On October 10, 2018, Matthew Johnston writes on Investopedia:
Traditional introductory economic textbooks generally treat banks as financial intermediaries, the role of which is to connect borrowers with savers, facilitating their interactions by acting as credible middlemen. Individuals who earn an income above their immediate consumption needs can deposit their unused income in a reputable bank, thus creating a reservoir of funds from which the bank can draw from in order to loan out to those whose incomes fall below their immediate consumption needs. While this story assumes that banks need your money in order to make loans, it is actually somewhat misleading.
Fairytale Banking
According to the above portrayal, the lending capacity of banks is limited by the magnitude of their customers’ deposits. In order to lend out more, a bank must secure new deposits by attracting more customers. Without deposits, there would be no loans, or in other words, deposits create loans.
Of course, this story of bank lending is usually supplemented by the money multiplier theory that is consistent with what is known as fractional reserve banking. In a fractional reserve system, only a fraction of a bank’s deposits needs to be held in cash or in a commercial bank’s deposit account at the central bank. The magnitude of this fraction is specified by the reserve requirement, the reciprocal of which indicates the multiple of reserves that banks are able to lend out. If the reserve requirement is 10% (i.e., 0.1) then the multiplier is 10, meaning banks are able to lend out 10 times more than their reserves.
The capacity of bank lending is not entirely restricted by banks’ ability to attract new deposits, but by the central bank’s monetary policy decisions about whether or not to increase reserves. However, given a particular monetary policy regime and barring any increase in reserves, the only way commercial banks can increase their lending capacity is to secure new deposits. Again, deposits create loans, and consequently, banks need your money in order to make new loans.
Banks in the Real World
In today’s modern economy most money takes the form of deposits, but rather than being created by a group of savers entrusting the bank withholding their money, deposits are actually created when banks extend credit (i.e. create new loans). As Joseph Schumpeter once wrote, “It is much more realistic to say that the banks “create credit,” that is, that they create deposits in their act of lending than to say that they lend the deposits that have been entrusted to them.”
When a bank makes a loan, there are two corresponding entries that are made on its balance sheet, one on the assets side and one on the liabilities side. The loan counts as an asset to the bank and it is simultaneously offset by a newly created deposit, which is a liability of the bank to the depositor holder. Contrary to the story described above, loans actually create deposits.
Now, this may seem a bit shocking since, if loans create deposits, private banks are creators of money. But you might be asking, “Isn’t the creation of money the central banks’ sole right and responsibility?” Well, if you believe that the reserve requirement is a binding constraint on banks’ ability to lend then yes, in a certain way banks cannot create money without the central bank either relaxing the reserve requirement or increasing the number of reserves in the banking system.
The truth, however, is that the reserve requirement does not act as a binding constraint on banks’ ability to lend and consequently their ability to create money. The reality is that banks first extend loans and then look for the required reserves later. Perhaps a few statements from some notable sources will help to convince you of that fact.
Alan Holmes, a former senior vice president of the New York Federal Reserve Bank, wrote in 1969, “in the real world banks extend credit, creating deposits in the process, and look for the reserves later.”
Vítor Constâncio, Vice-President of the European Central Bank (ECB), in a speech given in December 2011, argued, “In reality, the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.”
What Really Affects Banks’ Ability to Lend
So if bank lending is not restricted by the reserve requirement then do banks face any constraint at all? There two sorts of answers to this question, but they are related. The first answer is that banks are limited by profitability considerations; that is, given a certain demand for loans, banks base their lending decisions on their perception of the risk-return trade-offs, not reserve requirements.
The mention of risk brings us to the second, albeit related, answer to our question. In a context whereby deposit accounts are insured by the federal government, banks may find it tempting to take undue risks in their lending operations. Since the government insures deposit accounts, it is in the government’s best interest to put a damper on excessive risk-taking by banks. For this reason, regulatory capital requirements have been implemented to ensure that banks maintain a certain ratio of capital to existing assets.
If bank lending is constrained by anything at all, it is capital requirements, not reserve requirements. However, since capital requirements are specified as a ratio whose denominator consists of risk-weighted assets (RWAs), they are dependent on how risk is measured, which in turn is dependent on the subjective human judgment. Subjective judgment combined with ever-increasing profit-hungriness may lead some banks to underestimate the riskiness of their assets. Thus, even with regulatory capital requirements, there remains a significant amount of flexibility in the constraint imposed on banks’ ability to lend.
Bottom Line
Expectations of profitability then, remain one of the leading constraints on banks’ ability, or better, willingness, to lend. And it is for this reason that although banks don’t need your money, they do want your money. As noted above, banks lend first and look for reserves later, but they do look for the reserves.
Attracting new customers is one way, if not the cheapest way, to secure those reserves. Indeed, the current targeted fed funds rate – the rate at which banks borrow from each other – is between 0.25% and 0.50%, well above the 0.01% to 0.02% interest rate the Bank of America pays on a standard checking deposit. The banks don’t need your money; it’s just cheaper for them to borrow from you than it is to borrow from other banks.
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp
Gary Reber Comments:
How Is Money Created?
A commercial bank is in the business of creating general promises (“money”) that people in the community will recognize out of individual promises made by borrowers from the bank. And how does a bank do that? –– By making loans. But doesn’t making loans increase the money supply by depositing the proceeds, and then loaning them out again? No. All that happens is that the original amount of new money gets passed around from hand to hand. No new money can be created by making deposits or by re-depositing existing deposits; only by making new loans.
There are three basic types of banks, each filling a particular social and financial need — banks of deposit, banks of issue/circulation and banks of discount. A bank of deposit is what most people think of as a “bank” –– a bank that takes deposits and makes loans out of those deposits and its capitalization, but does not create money. A bank of issue/circulation does not create money, either, but functions to change one form of money into another form of money more easily used to carry out financial transactions. A bank of discount is the only type of bank that actually creates money. It only makes loans and accepts bills of exchange/commercial paper at a discount from the face value, and issues a promissory note to “buy” the bill or paper. A modern commercial, merchant, or mercantile bank (confusingly different names for the same thing) is a combination of all three types of bank. It takes deposits and makes loans out of those deposits, thus acting as a bank of deposit. It also changes one form of money — accepted bills of exchange and commercial paper — into a form more convenient for transacting business, usually by issuing a promissory note used to back a new demand deposit. It also accepts bills of exchange and commercial paper, “buying” (accepting) them by issuing a promissory note that it uses to back new demand deposits.
The Center for Economic and Social Justice (www.cesj.org) subscribes to the Banking Principle, as opposed to the so-called “multiplier theory” — disproved by Dr. Harold G. Moulton, author of The Formation Of Capital— promulgated as the Currency Principle. That’s the belief that banks create money out of nothing by double counting reserves. Under the Banking Principle there are two types of money, past savings money and future savings money. In technical terms, these are mortgages (contracts on existing assets) and bills of exchange (contracts on future assets). All money is a contract, just as all contracts are, in a legal sense, money. Any promise consisting of offer, acceptance, and consideration is a contract and thus money.
How does a mortgage differ from a bill of exchange? A mortgage is a contract conveying an ownership interest in past savings, that is, existing wealth owned by the issuer of the mortgage. A bill of exchange is a contract conveying an ownership interest in future savings, that is, wealth that the issuer doesn’t have now, but reasonably expects to have when the bill comes due.
The role of a commercial bank and a central bank (broadly speaking, a central bank is a commercial bank for commercial banks) is to “accept” money in the form of a personal contract, and issue its own general contract to “buy” it. Strictly speaking, a bank can only “create” money by accepting something of value and issuing a promissory note that obliges the bank to deliver value once the original borrower has redeemed the contract he, she or a non-person legal entity “sold” to the bank. A bank’s promissory notes, whether in the form of banknotes or to back a new demand deposit, are negotiable, and can be used as currency, a general medium of exchange with a uniform and (presumably) stable value.
Paradoxically, although many people think that commercial banks create money out of thin air by creating demand deposits, it is easily seen that when a commercial bank accepts a bill of exchange or commercial paper that it is really creating asset-backed money. In contrast, when the government emits “bills of credit” and the central bank “buys” the bills of credit (misleadingly usually called government bonds) by creating a demand deposit or printing currency for the government, it really is creating money out of thin air — or (more accurately) future taxes that might never be collected.
So,if everybody who consumes, produces, and everybody who produces, consumes, things would work a lot better in the world. When people cannot produce, something must be done to meet their consumption needs, or what was a simple economic problem (how people can consume) turns into a major political problem (how to keep order in society when people are deprived and starving). Thus, what should be the major, if not sole focus of government — how to assist people in becoming and remaining productive is ignored. Instead, government implements policies seeking to guarantee that most if not all people have sufficient effective demand to enable them to consume when they do not or cannot produce. This in turn requires ever-increasing levels of government interference not only in the economy, but in every aspect of life.
The conclusion is that, given financially feasible investments, i.e., investments that pay for themselves out of future profits and thereafter provide consumption income for the investor, there should never be a question of whether there’s enough savings accumulated in the economy to finance all the necessary new capital. Using future savings, there can always be enough money in the economy — and past savings can effectively be spent on consumption, which is their purpose, as they represent unconsumed production from the past.
Federal Reserve System
One feasible way to significantly broaden capital ownership simultaneously with the responsible growth of the economy is to lift ownership-concentrating Federal Reserve System credit barriers and other institutional barriers that have historically separated owners from non-owners and link tax and monetary reforms to the goal of expanded capital ownership. Removing barriers that inhibit or prevent ordinary people from purchasing capital that pays for itself out of its own future earnings is paramount as an actionable policy. This can be done under the existing legal powers of each of the 12 Federal Reserve regional banks, and will not add to the already unsustainable debt of the federal government or raise taxes on ordinary taxpayers. We need to free the system of dependency on Wall Street and the accumulated savings and money power of the rich and super-rich who control Wall Street. The Federal Reserve System has stifled the growth of America’s productive capacity through its monetary policy by monetizing public-sector growth and mounting federal deficits and “Wall Street” bailouts; by favoring speculation over investment; by shortchanging the capital credit needs of entrepreneurs, inventors, farmers, and workers; by increasing the dependency with usurious consumer credit; and by perpetuating unjust capital credit and ownership barriers between rich Americans and those without savings. The Federal Reserve Bank should be used to provide interest-free capital credit (including only transaction and risk premiums) and monetize each capital formation transaction, determined by the same expertise that determines it today — management and banks — that each transaction is viably feasible so that there is virtually no risk in the Federal Reserve. The first layer of risk would be taken by the commercial credit insurers, backed by a new government corporation –– the Capital Diffusion Reinsurance Corporation (CDRC) –– through which the loans could be guaranteed. The CDRC would reinsure any portion of any financing risk assessed as reasonable and insurable but not already insured by the commercial capital credit insurance underwriters. In establishing the CDRC, the federal government would not be undertaking a new responsibility but merely simplifying and rationalizing an existing one. This entity would fulfill the government’s responsibility for the health and prosperity of the American economy.
The Capital Diffusion Reinsurance Corporation would function similar to the Federal Housing Administration, generally known as “FHA”, which provides mortgage insurance on loans made by FHA-approved lenders throughout the United States and its territories. The FHAinsures mortgages on single family and multifamily homes including manufactured homes. FHA borrowers pay for mortgage insurance, which protects the lender from a loss if the borrower defaults on the loan.While pay-downs on home mortgages require a separate source of income, capital credit for productive capital formation is self-liquidating, with the earnings from the investment the source of the pay-down.
The fact is money power rules. When money power is broadly distributed in the hands of the citizens, not the politicians or bankers, the people shall rule. Ensuring that money power is broadly distributed should be the primary role of the Federal Reserve.
The Federal Reserve Board is already empowered under Section 13 of the Federal Reserve Act to reform monetary policy to discourage non-productive uses of credit, to encourage accelerated rates of private sector growth, and to promote widespread individual access to productive credit as a fundamental right of citizenship. The Federal Reserve Board needs to re-activate its discount mechanism to encourage private sector growth linked to universal capital ownership opportunities for all Americans.
The Federal Reserve, which has been largely responsible for the powerlessness of most American citizens, should set an example for all the central banks in the world. Members of the Federal Reserve need to wake-up and implement Section 13 paragraph 2, which directs the Federal Reserve to create credit for local banks to make loans to finance economic growth. We should not destroy the Federal Reserve or make it a political extension of the Treasury Department, but instead reform it so that the American citizens in each of the 12 Federal Reserve Regions become the owners. The result will be that money power will flow from the bottom up, not from the top down, not for consumer credit, not for credit that doesn’t pay for itself or non-productive uses of credit, but for credit for productive uses to expand the economy’s rate of growth.
