There have been comments on my previous article on bank deposits, and I just wanted to add a few thoughts. I expect I will end up writing a book (similar concept Abolish money (from the economy)!) on fractional reserve banks. (Abolish money! contains sections on banking, but not enough to cover everything that is going on.) In my opinion, the oversimplified primers on banking systems give a misleading picture of banks, leading to unnecessary mystical debates about “money creation” ” banks.
The argument is simple: in the English-speaking world, we no longer live in a world where traditional banking is the main mechanism for allocating credit. Banks may be everywhere in the financial system, but that’s mainly because regulatory changes have blown up the traditional distinctions between different types of financial firms. * The reality is that shadow banking is a dominant factor in the formation of results.
Simple example
Most bank leaders focus on how the amount of deposits is unchanged despite the effect of most customer transactions, other than loans made (“money creation” in mythology) or paid.
But as soon as we get to “non-traditional” finance, it becomes more murky.
The simplest example to think of is the act of a bank selling a term deposit to a client. For example, a customer withdraws $ 10,000 from a demand deposit account to purchase a $ 10,000 term deposit (for example, CD in the United States, GIC in Canada).
These term deposits are not included in the narrow definitions of money (“M1”) by most statistical organizations (?), But can appear in larger monetary aggregates. If we ignore these broad aggregates, the act of converting a demand deposit into a term deposit “destroys money”.
Note that the bank is not deeply concerned about this; they convert one source of funding (a demand deposit) into another (a term deposit). Under normal circumstances, the cost of interest is higher, but this is offset by the blocking of funding and probably the reduction in the duration risk of the bank. (Since the duration of assets will generally be longer than that of liabilities, removing funding reduces the mismatch.) Banks offer term deposits for a reason.
Although there are obvious legal and operational differences between time deposits and a bond issued by a bank (for example, eligibility for deposit insurance, put capacity, secondary market, cost of funding), from the point of view of seen from bank financing, a pool of term deposits looks like a bond issue. It is an indication that the issuance of bank bonds “also destroys money”.
Slightly modified example
Imagine that a customer of bank A buys a term deposit issued by bank B (a situation which, I think, is more common in the United States).
What happens is that bank A has an exit in the payment system and bank B an entry. If nothing else happened that day, Bank A would somehow have to raise funds. The simplest way to do this is to sell a financial asset – and Bank B would seek to buy a financial asset. In practice, we do not see such a perfect match, but rather something that looks like a balance (!) With all the buyers / sellers of liquidity corresponding to the orders that emerge by the end of the day.
The net result is that a demand deposit is destroyed (“money destroyed”), a “non-monetary” financial asset appears in the non-bank aggregate balance sheet and any financial instrument is passed from one bank to another .
(Thanks to the cultural imperialism of American textbooks, this would be explained as a “transfer of reserve.” This is the worst possible way to explain what is happening, and this probably explains why there is a great confusion in banking.)
Non-bank financing (“Shadow Banking”)
We now move on to the dreaded “parallel bank”. It is a historical accident that term deposits are not considered non-bank financing, but in practice, banks issue debt securities that are not deposits.
Imagine that Bank A issues a $ 100 million debenture which is conveniently purchased only by entities that held deposits in banks.
- For deposits initially at bank A, we obtain a destruction of the deposits and the issuance of a debt instrument which resembles the example of term deposit.
- For deposits elsewhere, there are exits from other banks (and corresponding entries at Bank A). The bottom line is that these deposits are destroyed and the financial assets are reorganized from the rest of the banking system at Bank A. (This is the mechanism by which banks build their liquidity position: they steal it from others if the system is used.) It looks like the second example.
The mythology that revolves around the creation of bank money completely ignores this effect. However, the movement of non-financial corporations to hold financial assets that are not deposits forces the banking system to issue securities that are not deposits (bank debentures, money market instruments, securitizations to reduce the balance sheet). Any individual bank will see a continuous outflow of customers from “shadow banking” assets and will be forced to issue securities to restore liquidity – to the detriment of other banks’ liquidity positions. As the coherent stock-flow models point out, the financial assets in circulation must correspond to what is demanded by the holders of financial assets (the balance appears again in post-Keynesian theory (!)).
The only way to stop it would be for the banks to form a cartel and not issue securities without a deposit. This would force the “deposit preservation law” to be kept. Nobody would want that, especially regulators, which is why it doesn’t happen in the real world.
Demystifying the loss of deposit
Against this backdrop, we can see why the arguments that banks should worry about deposits being paid to other banks in response to lending are irrelevant.
- For the banking system as a whole, “deposit transfers” are zero-sum, and since most banks grow loan books near the average rate (otherwise, regulators cross paths), the losses that occur in reason for “transfers” are negligible.
- There is a massive outflow of funds going to securities, which forces banks to issue debt securities and securitizations. When the housing markets are booming in the United States and Canada, the issue of residential mortgage-backed securities (RMBS) goes through the roof. Any overall movement of funds from depositors to fixed income securities will have an effect on bank liquidity, which needs to be strengthened.
The point is that banks cannot think of their liquidity position only in terms of creating new loans; they must react to clients’ portfolio allocation decisions and adapt their funding strategy accordingly.
Final remarks
Any discussion of actual banking transactions should take into account actual conditions, that is, non-bank institutions mainly hold fixed income assets without deposit. Once we do that, we realize that building a mythology around banks is silly.
Footnote:
* In Canada, it was the “four pillar” system: chartered banks, insurance companies, trust companies and stockbrokers. Today, mega banks carry out almost all of these activities under the aegis of a single holding company (banking “companies” are in fact a jumble of thousands of companies, some of which are operational companies). Although there is a melancholy for the “good old days”, there is no way to return to this type of system without a radical change in the way we regulate the economy. Currently, entire professions are built around evading the economic intent of the law. Unless the philosophy changes, trying to rebuild the pillar structure would fail.
(c) Brian Romanchuk 2019