My post about bank reserves generated a lot of discussion. Well, I guess it was really more of an anonymous commenter trying to explain it to me than a discussion, but anyway, the comment thread is worth a read. I also have two more reserves related links today (one of which is from David, another commenter in that thread). I think it's important for people to realize that 99% of Americans, me included, really have no idea how the banking system works. We (we the ones who don't understand) think that when we master the concept of fractional reserve lending (which, in itself, 90%+ of Americans probably don't understand) that we have it figured out. There's a big problem though, in that fractional reserve lending really doesn't illustrate how the system actually works anymore.
You can check out a piece from John Hussman that's a few years old for some more thoughts:
"Yes, during periods of crisis, the Fed has an important role to play in providing day-to-day liquidity so banks can meet depositor withdrawals. But aside from this short-term variation in the monetary base (which we saw, for example, around the “year 2000” turn), there is not even a slight relationship between bank reserves and total bank lending. Indeed, any remnant of that relationship was wiped out in the early 1990's, when reserve requirements were removed on all bank deposits other than checking accounts."
Note that the piece is from 2007.
Billy Blog also took issue with people panicking about the potential removal of reserve requirements.
"At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.
So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.
The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place."
What's probably most frustrating for readers, myself included, is the epiphany that banking doesn't work like we think it does - it doesn't work like the textbook fractional reserve banking example I gave in my prior post (where, with 10% reserves, a $100 deposit becomes a $90 loan, which is then re-deposited and becomes a new $81 loan, etc). In our system, in reality, you don't need deposits to lend. I think that fact troubles and confuses a lot of readers.
-KD
31 comments:
The lynch-pin is the Fed's ability to lend.
If the Fed has difficulty lending, reserves matter immediately.
I wonder what extreme outside pressures might cause the Fed to have problems lending?
At a much more extreme levels commodity (esp energy) and political pressures come to my mind immediately.
Comments appreciated...........
Agreed KD. It is frustrating that what I learned about fractional reserves in high school economics (and never again in college economics!) is not at all the way it works.
However there is another problem alluded to in some other blogs, the comments and by Mr B: how can the Fed which has no formal authority and responsibility for evaluating the collateral and cost of funds for individual banks fulfill this function in any sane, rational way? Setting reserves to zero is meaningless without doing something about this.
You summed up the problem in a few words--what we have been taught is wrong, and a fundamental belief in the "fairness" of money will follow. If we cannot rely on money to store wealth and get us what we want/need to live, what will we do?
The current view of most is that there is a finite amount of money in the system, of which banks are the "stewards".
Along this line of thought, if you give a bank 100$, they keep 10 and loan out 90.
A rough, but more accurate analogy would be that if you give a bank 100, they can loan out 1000. They create credit.
However, if another loan makes sense(in their view) - but they lack the 'requisite' deposit, they borrow 100 from the FED, and make another loan of 1000.
In this way the FED effects changes in the Money Supply via credit creation and destruction based on the price of FED funds relative to loan demand.
A few things should jump into one's head once they internalize this process.
1) All money that enters the system in the form of debt. It does so at a profit (on paper) to the Banks via the interest on given loans. This architecture naturally puts a structural upward pressure on the Money Supply to expand, from profit seeking banks looking to make loans, and thus is, ipso facto, inflationary. (Not always, as we are witnessing during this credit contraction, as debt has finally hit the ceiling - just usually )
2) The FED's implementation of monetary policy, using the Banks as the mechanism - is at direct conflict with them being the Regulator of said banks.
3) If banks are the mechanism of Money Supply in America, and are naturally subsidized for their 'work' - have they embedded themselves so deeply in the design that we can ever exist without them?
Again Kid - Great posts.
This hurt my head as well.
Our banking system makes perfect sense in a twisted, immoral, inherently unstable sort of way...
Kid, respect :)
As I think I said in the original thread or in the link provided there, FED should _not_ be the regulator of the asset side of banks but rather an agency collecting banking statistics and (more important) supervising the smooth functioning of payment system. This means that FED should provide unlimited liquidity to banks. This will overnight eliminate bank runs and all mad stories about them.
However, full regulatory power should go to FDIC or similar agency which will be obliged to care after the asset side of the banking system and should _REALLY_ act preemptively and close (or anyhow take care of) banks _approaching_ solvency limits.
This requires a complete review of the current banking framework but many people would agree that we arrived at this point. Especially given a fundamental mis-understanding of operational realities.
What I meant was: a fundamental disbelief in the "fairness" of money will follow.
Other than that one word, it was all right :>)
the fact that banks can lend without taking in deposits - ie, that they don't actually lend against their deposits - is the one that confuses/angers/signals as "unfair" to most people, in my opinion.
@KD;
Yes, the next logical question is--why can't I just lend out money, if I don't need deposits--why should the banks have a monopoly on money creation (the US government creates money through its captive bank, the Federal Reserve Bank).
And really, why should they?
"the fact that banks can lend without taking in deposits..."
Hang on. Loans still have to be funded - an individual bank doesn't get to "create" money in that sense. It's just that the bank doesn't need to have the funds in hand before it makes the loan. It can make the leap of faith that it will be able to find funding in time for settlement. Money creation happens at the system level: bank A lends $100 which is deposited in bank B, bank B lends $50 which is deposited in bank A, and the result is that $150 is created but is nonetheless available for wholesale settlement because B has $50 surplus that it can lend to A.
I don't know why this would seem so unnatural to an ex-trader. A plain vanilla bank is making a market in money, and it profits (primarily) by trading off its own prices. It doesn't necessarily have the money in hand before it sells it any more than a broker has necessarily already borrowed a share before it executes a short sell for a customer. A bank has no way of knowing in advance, except statistically, whether it will be a net buyer or seller of money on the wholesale market at end of day settlement. (No, brokers don't create shares if naked shorts are disallowed - no analogy is perfect.)
Operationally, reserve requirements are a side issue. Functionally, they are about liquidity, not solvency. Even where there are no legal reserve requirements, no bank operates without any reserves at all any more than you would operate your personal finances without any cash at all, even you prefer other assets on a risk-adjusted basis. And if there is a liquidity glitch, the central bank can step in and create liquidity. Lowering reserves just makes lending marginally more profitable (or borrowing marginally cheaper): instead of earning ($10 @ fed funds rate + $90 @ lending rate) - $100 @ funding rate, with no reserves you would earn $100 x (lending rate - funding rate.) But removing reserve requirements will not necesarily result in any change in actual reserves held - that should be obvious since U.S. banks currently hold far more than their legal minimums.
Banks want you to have skin in the game. That's why the traditional home mortgage required a 20% down payment. That and the fact the 20% would cover their foreclosure costs. (Sorry slipping into cynicism again. I hate banks.) When they lend without having deposits, essentially borrowing from the Fed for the money to make the loan, they are violating their own loan requirements of their borrowers. Who cares about underwriting if it's someone elses money?
anon - your last paragraph has basically been PROVEN wrong already though - that was my point in the previous thread.
you wrote: "no bank operates without any reserves at all any more than you would operate your personal finances without any cash at all"
ummm - except that's not true. plenty of banks did essentially EXACTLY that! that's why we had a crisis.
and no - banks don't actually make a market in money - that is exactly why it's confusing to an ex trader. I, and many other, would expect that banks make money (on the spread) by taking in my deposits, paying me 50 bps, and lending my money out to MikeMortgage at 5%.. that's making a market in money. it's logical. it's how we learned it.
except that they don't really need my deposit at all! all they need to do is borrow a little bit (the reserve requirement!) of the MikeMortgage amount from the Fed or the interbank market. and now, if reserves are eliminated, they might not need to borrow anything at all. just lend baby! it's absurd. you're logic is that they obviously won't just lend to every Tom Dick and Harry in the world, because they are rational. My point is: see 2007-2008 banking crisis. the banks have PROVEN their inability to estimate default risks already.
as long as banks don't make any bad loans, there are still no problems. but that assumption is useless in the real world
anon - i guess a further question is, what is the "funding rate" in your comment? see, in my world (ex-trader), it's the rate the bank pays on deposits... but in the real world, banks don't need deposits to fund themselves. they can borrow from the Fed to fund loans, right? (I think i screwed this up in my previous comment when I said they borrow the reserve requirement. The reserve requirement applies to deposits, not loans!!!)
i guess a key clarification is just because the bank doesn't need deposits doesn't mean you can open up a bank and lend willy nilly - the Fed won't lend you the money to re-lend - you need EQUITY still... right?
maybe you can explain Bill MItchell's comment in the link: "The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact."
how do loans create deposits? on a SYSTEMWIDE basis, they do, but at the bank of KidDynamite, if I lend money to MikeyMortgage, there is certainly no guarantee that the spent money will end up back in my bank as a deposit! how do i FUND my loan if i don't have a deposit first? i borrow the full amount from the Fed? and the Fed is willing to lend it to me because... well - why? because i have equity?
i think i found one of my key flaws of confusion in this entire two-post discussion.
first off, my comment from 3:20pm, included this:
"except that they don't really need my deposit at all! all they need to do is borrow a little bit (the reserve requirement!) of the MikeMortgage amount from the Fed or the interbank market. and now, if reserves are eliminated, they might not need to borrow anything at all. just lend baby!"
now - that is TOTALLY wrong - i think. anyone? reserves are against DEPOSITS, not LOANS. right?
even if banks don't need reserves on deposits, they still need to fund loans somehow. and even if they don't need deposits to fund loans, they still need to borrow that money from somewhere (take a loan to make a loan!)
as long as everyone is prudent in their loan standards, and no one (like the Fed) gives the Bank of Kid Dynamite funds (loans) to re-lend (to my customers), everything is hunky-dory.
but again, we've already proven that this is not a realistic assumption to make.
"ummm - except that's not true. plenty of banks did essentially EXACTLY that! that's why we had a crisis."
I can't agree with you there, Kiddo. Every single bank that blew up had reserves. What they didn't have was equity. No amount of liquidity can make up for negative value.
"except that they don't really need my deposit at all!"
But they need somebody's deposit - that is what I (and the other anon) are trying to tell you. Most banks prefer retail deposits because they are "stickier" than wholesale even though not necessarily cheaper, but as a practical matter nobody can operate without some wholesale funding. (The deposit base is the franchise of a bank, the barrier to entry in the business - "a bank's liabilities are its assets" means that its financial liabilities are its business assets.)
"what is the "funding rate" in your comment?"
The cheapest you can find. If it's higher than your lending rate, you lose, just like you do when making a market in any other asset. In extremis, the Fed will lend you money at a penalty rate. That's why it's "the lender of last resort" - it's not just a hollow slogan.
"reserves are against DEPOSITS, not LOANS. right?"
Yes! The point of a reserve is to satisfy demand for cash redemptions. That's it.
thanks anon - as you can see by my three consecutive comments, i am indeed confused, and i'm not afraid to admit it...
i think i have it though...
Bank of KD opens up for business. I don't need customer deposits, but if i lend money to MikeMortgage, i still need to borrow that money from somewhere. I would probably prefer to borrow it from customers (deposits) - which are probably almost always cheaper, but if i can't, i can hopefully borrow it from the Fed. we're not talking about RESERVES here at all - right? we're talking about borrowing the money so that i can lend it.
now, i've borrowed $1mm from the Fed, at say, currently 15bps, and I've lent it to MikeyMortgage at 5%. Jackpot!
of course, the Fed lends to me for a reason - and that's because i have equity - right? even though I don't have any customer deposits?
do i have this right?
note that this comment has absolutely NOTHING to do with reserves - I HOPE.
also note, that as i've said multiple times, this doesn't mean everything is ok, as we've proven the inability by all parties to effectively evaluate credit risk.
finally, now I owe the fed $1mm.... if we have reserve requirements, do I have to borrow additional money so that I have reserves for that DEPOSIT that the Fed has with my bank?
without complicating things: in practicality, banks usually do borrow from their customers (they take in deposits) - but your point is that they don't NEED to - they can borrow from the Fed too.. (And again, we're NOT talking about reserves in that point)
A commercial bank has two functions which are conflated by historical accident: an escrow function (they hold money for me and send it out when I tell them to) and a lending function. These two operations do not have to be mingled--it's just that we expect them to be!
You do not need to have deposits to lend fiat money!!! (Maybe the system is better if you do, but it is not necessary--it is a policy choice.) All that is necessary is that the counterparty is willing to accept your assurance that the money you are sending is "real." Think of it like this--if you ask me for money, and I give you one of my IOU's in exchange for your IOU, do you have money? Only if the IOU I give you is called a Federal Reserve Note (that is, legal tender). So how do I get the right to issue that Federal Reserve Note instead of my personal IOU? Because the Fed says I can, that's why--I'm a bank and a member of the Federal Reserve System, and as long as I abide by their rules, I can issue Federal Reserve notes instead of my personal IOU's. Now, the rules may restrict my ability to issue credit, but those rules are a policy choice and not a physical necessity.
"you can open up a bank and lend willy nilly - the Fed won't lend you the money to re-lend - you need EQUITY still... right?"
I'm addressing this in a separate post because it requires a lengthy answer that has nothing to do with reserves.
First, to open a bank, of course you need equity. You require equity to legally conduct bank operations - that is what the phrase "regulatory capital requirements" refers to. I thought we were talking about ordinary commercial and retail banking here. In that case, if your equity falls too low (your leverage rises too high), the FDIC will shut you down. Neither the Fed nor any other government institution will lend money to an insolvent bank under normal circumstances. The legal equity requirements are there because the market won't tolerate low equity either; a rumor of insolvency will provoke a bank run. Whether this is a retail or wholesale run depends on circumstances.
I had caveats in there: "normal circumstances" and "normal commercial and retail banking." That is because it is highly plausible (there is a "colorable case"!) that the Fed has in fact been lending money to insolvent banks hoping that they will earn their way back to solvency so that it will avoid having to deal with the fallout of closing them down - closing down the majority of the world's financial system simultaneously is unexplored territory.
If that is right, then contrary to what everyone said about Japan - that it could never happen here - it is in fact happening here. But the banks in question are large money-center banks and the crappy assets that have destroyed their equity are not the product of ordinary banking - neither the circumstances nor the banks are normal. And to the point: no economically feasible level of reserves (which contribute to equity on the asset side of the ledger) would have saved them.
What constrains a bank from lending? Where are they capped?
They are not at all constrained by deposits. High End banks (like Goldman now) don't even take deposits in that sense.
OK. Now any bank registered by their State, and with a ton of regulatory bodies (FDIC etc....) - can make a loan. They can do this without a dime of "deposits". Yes they can print money. Yes. Get this point.
If they need to borrow funds From the FED to satisfy reserve requirements (which ultimately is just a tax on existing loans) because they have not taken a single deposit, they go ahead and do so, at the prevailing rate, in needed amount (8%,10% - but not 100%) - via the FED.
What CANNOT BE BORROWED FROM THE FED AND MUST BE IN CASH OR LIQUID SECURITIES
is Equity.
This is something that differentiates itself from reserves, because only you - the Bank - can use it. It cannot be called away. It is yours.
That is your start up capital, issued stock, Cold hard currency - not a customers' money, nor the FED's. Different from reserves.
Current Tier 1 rules are in the 4% -10% range of outstanding loans(depending on size of bank) must be in Equity.
If you get near the ceiling, you get on the radar of the regulators.
If mom throws you a 100 million and you start your own bank you can make 1 billion in loans without a single deposit. (and you are registered blah blah blah!) This is backstopped by the 100 million.
(This is why they hate people shorting Bank stocks (which is equity) - it fucks up the Capital Ratios and fritzes out the whole system)
Further, like Citi, you make loans - therefore profits - stock goes up - equity grows from stock price - more room to make more loans - stock goes up - you get it....
i need someone to address my 4:41pm comment. basically, if i don't have any deposits in my bank, am i lending out of my equity - my startup capital? or am i borrowing from the fed to make loans to customers - and the Fed lends to me because my equity is sound collateral?
scharfy - your comment confused the crap out of me.. you wrote "If they need to borrow funds From the FED to satisfy reserve requirements (which ultimately is just a tax on existing loans) because they have not taken a single deposit, they go ahead and do so, at the prevailing rate, in needed amount (8%,10% - but not 100%) - via the FED."
but we just got done figuring out that reserves aren't against loans - they are against deposits! banks can borrow from the fed to fund their loans - and if they have no deposits, they need to borrow the full amount of the loan - which essentially means they just took a deposit from the FED... if there are reserve requirements of 10%, do they need to borrow an extra 10% from the Fed to cover the reserve requirements too? seems logical...
also, scharfy, i think you're mistaken about stock prices. equity need not be related to stock prices at all. if KD Bank sells a million shares at $100 each, i have $100mm in my treasury - regardless of what happens to my stock price.
Well I am not angry or confused, I am amazed. What the summary here seems to be is that:
-As long as "liquidity" is available than money is fungible because you never really have to have it all at once.
Of course in the end the FED has a printing press so the argument is that liquidity can never be an issue.
While true in the lawyer/legal sense of the argument, it is also bullshit.
In essense the banking system is built on the idea that money once in motion, stays in motion and there is never a "called all in" to borrow a poker term. Of course back at the apex of the crisis when money markets were being drained this was a partial call and the FED/Treasury wet their pants in fear over the removal of a small (relative to the "liquidity" out in the system) amount of real money from the system.
The evidence would make the pie in the sky argument that reserves are meaningless and money can be created from nothing as long as loans (credit) are made a failure because why did they bother to do anything if eveything was all set?
Sorry to simplify but all the tangled paths of this make something so simple very complicated.
The oldest profession is prostitution because it is hard to screw up (pun intended) and it is very profitable. The second oldest is banking for the two same reasons. Of course over time smart asses with theories have bent things around theoretical constructs so much that banking is screwed up. Classic. Rememebr the models and theories that said people would never, ever "walk away" from a home mortgage and never pay a credit card or car loan before a mortgage? Working out nicely indeed.
Kid -
Yes you are right Tier 1 capital doesn't include current stock price - duh...
Scharfy
Sorry for the muddled post - I'm no expert but I've had a money and banking hobby since 2008, and i stay at holiday inn.
Anyway the part that we all agree on - is that banks don't loan money. They create credit - and in doing so, NEW unaccounted for money enters the money supply. Gotta internalize that. They don't funnel from the FED, dip into to equity or any of that.
They generate, from only the borrowers promise to pay, NEW friggin money. At a cost of 0 percent for life. It is a birth. A checking acct that did not exist, now exists.
Banks don't lend our money. They write loans. And can do so from scratch, and are limited primarily by how much equity they have, versus their assessment of the creditworthiness of borrowers.
The reserve requirement mess and capital ratios, as I am finding are more arcane and complex than I had even thought - - so I'm on the learn as well.
I look forward to a summary post from you on Monday cleaning this up for me.
Scharfy
All this time I thought I was nuts because I thought the banking system was a joke, now I am convinced.
End this crap, I dont care the cost. If you cannot explain it in 3 sentences it is no good. What a fiing joke. All our structure is built to help those who built it. Hilarious.
GYC - the Federal Reserve system is pretty insane. If we didn't have the world's reserve currency, the USA almost certainly would have seen our financial system destroyed after what happened in the past few years (in fact, that's happening to Greece as we speak). we're lucky that we can print seemingly endless amounts of money, and still have the confidence of global markets in our currency.
over at naked cap
good article on credit creation
There has been a running commentary over at Naked Cap with a few knowledgeable guys commenting...
scharfy
ha there you are in the comments...
scharfy
scharfy - it's not a competition, but the comments on this thread are much more informed than the comment on the NC thread. i think the author of the thread, GW, made the same mistake i made. I don't think he's right - as you can see in my comment there.
check out MacroStategyMan's comments on this earlier thread.
George Washington started with a misleading post. and gets corrected...
MacroStrategyMan is Rob Parenteu, writes very clearly and is the author of the Richenbacher Letter... The post is junk but the comment thread is enlightening.
NakedCap
a lot of people keep saying something like "Bank makes the loans. The loans create deposits"
I simply don't get it.
if i (the bank) loan you money, how does it "create a deposit" ? it most certainly does NOT need to create a deposit at MY bank... this is where i'm stuck. (i make a loan to you, you buy a house, the home seller puts the money in the bank... only maybe the homeseller puts the money in someone else's bank! or maybe he takes the money and goes to Mexico. who knows. it most certainly doesn't have to come back to the Bank of KD)
WHERE DO I GET THE MONEY TO LEND OUT if i don't have deposits? do i lend out of my equity? or do i borrow the amount of the loan FROM the Fed, using my equity as collateral?
note again, i am NOT talking about reserves here...
You don't need to have money to lend it, create it as a deposit, whatever you want to call it. You just need the license to create legal tender.
BB
Kid, I just love you. I learned of your site from TBI, and I use it to educate myself. I am completely confused, but kind of starting to understand. My conclusion, a simplistic one, is that it is all a casino and none of us will win over the house.
I love your blog. I'm just a suburban housewife trying to figure out how to manage or invest, and I'm simply terrified, large sums of cash just sitting around earning nothing in these banks. My head hurts.
Bring on the guillotines! Brooksley Born and Elizabeth Warren to reshape the entire system.
Post a Comment