> Can you describe how a bank uses money that it has to originate loans?
Yes.
If I take a loan out of a bank in physical banknotes, then the bank physically loses the amount of banknotes that I physically receive. Physical banknotes are not duplicated. If I take out 100 euros in physical banknotes, then the bank loses the corresponding 100 euros in physical banknotes. The bank does not magically create physical banknotes out of thin air.
If I take a loan out of a bank in the form of electronic transfer to another bank, then usually one of 2 things happen:
1. The receiving bank requires the sending bank to settle all transfers that occurred throughout a timespan such as 1 day, by transferring reserves held at the central bank. For example, if the net outflow from bank A to bank B is +2M, then bank B would require bank A to transfer 2M of reserves to settle the transfers. Note that also in this case bank A loses the amount of money that it lent to me. Money wasn't duplicated. It was transferred out of the bank.
or
2. The receiving bank B has looked through the books of sending bank A, they have a prior relationship, and bank B provides an unsecured loan to bank A. Note that if bank A actually had 0 money anywhere, then bank B wouldn't want to provide bank A an unsecured loan. In this case bank A does not lose physical banknotes, and does not lose reserves held at the central bank, but they still have to record the unsecured loan. In an accounting sense, they didn't magically gain "free money" by providing a loan to their customer.
> This description of money creation contrasts with the notion that banks can only lend out pre-existing money, outlined in the previous section. Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out
I believe this is referring to the creation of the accounting entry. It's true in the most pedantic sense, which is incredibly misleading and unhelpful. Yes, when you type a number into a computer, you can type any number. If I were to open a business where I operate like a bank, taking deposits from people and loaning money to people, and I were to keep a ledger of how much money each person has at their "accounts" with me, I could type any number I want in that ledger. Let's say I type in "9999999999999 dollars". Sure, why not. If your argument is that one can type in any number they want on a computer, then that's true, but it's not a useful argument to make.
Do you think that a bank which has NO MONEY is able to (in a practical sense) create infinite money out of thin air? Sure it can type "9999999999999 dollars" on a computer, but that wouldn't be "real money" in any practical sense, because you wouldn't be able to exchange it for goods and services.
Follow-up question: if you genuinely believe this to be possible, then why isn't anybody doing that? Surely there are many people working at banks who would like to collude with their friends and family to create infinite money. If you believe that to be possible, why has it literally never happened?
> Furthermore, it's not clear to me how you believe that the BoE article contradicts what I'm saying. I'm under the impression that you (along with most other people) are simply misunderstanding what you are reading here.
The contradiction seems fundamental. You're suggesting existing deposits facilitate the creation of loans. The entire BoE article is a repeated attempt at showing how loans create deposits.
> Do you think that a bank which has NO MONEY is able to (in a practical sense) create infinite money out of thin air? Sure it can type "9999999999999 dollars" on a computer, but that wouldn't be "real money" in any practical sense, because you wouldn't be able to exchange it for goods and services.
That's ... exactly how it works.
If the bank believes you are good for 9999999999999 dollars over the term of the loan, they put +x in your demand deposit account, and -x in your loan account (and from bank's view those are respectively the bank's own liabilities and assets).
You can then go and send that money (demand deposit) somewhere else to buy a house or whatever (goods and services). Bank A and bank B both have banking licences, which means they mutually trust using each other's customer demand deposit accounts as 'money'.
You mentioned you wouldn't be able to exchange that for goods and services - but that's exactly what happens. You then need to find those dollars and pay back the loan eventually from a job or whatever, or else you go bankrupt.
If you would like to turn that demand deposit into hard cash to keep under the mattress, your commercial bank will send your demand deposit to the commercial bank's account with the central bank, and the central bank will truck over some cash in return.
I know you get this since you write it as IOUs in the article. What I'm trying to get across is that nothing has to precede the creation of the IOU, whereas I think you say an initial deposit of government-issued central bank money (cash) is required.
> Follow-up question: if you genuinely believe this to be possible, then why isn't anybody doing that? Surely there are many people working at banks who would like to collude with their friends and family to create infinite money. If you believe that to be possible, why has it literally never happened?
Try it :) I think odds are you end up in jail.
And if a bank (or crypto exchange!) is in the business of writing crap to counterparties who can't pay them back, the bank probably goes out of business once everyone realizes the bank assets (loans) are garbage.
Further, regulators like to see banks hold capital against their assets to make sure they can fill the gap when some loans inevitably go bad. That capital could be retained earnings, shareholder capital, etc etc. It just doesn't have to come from an initial deposit.
> What I'm trying to get across is that nothing has to precede the creation of the IOU, whereas I think you say an initial deposit of government-issued central bank money (known as cash).
I'll start responding to this because I think it's a point where we agree: yes, you can type any number in a computer and call it "money". Yes, I agree nothing has to precede the creation of numbers on a computer. However, in order for those numbers to actually "be money" in a practical sense where someone could exchange them to goods and services, the bank has to actually own some real money. If the bank literally has 0 reserves, then the money that it creates on the computer will not be in practice exchangeable to goods and services.
> > Do you think that a bank which has NO MONEY is able to (in a practical sense) create infinite money out of thin air?
> That's ... exactly how it works. [...] You can then go and send that money (demand deposit) somewhere else to buy a house or whatever (goods and services). Bank A and bank B both have banking licences, which means they mutually trust using each other's customer demand deposit accounts as 'money'.
If bank A tries to send 9999999999999 dollars to bank B, bank B doesn't simply trust that bank A is good for it. The transfer would not actually go through in the real world. Please produce a single example where this has happened: a single example where a bank had 0 reserves, created >9999999999999 USD out of thin air, and then somebody exchanged that money to goods and services. A single example is enough to prove me wrong. What you're claiming to be possible has never actually happened.
> If you would like to turn that demand deposit into hard cash to keep under the mattress, your commercial bank will send your demand deposit to the commercial bank's account with the central bank, and the central bank will truck over some cash in return.
So in this scenario we have a bank that has 0 reserves in the central bank, and the bank then goes to the central bank and says "I would like to withdraw 9999999999999 dollars in cash, please". This scenario is comparable to you opening up a checking account at a (regular) bank with 0 dollars in it and then walking into the bank saying "I would like to withdraw 9999999999999 dollars in cash, please". The bank would tell you "sorry, your account has 0 dollars, which is less than the 9999999999999 you are trying to withdraw, so we can't make the withdrawal". This is exactly what the central bank would respond to a bank that is holding 0 dollars in reserves at the central bank while trying to withdraw an amount greater than 0 dollars. Even if the bank was asking the central bank to produce $5, the central bank would say no, $5 > $0, you can't withdraw money you don't have.
Edit: to add clarity, I'm saying that this specific part of your claims is wrong: "your commercial bank will send your demand deposit to the commercial bank's account with the central bank". To the extent that the commercial bank is able to "create money out of thin air", it isn't the type of money that the central bank would accept as a deposit. You can fact check this.
> Trying to get a loan without intention of paying it back is bank fraud. It happens and occasionally for very large sums [...]
That's completely unrelated to this discussion. Yes, a bank can loan out money (money that it has) to a fraudster who has no intention of paying back the loan. The question we have here is, can a bank that has 0 money, can it magically create 9999999999999 dollars out of thin air and loan it out. That's unrelated to whether the loanee will eventually pay it back or not.
> The contradiction seems fundamental. You're suggesting existing deposits facilitate the creation of loans. The entire BoE article is a repeated attempt at showing how loans create deposits.
You present these things as mutually exclusive - they're not. Existing deposits facilitate the creation of loans, and the creation of loans expands the amount of existing deposits. Both of these things can be true at the same time, and they are true at the same time.
> If I take a loan out of a bank in physical banknotes, then the bank physically loses the amount of banknotes that I physically receive. Physical banknotes are not duplicated
The withdrawl of money from a bank as notes/coins is a different operation than the origination of a loan. When banks originate a loan, the first thing that happens is that you see the balance appear in your account. You can then choose to withdraw that in cash.
> If I take a loan out of a bank in the form of electronic transfer to another bank, then usually one of 2 things happen:
Again, the origination of the loan and the transfer of settlement funds to another bank are separate operations. You cannot take out a loan in the form of electronic transfer to another bank.
> 1. The receiving bank requires ... they didn't magically gain "free money" by providing a loan to their customer.
Agreed, so what you've described so far is that banks need reserve balances sufficient to cover interbank settlements and cash withdrawls, and banks do not receive money by originating loans.
What they do when they originate loans is provide an asset to the customer (a demand deposit balance) in exchange for a liability of the customer (the loan agreement).
> I believe this is referring to the creation of the accounting entry
All "money" is simply an accounting entry.
> It's true in the most pedantic sense, which is incredibly misleading and unhelpful.
It's true in every sense, and is very helpful if you want to understand how banking and money work.
> Yes, when you type a number into a computer, you can type any number. If I were to open a business where I operate like a bank, taking deposits from people and loaning money to people
You haven't described the mechanism by which a bank can use deposits it has taken from customers to originate loans to other customers.
> and I were to keep a ledger of how much money each person has at their "accounts" with me, I could type any number I want in that ledger. Let's say I type in "9999999999999 dollars". Sure, why not. If your argument is that one can type in any number they want on a computer, then that's true, but it's not a useful argument to make.
Yes it is, because it's an accurate description of how banks originate loans.
> Do you think that a bank which has NO MONEY is able to (in a practical sense) create infinite money out of thin air? Sure it can type "9999999999999 dollars" on a computer, but that wouldn't be "real money" in any practical sense, because you wouldn't be able to exchange it for goods and services.
Deposits created by a bank are good for all transactions within that bank. If all people were customers of the same bank (some sort of "central bank" if you will) and all currency were digital, then the bank could indeed create infinity dollars without liquidity risk, because all transactions would occur within their own accounting system with no external settlements.
> Follow-up question: if you genuinely believe this to be possible, then why isn't anybody doing that? Surely there are many people working at banks who would like to collude with their friends and family to create infinite money. If you believe that to be possible, why has it literally never happened?
The reason it has never happened in precisely the way you outline above is quite simply regulation. But also, it does happen, fraud in loan origination isn't that rare. Here's a recent example of a banker originating $16m in loans to Paul Manafort in exchange for a shot at working with Trump:
But let's imagine that a bank did attempt to operate without any settlement balances. What would that look like?
It would originate loans by adding $9,999,999,999 to someone's account, and since they're not the only bank, the person has the choice to spend that money wherever they please and some of that money will end up being withdrawn as notes/coins or transferred to another bank.
The originator of the loan would then have to borrow settlement balances sufficient to cover withdrawals in notes/coins and cover interbank settlements. As a result it would be paying interest, which puts up its costs. Now let's imagine all banks did that, starting from $0 on day one.
What happens? The central bank, which is the lender of last resort, lends money to all those banks and they have to pay interest on it, but in lending the money, the central bank has created reserve balances. Now, the bank that is most successful at attracting people to create accounts receives more reserve balances than the others, which they can use to pay back the central bank, thus reducing their costs. If they continue being more successful, they will eventually not only have paid back the central bank, but will have excess reserves which they can use to satisfy future interbank settlements and cash withdrawls and they may even have so much in reserve that they can compete with the central bank to lend those reserves to other banks (at an interest rate just below what the central bank charges -- ringing any bells?) which makes them EVEN MORE money.
So the reason banks like to attract deposits is that it makes them more profitable.
Of course, there are also regulations and capital requirements that are imposed on banks, and the government also creates net financial assets in the banking sector by issuing bonds on the primary market (which is a vestigial way of overt money creation kept in place because it is convenient for a bunch of rich people to get richer, but that's another story).
But fundamentally, we could have a banking system that operates exactly as I described where ALL money creation occurred only through the origination of private credit and subsequent lending of reserve balances by the central bank. It would be a horrible economy with massive inequality and instability, but you could do it, if you so desired. The reason we regulate it is to remove some of that instability (removing the inequality, we're still working on!)
> the origination of the loan and the transfer of settlement funds to another bank are separate operations
Correct. The first operation ("writing a number on a computer") can occur regardless of how much money the bank has. But if operation 2 is not possible, then the number that was created in operation 1 is de facto not money. Remember, we're arguing whether the bank needs to have physical banknotes and central bank reserves in order to "create money" when originating a loan. We're not arguing about whether the bank can type in random numbers on a computer - on that point we are already in agreement. The disagreement concerns whether/when those numbers can be considered to be "money".
> All "money" is simply an accounting entry.
Excluding physical banknotes, yes that is true, but you are implying the reverse of that statement to be true and it's not true at all: all accounting entries are not "money". If I open an excel sheet right now and type in "99999999", that is an accounting entry, but it is not money. Likewise, if a troubled bank has completely ran out of capital and is not supported by structures like the FDIC, and it proceeds to type in "9999999" as an accounting entry for the account balance of the chairman's wife, that is not "money". The chairman's wife will not be able to exchange it to goods and services - hence, it is not "money".
> Deposits created by a bank are good for all transactions within that bank. If all people were customers of the same bank (some sort of "central bank" if you will) and all currency were digital, then the bank could indeed create infinity dollars without liquidity risk, because all transactions would occur within their own accounting system with no external settlements.
Yes, central banks have the ability to create practically infinite amounts of real money from thin air. The argument doesn't concern the central bank's ability to create money, it concerns a commercial/retail bank's ability to create money in the process of originating loans.
> > Follow-up question: if you genuinely believe [a bank which has NO MONEY is able to (in a practical sense) create infinite money out of thin air] to be possible, then why isn't anybody doing that? Surely there are many people working at banks who would like to collude with their friends and family to create infinite money. If you believe that to be possible, why has it literally never happened?
> it does happen, fraud in loan origination isn't that rare. Here's a recent example of a banker originating $16m in loans to Paul Manafort in exchange for a shot at working with Trump:
Nope, that is not an example of a bank issuing an infinite amount of money while having literally zero money in reserves. That is an example of a bank which has >16M in reserves, then issuing loans for 16M. Nothing weird about that. Completely unrelated to what I was asking for. Show me a bank which has 0 reserves, then issues loans for billions of dollars, and then exchanges those billions to goods and services. You can't do that, because that has never happened, because it's not possible.
> But let's imagine that a bank did attempt to operate without any settlement balances. What would that look like? It would originate loans by adding $9,999,999,999 to someone's account, and since they're not the only bank, the person has the choice to spend that money wherever they please and some of that money will end up being withdrawn as notes/coins or transferred to another bank. The originator of the loan would then have to borrow settlement balances sufficient to cover withdrawals in notes/coins and cover interbank settlements. What happens? The central bank, which is the lender of last resort, lends money to all those banks and they have to pay interest on it, but in lending the money, the central bank has created reserve balances
No, the central bank would NOT provide a loan in this outrageous, obviously fraudulent instance. Again, you're claiming this to be possible, but it has never happened.
> But fundamentally, we could have a banking system that operates exactly as I described where ALL money creation occurred only through the origination of private credit and subsequent lending of reserve balances by the central bank. It would be a horrible economy with massive inequality and instability, but you could do it, if you so desired. The reason we regulate it is to remove some of that instability (removing the inequality, we're still working on!)
Now I'm confused. So the example you provided was not supposed to reflect reality? It was just a "we could in theory have a banking system like this"? Yes we could in theory, but in practice we don't. In practice normal banks need reserves in order to issue loans.
> The first operation ("writing a number on a computer") can occur regardless of how much money the bank has. But if operation 2 is not possible, then the number that was created in operation 1 is de facto not money. Remember, we're arguing whether the bank needs to have physical banknotes and central bank reserves in order to "create money" when originating a loan. We're not arguing about whether the bank can type in random numbers on a computer - on that point we are already in agreement. The disagreement concerns whether/when those numbers can be considered to be "money".
I agree that money is a very ambiguous (and probably not very helpful) term, but insofar as we can consider the M1 money supply measure to be the quantity of money available in the economy at any given point in time (which is what the BoE paper is referring to when it says "money creation"), originating loans definitely creates money[0]. When you get a loan, the money lands in your demand deposit account, it's definitely "money" according to the definition of money being used in the BoE paper.
>> All "money" is simply an accounting entry.
> Excluding physical banknotes, yes that is true
Minor point but I would include notes and coins as "entries" in the same accounting system, in the same way as receipts, invoices or cheques. Not really critical to the conversation though ...
> but you are implying the reverse of that statement to be true and it's not true at all: all accounting entries are not "money". If I open an excel sheet right now and type in "99999999", that is an accounting entry, but it is not money.
Well, they sort of are. I mean, any liability denominated in the state's unit of account is, in some way, money. This is the crux of Minsky's "Heirarchy of Money"[0]
For Minsky, there is nothing special or elusive about money. In fact, he says, "everyone can create money; the problem is to get it accepted" (1986, p. 228)[1]
> Likewise, if a troubled bank has completely ran out of capital and is not supported by structures like the FDIC, and it proceeds to type in "9999999" as an accounting entry for the account balance of the chairman's wife, that is not "money". The chairman's wife will not be able to exchange it to goods and services - hence, it is not "money".
Right, but banks are supported by those structures. That's what makes them banks. As we saw in 2008, the government went to extroardinary lengths to insure that even the most recklessly issued loans didn't result in banks becoming insolvent. Bill Black is definitely worth a listen to on this topic[2].
>> Follow-up question: ... Nope, that is not an example of a bank issuing an infinite amount of money while having literally zero money in reserves. That is an example of a bank which has >16M in reserves, then issuing loans for 16M. Nothing weird about that
Well, we don't really know what the reserve position of that bank was, and $16m was probably a relatively small amount relative to the overall capital position, but this is definitely an example of someone going outside of what would be considered normally regulated procedure (regulation being the only thing that separates "good" loans from "bad" loans) for personal gain which is why I thought it was relevant to your point.
>> But let's imagine that a bank did attempt to operate without any settlement balances ... No, the central bank would NOT provide a loan in this outrageous, obviously fraudulent instance. Again, you're claiming this to be possible, but it has never happened.
When a bank receives its license, it can immediately start both taking deposits and issuing loans. Banks lend money to each other all the time, and most loans from the central bank are against collateral such as government securities and other very liquid forms of capital[3] however the central bank will, under some circumstances, lend money to banks against the assets they have themselves created through loan origination[4].
So while my little thought experiment about "starting from $0" is not quite accurate, it's not that far off!
>> But fundamentally, we could have a banking system that operates exactly as I described ...
> So the example you provided was not supposed to reflect reality? It was just a "we could in theory have a banking system like this"? Yes we could in theory, but in practice we don't. In practice normal banks need reserves in order to issue loans.
My example was intended to show you how banks hold reserves in order to make their loan operations more profitable. The point was that even if you started off with all banks at $0 in reserves and funded the entire operation using only central bank loans, you would end up with a system similar to what we have now where the primary reason banks need reserves is to increase profitability. It may be the case that a bank that had no reserves at all would go bust because it wouldn't be able to compete with other banks, but it's certainly not the case that they all need to attract reserve deposits equal to the amount of loans they want to originate. They only need sufficient reserves to satisfy net flows of funds and, because they're banks, they have access to the types of credit facilities they need in order to satisfy short term liquidity shortfalls.
In fact, there was a spectacular neobanking collapse in Australia recently:
"Xinja failed in part because it started taking deposits before it made loans. That meant it had to pay interest to customers before it was generating income."[5]
Banks don't need a certain level of reserves or even highly liquid government securities to satisfy capital adequacy requirements. If you look at the documentation around commencement of a bank and capital adequacy standards[6][7] you'll find a story that is much more complicated than simply "reserve funds". They look at all sorts of financial instruments able to "absorb losses" or "commitment of funds". These mean that you can have investors who have pledged to step in to satisfy liquidity requirements or provide collateral/security for loans from other banks and/or the central bank.
There is a difference between the "capital adequacy" requirements placed on banks and the imagined "reserve requirement". Bill Mitchell sets it out clearly:
"To understand why reserve requirements do no constrain lending you have to understand how a bank operates. Banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).
These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these horizontal transactions will not add the required reserves.
In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds. At the individual bank level, certainly the “price of reserves” may 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."[8]
In other words, banks issue as much credit as they can to as many credit worthy customers as they can find, and separately look for ways to satisfy any regulatory requirements. It is the case that regulatory requirements will inform lending criteria but it's nowhere near as simple as "x% of reserves".
I think that's the most prudently argued response I've got on HN.
It sounds like we are mostly in agreement, but we disagree on:
1. When something should or shouldn't be called "money"
2. Will the bank - in practice - lose its money-printing ability if it behaves extremely bad
Regarding point 1, I guess we're going to just agree to disagree.
Regarding point 2, it's up to you to provide a single counter-example and prove me wrong. Theoretical arguments won't cut it here.
I'll answer some individual points below:
> I agree that money is a very ambiguous (and probably not very helpful) term, but insofar as we can consider the M1 money supply measure to be the quantity of money available in the economy at any given point in time (which is what the BoE paper is referring to when it says "money creation"), originating loans definitely creates money[0]. When you get a loan, the money lands in your demand deposit account, it's definitely "money" according to the definition of money being used in the BoE paper.
The BoE paper wasn't describing the case where a troubled bank with 0 capital makes up infinite amount of demand deposits. If such a case were to happen in practice, automated systems might initially report the amount of circulating money as infinite, but very soon someone would "correct the error".
> When a bank receives its license, it can immediately start both taking deposits and issuing loans.
This might be as it is written in Australian law, but in practice no bank is going to receive a license if it has 0 capital when starting up. Sure, it doesn't need deposits to start lending, but it still needs reserves.
> Banks lend money to each other all the time, and most loans from the central bank are against collateral such as government securities and other very liquid forms of capital[3] however the central bank will, under some circumstances, lend money to banks against the assets they have themselves created through loan origination[4]. So while my little thought experiment about "starting from $0" is not quite accurate, it's not that far off!
Well, I'd say it's far off. We're comparing "normal bank issuing loans more or less prudently" to "bank with 0 capital issuing infinite money to the chairman's wife". I would argue that your typical central bank is willing to bail out most cases in the former category, while refusing to bail out any case in the latter category.
> It may be the case that a bank that had no reserves at all would go bust because it wouldn't be able to compete with other banks, but it's certainly not the case that they all need to attract reserve deposits equal to the amount of loans they want to originate.
I'm obviously not claiming that banks need reserve deposits equal to the amount of loans they originate. I'm saying that banks need some deposits to issue loans, and I'm saying that any one individual loan is never going to be larger than the amount of reserves held by the bank. The sum of all loans might be larger than the amount of reserves held, but no single individual loan is going to be.
> They only need sufficient reserves to satisfy net flows of funds and, because they're banks, they have access to the types of credit facilities they need in order to satisfy short term liquidity shortfalls.
If a bank issues a huge loan that the customer intends to withdraw from the bank, that can cause a short term liquidity shortfall. So if you're saying the bank needs sufficient reserves to cover for potential short term liquidity shortfalls, then I suppose we are in agreement over the main question in this debate.
> loans are made independent of the banks’ reserve positions [...] 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."
I'd be to happy to accept a single counter-example where a bank with 0 reserves issues >999999999 dollars to a family friend who then exchanges it to goods and services. Just a single example of this, and I will say I was wrong. Without a single documented case of this happening, you are essentially claiming "this could happen in theory". That's different from "this is how the world actually is today". Many things could theoretically happen in the world, but they don't, and that's not how to world is. In practice banks are constrained in their loan-making by their reserves, even if you have 9 research papers that claim otherwise "in theory".
> Regarding point 1, I guess we're going to just agree to disagree.
I actually agree with you really, I think the term money is terrible and leads to all sorts of misunderstandings about how the world works. But in the sense of the word being used in that BoE paper, bank loans create "money" as in "money supply" as it is measured in official documents.
> 2. Will the bank - in practice - lose its money-printing ability if it behaves extremely bad
I absolutely agree that bad behaviour will (in an ideal world!) lead to the loss of a banking license (although recent events point to the contrary, "To Big To Fail" and all that -- I think that banks should have gone bankrupt and people should have gone to jail after 2008!)
But, with regulation as it stands currently, not having enough reserves to remain liquid prior to originating a loan isn't bad behaviour. In some cases banks can have a negative balance as long as it's not negative for a sustained period of time (regulations differ between jurisdictions). Capital adequacy is not the same as a reserve ratio!
> If a bank issues a huge loan that the customer intends to withdraw from the bank, that can cause a short term liquidity shortfall. So if you're saying the bank needs sufficient reserves to cover for potential short term liquidity shortfalls, then I suppose we are in agreement over the main question in this debate.
I think the key here is the sequence of events, which is subtle but crucial.
Banks don't first take deposits equal to the amount of loans they wish to originate, and then subsequently go looking for people to whom they will originate loans with those reserves as a guarantee of their ability to ensure liquidity to satisfy net flows of funds.
They originate the loans and then separately go looking for whatever funds they need to satisfy their liquidity.
Capital requirements are far more complicated than simply having a reserve ratio. They can be things like commitments of funds subordinated to demand deposit liabilities. In other words capital can be a potential source of liquidity, rather than actual reserves sitting in your account.
They also borrow from each other and from the central bank, including with self securitisation.
> I'd be to happy to accept a single counter-example where a bank with 0 reserves issues >999999999 dollars to a family friend who then exchanges it to goods and services
It doesn't have to be fraudulent in order to fit what the BoE is saying. It just needs to be the case that banks aren't constrained by their deposits, but rather their capital which can take many forms. Reserves make their operations more profitable, and if they're unprofitable enough for long enough, they'll go bust. But the statement "banks lend out reserves" is demonstrably wrong.
> In practice banks are constrained in their loan-making by their reserves, even if you have 9 research papers that claim otherwise "in theory".
I've provided reference documentation from the RBA (that's Australia's central bank) and APRA (Australia's financial regulator), and the original paper is a document produced by BoE which is the UKs central bank, so I think this is a little more than a purely theoretical argument!
I've also discussed this personally with Sean Carmody[0] who works for APRA and has a long history of working in banking with extensive experience particularly in liquidity risk management.
I'm not making it up!
EDIT: Also if you're interested, this whole lecture series is very good (gotta skip over the start with the host economist talking he rambles on a bit) but in particular lectures 6&7 address banking structure and regulation based on the work of Minksy https://www.youtube.com/playlist?list=PLnw-449iRxO-BbfN55FdO...
> the statement "banks lend out reserves" is demonstrably wrong.
It is indeed wrong, but nobody here has made such a statement. Saying "banks lend out reserves" implies that when a bank issues a loan worth $X, their reserves are immediately reduced by $X. I've been pretty clear in my statements that their reserves are not reduced until the customer withdraws $X to another bank (which does not always happen, and even when it does happen, other customers from other banks transfer funds back into this bank, so the net flow is not always negative as multiple banks keep issuing loans and money is shuffled between banks).
> banks aren't constrained by their deposits, but rather their capital which can take many forms
Sure! I like this way of putting it.
Now, a bank which has a high amount of capital can in practice issue more loans than a bank which has a low amount of capital. And one way of increasing the bank's capital (and thus improving the bank's ability to issue loans) is increasing the bank's reserves. So there's some kind of positive correlation between a bank's reserves and its ability to issue loans, right? You mentioned yourself that a bank has to have sufficient capital to survive short term liquidity events, and issuing a large amount of loans increases the probability of such events.
> I've provided reference documentation from the RBA (that's Australia's central bank) and APRA (Australia's financial regulator), and the original paper is a document produced by BoE which is the UKs central bank, so I think this is a little more than a purely theoretical argument!
The sources you've provided describe the "general case" of banks making loans as part of normal business proceedings. The documents do not describe the extreme case of a bank issuing infinite money to the chairman's wife. I don't believe that the writers had this extreme case in mind at all when they were writing these papers. You're making the argument that the same mechanisms that enable the general case would equally apply to the extreme case. I don't believe that, and I don't believe all of the writers of those papers would agree with you either. Even if the writers are sometimes using inappropriately strong expressions like "there is no relationship between customer deposits and loan issuance", I don't believe they mean that literally (and if they do mean that literally, then I'm going to argue that the papers are wrong).
Let's go back to the concrete example: A bank is known to have lost ALL of its capital and is known to have billions in liabilities that it will never be able to pay off. The bank then issues a $10B loan to the chairman's wife. The chairman's wife then exchanges that $10B to physical yachts and aeroplanes. You believe that this can happen in practice, because you believe that the central bank would provide the reserves needed to settle the transfers, even though the central bank is aware that the bank is acting with malice and committing fraud. You believe that this behavior might "lead to the loss of a banking license", but you don't believe it might prevent yacht-buying and aeroplane-buying before the loss of banking license occurs? If I understood your position correctly, then we disagree here, and I'd be happy to change my position when a single counter-example is presented. If something like this has never happened in history, then I don't believe it can realistically happen in the future either.
The reason why I'm bringing up this extreme case is to demonstrate that clearly there is some connection between the bank's... I'm going to say capital... and its ability to issue loans. This connection also exists in less extreme cases, but it's easier for me to demonstrate with this extreme example.
> It is indeed wrong, but nobody here has made such a statement
Really? The very first comment I replied to was:
"banks at least tell you they are loaning your deposits out"
My response:
"Side not but that’s not really how banking works. Banks create deposits when they originate loans and separately look for the assets they need in order to satisfy any regulatory requirements and net flows of funds for inter bank settlements."
Your initial response:
"No, when you take a loan out of a bank, the bank doesn't "create deposits" that it loans to you. The bank loans you existing deposits"
Are you saying there's a distinction between "banks loan you existing deposits" and "banks lend out reserves"? They seem to be the same statement to me ...
> Now, a bank which has a high amount of capital can in practice issue more loans than a bank which has a low amount of capital. And one way of increasing the bank's capital (and thus improving the bank's ability to issue loans) is increasing the bank's reserves
Yeah that's one way they can do it. Those reserves would then almost always be swapped for bonds unless there's more money to be made by loaning them to other banks (which is how the central bank sets and defends the interest rate).
> So there's some kind of positive correlation between a bank's reserves and its ability to issue loans, right? You mentioned yourself that a bank has to have sufficient capital to survive short term liquidity events, and issuing a large amount of loans increases the probability of such events.
You could, if you wanted to, have a bank that capitalised entirely with reserves, but it's way more profitable to attract reserves, lend them out to other banks who have attracted less reserves, and buy bonds with said reserves. You can use the loans you made yesterday to another bank as collateral to borrow at the discount window, for example, if you find yourself in your own liquidity crunch.
So I'd say a more accurate statement is that there is a positive correlation between a bank's ability to attract reserve deposits and its profitability, both due to additional loan origination capacity and due to low capital costs. But reserves are only one piece of the puzzle.
I would say that reserves within a bank's capital mix are similar to tyres and car safety. Having bald tyres is really unsafe, and having better tyres improves your car's safety, but there are tonnes of other ways to drive safely and there's a point at which you're over spending on tyres that won't make any difference to the overall safety of the car (don't you just love car analogies?)
> The sources you've provided describe the "general case" of banks making loans as part of normal business proceedings.
Yes agreed.
> You're making the argument that the same mechanisms that enable the general case would equally apply to the extreme case.
Not really, the part where I used "starting from scratch" as an example was to highlight that reserves increase profitability of a bank and that while, due to regulation, banks can't just start with "nothing" (they need some way to satisfy their liqudity requirements, aka capital), but the system we end up with a little while after "starting from scratch" is very similar to what we have now. The crux of the matter is that reserves increase profitability. It is almost certainly the case that a bank that always has to borrow to satisfy all liquidity requirements will go broke, so regulators don't let that happen, but also a bank which over capitlises reserves relative to loan origination (Xinja being the extreme example of that) will also fail.
The genesis of this thread was the notion that banks "lend out deposits", that's what I'm arguing against.
> but you don't believe it might prevent yacht-buying and aeroplane-buying before the loss of banking license occurs?
Well, actually probably not! Like, they couldn't do it twice, but banks are allowed to have negative reserve balances for a time. If they had been found to be fraudulent then they should go to jail (would they though?) but on the actual day that this happened, the yacht transaction would probably actually succeed. Of course, if the owner of the yacht could be traced back to the fraud committed as a willing participant then that yacht could well be siezed as part of the estate and so on, proceeds of crime and whatnot.
But if some dude really flipped and just typed in the numbers, they could do it, but it would wind up very quickly.
However there are not-too-dissimilar tactics used in banks such as appraisal fraud and liars loans. If you listen to Bill Black's recipe for control fraud it's more or less what you're describing[0], just a little slower and a little more "book cookey".
His book "The Best Way to Rob a Bank is to Own One" has many examples of control fraud. Sure it's a little more deceptive than just opening a spreadsheet and typing in the numbers, but they're totally faking capital levels in order to obtain liquidity to satisfy net flows of funds, resulting in tremendous short term profits and eventual collapse.
> The reason why I'm bringing up this extreme case is to demonstrate that clearly there is some connection between the bank's... I'm going to say capital... and its ability to issue loans. This connection also exists in less extreme cases, but it's easier for me to demonstrate with this extreme example.
Right so what you could say is there's definitely a "credit limit". If you typed in $9,999,999,999,999 into the spreadsheet and then tried to spend it all externally (meaning that none of the people you were buying from had accounts at the same bank, OR you tried to withdraw all that money as notes and coins) then that would set off some sort of warning: either you'd be trying to borrow too much too quickly from too many people, or your account would be so negative overnight that the Fed would give you a call and be like "ummmm ... no". This is pretty similar to what things might look like if you or I tried to spend too much too quickly on our AMEX card.
But "having reserve deposits" is not a pre-requisite for originating a loan. Banks can (and do!) get away with somewhat subtler forms of control fraud over a period of time that is not really that long (2 - 3 years, say) during which time executives can stash an enormous amount of cash and just leave the mess for the regulators to clean up.
There certainly are people who advocate for 100% reserve banking and an end to private credit such as Positive Money[1] but their policies are not very practical and (as per the lecture series I linked to earlier) some private credit creation is probably a good thing to have in an economy. The problem is how dominant the financial system itself (which is, ultimately, just a record keeping system) has become in terms of GDP. We need to make finance boring again!
[1] https://positivemoney.org it's worth noting that while I do, in general, not agree with much of what PM has to say my understanding is that they were actually quite instrumental in lobbying to get the BoE to produce the paper to which I originally linked. In their case they were motivated to "expose the reality" and shock everyone into demanding 100% reserve banking but I don't think anyone was actually all that shocked by it, except David Graeber who wrote about it https://www.theguardian.com/commentisfree/2014/mar/18/truth-... and, as luck would have it, was where I first learned about MMT in the comments section when someone linked to this youtube video https://www.youtube.com/watch?v=bTZGU9s0idM
> > It is indeed wrong, but nobody here has [claimed that "banks lend out reserves"]
> Really? The very first comment I replied to was: "banks at least tell you they are loaning your deposits out"
Hmmh, you're right, that claim has been made. Also I acknowledge that I have phrased some sentences ambiguously. Specifically this one that you dug up:
> > "No, when you take a loan out of a bank, the bank doesn't "create deposits" that it loans to you. The bank loans you existing deposits"
> Are you saying there's a distinction between "banks loan you existing deposits" and "banks lend out reserves"? They seem to be the same statement to me ...
No, I wasn't trying to make that distinction in this context (in another context we were discussing a hypothetical of a newly-founded bank which might have a lot of reserves even before it has depositors, and in that context that distinction is meaningful).
I was making a distinction between the act of writing numbers on a computer, and the act of taking money out of a bank. Note that my sentence began with these words: "when you take a loan out of a bank". When I say "out", I'm referring to a cash withdrawal or bank transfer to another bank. When you withdraw your loan out of the bank, the bank needs to spend some reserves in order to settle the transfer.
You made a point that sometimes the bank acquires those reserves AFTER it issues the loan, and I take your point. You also made a point that the bank might fraudulently acquire those reserves, I accept that as well. My point wasn't really focused on when the reserves need to be available for the bank, or how the reserves were originated (deposits vs fraud vs selling off assets vs ...). My point was that when you take money out of a bank, the bank can't fake it. It needs to have some stuff that it can't make up out of thin air, and after you take that stuff, the bank no longer has that stuff.
> You could, if you wanted to, have a bank that capitalised entirely with reserves, but it's way more profitable to attract reserves, lend them out to other banks who have attracted less reserves, and buy bonds with said reserves. You can use the loans you made yesterday to another bank as collateral to borrow at the discount window, for example, if you find yourself in your own liquidity crunch.
I take your point that a bank's capital mix can consist of many different kinds of assets and reserves play only a small part. We can continue this by discussing the relationship between the bank's capital and its ability to issue loans, since that is a more accurate way of describing things.
> Right so what you could say is there's definitely a "credit limit" [...] Fed would give you a call and be like "ummmm ... no" [...] But "having reserve deposits" is not a pre-requisite for originating a loan. Banks can (and do!) get away with somewhat subtler forms of control fraud over a period of time that is not really that long (2 - 3 years, say) during which time executives can stash an enormous amount of cash and just leave the mess for the regulators to clean up.
Awesome. It sounds like we agree.
Listen, I've enjoyed this discussion so far, and I learned some things I didn't know beforehand, but it's time to call it a day. If you feel that we still disagree on some substantial points, I'd like to hear you hash it out in the form of "this is my opinion, and here is how that's different from your opinion" (articulate not only your own point of view, but also the opposing point of view, and how it is different from yours). I suspect that we're actually in agreement of all substantial points, while we might somewhat disagree on minor things like definitions for words or how easy it is to swap fake money to yachts.
> When I say "out", I'm referring to a cash withdrawal or bank transfer to another bank. When you withdraw your loan out of the bank, the bank needs to spend some reserves in order to settle the transfer.
Yes.
If I take a loan out of a bank in physical banknotes, then the bank physically loses the amount of banknotes that I physically receive. Physical banknotes are not duplicated. If I take out 100 euros in physical banknotes, then the bank loses the corresponding 100 euros in physical banknotes. The bank does not magically create physical banknotes out of thin air.
If I take a loan out of a bank in the form of electronic transfer to another bank, then usually one of 2 things happen:
1. The receiving bank requires the sending bank to settle all transfers that occurred throughout a timespan such as 1 day, by transferring reserves held at the central bank. For example, if the net outflow from bank A to bank B is +2M, then bank B would require bank A to transfer 2M of reserves to settle the transfers. Note that also in this case bank A loses the amount of money that it lent to me. Money wasn't duplicated. It was transferred out of the bank.
or
2. The receiving bank B has looked through the books of sending bank A, they have a prior relationship, and bank B provides an unsecured loan to bank A. Note that if bank A actually had 0 money anywhere, then bank B wouldn't want to provide bank A an unsecured loan. In this case bank A does not lose physical banknotes, and does not lose reserves held at the central bank, but they still have to record the unsecured loan. In an accounting sense, they didn't magically gain "free money" by providing a loan to their customer.
> This description of money creation contrasts with the notion that banks can only lend out pre-existing money, outlined in the previous section. Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out
I believe this is referring to the creation of the accounting entry. It's true in the most pedantic sense, which is incredibly misleading and unhelpful. Yes, when you type a number into a computer, you can type any number. If I were to open a business where I operate like a bank, taking deposits from people and loaning money to people, and I were to keep a ledger of how much money each person has at their "accounts" with me, I could type any number I want in that ledger. Let's say I type in "9999999999999 dollars". Sure, why not. If your argument is that one can type in any number they want on a computer, then that's true, but it's not a useful argument to make.
Do you think that a bank which has NO MONEY is able to (in a practical sense) create infinite money out of thin air? Sure it can type "9999999999999 dollars" on a computer, but that wouldn't be "real money" in any practical sense, because you wouldn't be able to exchange it for goods and services.
Follow-up question: if you genuinely believe this to be possible, then why isn't anybody doing that? Surely there are many people working at banks who would like to collude with their friends and family to create infinite money. If you believe that to be possible, why has it literally never happened?