresa May officially invokes article 50 to leave the European  Union.

Sadly, I am not yet ready to add commentary to current events, however important. My initial theme is to carry on explaining the operations of the UK banking system, presented in a way that should be available and understandable to anyone who is concerned about the economic reality we live in. No-one should be denied such access and needs to be equipped to detect and avoid the distortions presented by the COmmon Wisdom of the DominaNt Group a.k.a. “CowDung”. hopefully these posts can help in that regard.

In my last post on this topic, Can Banks Create Credit?, I noted that you should not take my word for this. This post is the first answer to that.

The Bank of England publishes an online  quarterly magazine called the Quarterly Bulletin. The Quarterly Bulletin 2014 Q4  contains two important articles with accompanying video overviews:-

This is essential reading for anyone interested money, pretty much everyone!

Money in the modern economy: an introduction

Money is essential to the workings of a modern economy, but its nature has varied substantially over time. This article provides an introduction to what money is today. Money today is a type of IOU, but one that is special because everyone in the economy trusts that it will be accepted by other people in exchange for goods and services. There are three main types of money: currency, bank deposits and central bank reserves. Each represents an IOU from one sector of the economy to another. Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves.

This article has introduced what money means and the different types of money that exist in a modern economy. Money today is a form of debt, but a special kind of debt that is accepted as the medium of exchange in the economy. And most of that money takes the form of bank deposits, which are created by commercial banks themselves. A companion piece to this article, ‘Money creation in the modern economy’. describes the process of money creation by commercial banks in more detail.


Money creation in the modern economy

This article explains how the majority of money in the modern economy is created by commercial banks making loans. Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.[My emphasis]

This article emphasizes some of the themes I have noted in previous posts regarding the myths of  Loanable Funds, Fractional Reserves and the Money Multiplier and the implications of these myths will be explored in following posts. Note that “some popular conceptions” (and other statements in the article) are a polite and diplomatic way of calling bullshit (or cowdung) on the banking sections of economics textbooks.

I need to finish with a  couple of caveats.

First is that just because this is published by the BoE does not mean it is immune from criticism. Far from it. Indeed a theme I will develop is how many central banks have misled themselves as well as others with distorting if not fatally flawed in-house models of their economies. Still I do regard the above two articles as very accurate given my background in actual banking.

Second, these articles were published in 2014, there are other and older references for these accurate descriptions of money in the Uk and elsewhere. I have not yet found a good summary post of all those central bank references and am slowly building up a file which I will post when I am satisfied with the content.

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.


Do Banks Loan Deposits?

A very simple question that to most people is obviously true. But is it?

The story in most[1] introductory economics textbooks goes something as follows:

  1. Bank A receives a deposit of £1000
  2. With a reserve requirement of 10%, the bank keeps £100 in its reserves and can lend out £900.
  3. This can be used to pay an account in Bank B and the same process occurs.

A quick spreadsheet for an initial deposit of £1000 with a 10% reserve requirement and a minimum loan size of £100 shows the total loans:

Deposit Reserved Loaned
£1,000.00 £100.00 £900.00
£900.00 £90.00 £810.00
£810.00 £81.00 £729.00
£729.00 £72.90 £656.10
£656.10 £65.61 £590.49
£590.49 £59.05 £531.44
£531.44 £53.14 £478.30
£478.30 £47.83 £430.47
£430.47 £43.05 £387.42
£387.42 £38.74 £348.68
£348.68 £34.87 £313.81
£313.81 £31.38 £282.43
£282.43 £28.24 £254.19
£254.19 £25.42 £228.77
£228.77 £22.88 £205.89
£205.89 £20.59 £185.30
£185.30 £18.53 £166.77
£166.77 £16.68 £150.09
£150.09 £15.01 £135.09
£135.09 £13.51 £121.58
£121.58 £12.16 £109.42
£109.42 £10.94 £98.48
£9,015.23 £901.52 £8,113.71

Now a bank can aggregate deposits from different accounts and so carry on the loan process even with a minimum loan set to £100. The end result is that the original £1000 ends up in the banks (taken together) reserve accounts at the Central Bank and that £10,000 has been loaned out. This is the Money Multiplier – with a 10% reserve requirement money has been multiplied by 10.

It is important to note that no new money is created, rather it is the same money that has been circulating from deposit to loan with each bank retaining 10% of that deposit each time. (Of course, any bank could be involved in the deposit loan process multiple times, indeed it could even always be the same bank).

The argument is meant to be a demonstration of what is known as the Loanable Funds Doctrine within neo-classical mainstream macroeconomics, which implies that bank are just financial intermediaries, banks lend deposits, merely matching patient savers with impatient borrowers and, as such, can be  left out of their models of the macro economy – the study of the economics of nations. They might be added in as a friction – the cost of doing business –  as this service has transaction costs to the loans process (otherwise how would the banks generate profits), but they are not intrinsic to their models.

So when the Queen asked economists how they missed the Global Financial Crisis (GFC), part of the answer is because of believing the above, justified them in not modelling a key part of the financial markets and so they missed the signficant effect these had on the real economy.

In the next post I will show this is not how banks make loans and how they do.

Some concluding remarks on issues that should be discussed if the above were true but are rarely if ever discussed.

Clearly it takes time for the deposit-loan-redeposit process to occur. The above process was shown 34 times to get from an initial deposit of £1000 down to £100. Even allowing for aggregation across accounts, the velocity of this process needs to taken into account in deriving the money multiplier but I never see such a point being made. That point also leads to the Monetarist’s favourite  Quantity of Money theory, but there they assume that this velocity is constant and quite low. (I will not explore this theme more for now, I have bigger fish to fry).

Another point that follows from the velocity issue is that the fractional reserve could be a policy parameter available to the Central Bank. For example,  changing the reserve requirement from 10% to 5% could be a form of private sector stimulation, as the available loans at each stage would be 5% larger and so available sooner in having an effect on demand in the economy. Again I do not see this being discussed in such a way. (Of course, the original argument for a reserve requirement was to ensure banks were liquid enough to avoid bank runs but there are, as we shall see, other means of managing liquidity).

Thats all for now.

[1] I would be grateful anyone has any references to textbooks that don’t commit this error to add these in the comments, I have not yet found any within the mainstream economics approach.