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This article has a surprising misunderstanding of the way banks work for a publication called “The Economist”. It is unintuitive, but banks do not and can not l

This article has a surprising misunderstanding of the way banks work for a publication called “The Economist”. It is unintuitive, but banks do not and can not lend out deposits. Banks lever their capital (that is, paid up shares and retained profits) to lend, and that lending creates new deposits. Existing deposits and debt funding (money markets etc.) are useful as liquidity so they can settle interbank transfers, but they aren’t allowed to lend out of them, both out of regulations like the Basel framework, but also because it would violate accountancy rules (deposits are liabilities, and you can’t back a liability with a liability. In reality they create the loan (asset) with a corresponding liability (the deposit). The Bank of England (basically the UK federal bank) has published a good article on this - https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/m...

empath75 8y ago
Money is fungible so it doesn’t really matter where they’re getting the money from. They certainly aren’t keeping those deposits in a vault somewhere.
zeroxfe 8y ago
> In reality they create the loan (asset) with a corresponding liability (the deposit). Isn't that just a book-keeping technicality? Fundamentally, the bank is still using deposits to leverage a loan. Or am I misunderstanding your point?
- empath75 8y ago
  So basically I deposit $1000. Someone else goes to the bank and says ‘I want to borrow $1000’ Great the bank says, approved. And they set up a bank account for you that says you have $1000 in it. Now they’ve got $1000 in reserves and 2 accounts that claim to have $1000 in it. Now when you withdraw $500 where does that money come from? I can assure you it’s not from the banker’s wallet. That’s coming out of my deposit. Not from my account because my account still says they have $1000 on hold for me, it comes from the actual cash I deposited. (Which of course isn’t actually cash in most cases) None of that matters in practice because unless everyone tries to withdraw all the money at once there’s plenty to cover all the withdrawals, but they are definitely using money from deposits to cover withdrawals.
  - neilwilson 8y ago
    You can't deposit a $1000 unless either a bank or the state created it first. Those greenbacks are just receipts for a deposit at the Fed created by prior government spending.
  - stephen_g 8y ago
    I think part of the problem to understanding is that you’re assuming that banks are places that store money. They aren’t really, they are places that hold various types of assets and manage IOUs between themselves and other parties (other Banks, the Government/Fed, and customers etc.) in either direction. Banks don’t really store money, you give them money and they give you bank credit, and then later on you exchange that credit back for money or transfer credit to someone at another bank and the two banks settle that with some asset (could be reserves etc.). I think this is the main confusion, of course the physical cash the bank gives you for a withdraw might have been given to the bank during a deposit transaction, but in terms of the transactions on the balance sheet it did not come from there.
  - Applejinx 8y ago
    No, they say "I'm going to claim you can have $5000, because I can document that once I took in $1000 and I assert that I will take in $1000 again, perhaps many times". Never mind $500, they don't even need to touch the $1000 you put in. They are just making it up as they go because they're a bank and can credibly assert that they will be handling capital in future. They are using the FACT of having deposits to get the credibility to make up whatever loans they want. This is why leverage is like ten to one making the amount of capital in the world many times the assets of the world and everything in it. When you withdraw $500 _they_just_make_it_up_.
- neilwilson 8y ago
  It's a little more than a technicality. It's to do with the order of processes. Essentially there is nowhere in a modern bank where they go "if deposits <= 0 deny loan" Yet I see that time and again in economic models that supposedly have banks in them. Bank lending and the treasury backfill process that manages the equity buffer are parallel processes that are linked by price not quantity. That means that banks will and can lend to any and all creditworthy customers they get prepared to pay the current price of money. It's a dynamic system that can expand and shrink based upon the demand for credit.
  - derriz 8y ago
    I'm not sure what you mean by "modern bank" - when is the cut off date for you? I can assure you that banks can and do end up in a position where they are unable to provide loans. Admittedly the process isn't "if deposits <= 0" because banks don't just access funds from depositors. A retail bank will typically have a blend of funding sources where deposit accounts make up 30-40% of the liabilities on the balance sheets. The rest of the funds are raised on money markets and through inter-bank lending or bond issuance. A bank's balance sheet looks like: - Liabilities: deposit accounts, issued bonds, borrowings - Assets: loans, reserves, equity. I can assure you that "if reserves < X" will mean that a bank is unable to offer a loan to a customer - credit worthy or not. I experienced a banking crisis first hand in the country of my birth and this is exactly what happened. This is why banking crisis are damaging to the economy as a whole - even creditworthy customers and businesses are starved of funds.
    - neilwilson 8y ago
      What do you buy capital Bonds/ equity with? Bank deposits. The more deposits there are the more demand there is for bank capital in aggregate. The system reaches an equilibrium at a price not a quantity. The quantity floats as required by the price of money. Reserves are always available since the other banks lend them out and the central bank as lender of last resort. They have no control function in quantity. Only in their price.
      - 8y ago
- pgorczak 8y ago
  According to GP's linked article it's true when looking at the banking sector as a whole. For a single bank it seems like more of a technicality. Also from the article: > For example, if all of the deposits that a bank held were in the form of instant access accounts, such as current accounts, then the bank might run the risk of lots of these deposits being withdrawn in a short period of time. Because banks tend to lend for periods of many months or years, the bank may not be able to repay all of those deposits — it would face a great deal of liquidity risk.
  - neilwilson 8y ago
    Withdrawals go elsewhere and the central bank system then lends them back to the original source. In aggregate you just end up with a lot of label swapping. All that changes is the cost of the liabilities.
    - pgorczak 8y ago
      If I swap my labels wrong I can still go bankrupt though.
  - deleted 8y ago
    [deleted]
fanzhang 8y ago
Banks absolutely do lend out deposits. An average bank will take a $100K in deposits, have $10K in equity, and then lend out $110K in a mortgage. > Banks lever their capital And with what do the banks lever up their capital? (What is the indirect object of that sentence?) The answer, of course, is deposits. Take an example of a bank local to me: http://ir.cambridgetrust.com/AsReported/Index http://ir.cambridgetrust.com/AsReported/Index They have about a $1.370B in deposits. Where do they put it? Look in the assets section and you'll see it's all commercial and residential mortgages.
- stephen_g 8y ago
  That’s a common misconception. What you have described is called the money multiplier model, and is absolutely incorrect. That’s exactly what the Bank of England paper is saying. An additional point of reference is the Basel rules, which are pretty clear on this, if you care enough to read a few dozen pages of banking regulation. > “And with what do the banks lever up their capital? (What is the indirect object of that sentence?) The answer, of course, is deposits.” Incorrect. It’a a little more abstract than that. Bank credit doesn’t exist as anything but numbers in a database. Deposits are IOUs from the bank, which are increased when the bank lends, and mortgages are IOUs from people to the bank. If everything just stayed within the single bank, they wouldn’t need any existing deposits at all, or any reserves! What you need the reserves for (one source of which is incoming deposits from other banks, or cash deposits, or cheques from the Government) is interbank settlement. But the bank needs only a small fraction of the actual volume of transactions, because they are generally going both ways, and transfers are only a small fraction of the actual amount of bank credit that exists. That’s how the bank maintains solvency.
  - neilwilson 8y ago
    You don't need reserves for interbank settlement either. That's actually a centralised optimisation to reduce collateral requirements. At root if you transfer your deposit to another bank that target bank becomes the depositor in the source bank. Or the transfer can't happen. Banks then shuffle those deposits they have take on around until they are happy with the risk. That's interbank clearing.
barrkel 8y ago
Deposits have two sides on the books: liability to the depositor, and cash as asset. They don't lend out the liability, they lend out the cash. That converts one asset, cash, into another asset, loans. I don't see this as misleading to say that they lend out deposits. Yes, in a more realistic situation, they'll be using their assets as security for borrowing short term money that they lend out long term, so it's not exactly the same money, but it's still involved in the same risks.
- stephen_g 8y ago
  Nope, that’s not quite it, because if somebody puts $10 in the bank, it creates $10 of assets (cash or reserves) and $10 of liabilities (deposits) so it doesn’t give the bank anything they can do anything with, apart from liquidity. The only way it can work is if writing a mortgage creates an asset (the loan), and then a new liability is made to match it (a deposit of the same amount). The security is 100% the bank’s capital, since any assets (cash/reserves) from deposits have matching liabilities. The article I linked above from the UK’s central bank is confirming that all modem banks work the way I am saying.
  - wodenokoto 8y ago
    It's been a long time since I did eco101, but I thought the multiplier was what made it possible for a bank to receive a $10 deposit and loan out $100.
    - stephen_g 8y ago
      The money multiplier has always been a simplified model that doesn’t actually explain how any modern real-world banks work.
  - derriz 8y ago
    When someone puts $10 in a bank, it most certainly gives the bank something they can do something with. In this case they can lend $9 out - assuming 10% reserve. On the balance sheet the bank then has $10 on the liability side - the deposit - and $9 loan and $1 reserve on the asset side. I think that you're confusing accounting with business.
cm2187 8y ago
I am not sure where you saw that banks are not using deposits to fund loans. For instance if you look at lloyd's balance sheet [1]: loans 482,752 cash and afs (liquidity pool) 100,619 trading assets 163,878 other 64,860 total assets 812,109 Deposits 447,928 trading liabilities 50,877 wholesale funding & capital 140,828 Insurance liabilities 103,413 other 69,063 total liabilities & equity 812,109 I believe the trading assets, trading liabilities and insurance liabilities must have to do with their insurance business and sort of net each others. What is left is basically 450bn of deposits and 140bn of capital and wholesale funding, funding 480bn of loans and 100bn of liquidity. Now cash is fungible, and you cannot point to a particular asset and say that a particular liability is funding this asset. But overall, deposits are funding loans. [1] https://www.lloydsbankinggroup.com/globalassets/documents/investors/2017/2017_lbg_annual_report_v3.pdf https://www.lloydsbankinggroup.com/globalassets/documents/in...
- stephen_g 8y ago
  Only 1) the Basel framework of bank regulation which has been internationally adopted, and 2) explanations from the Bank of England (linked above) which categorically states that this is actually how banks work. The Deutsche Bundesbank has also published something to this effect, and the Governer if the Reserve Bank of Australia talked about it in a speech the other day [1]. 1. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html
  - cm2187 8y ago
    I don’t want to get into some ad hominem attacks but I don’t think Basel 3 says that. Anyway, this is simple arithmetic, Lloyds could not have such a large loan book if it wasn’t funded by deposits. There are simply just not enough wholesale funding and capital liabilities. And the liquidity requirements are only a fraction of the deposits, particularly for retail deposits which are assumed to be sticky.
rfjakob 8y ago
I'm not really sure what you mean. The Bank of England article you linked says: > that would leave the buyer’s bank with fewer reserves and more loans relative to its deposits than before. [...] > By attracting new deposits, the bank can increase its lending without running down its reserves, as shown in the third row of Figure 2. So actually the banks need deposits to hand out loans. What you are saying is that the deposits get a new label before handing them out as loans?
- stephen_g 8y ago
  Banks need the liquidity from various sources (including deposits) because they lend, not to lend. On the bank's balance sheet, they cannot take deposits and lend them out.
  - rfjakob 8y ago
    Don't banks take deposits because they want to lend?
    - stephen_g 8y ago
      Sure, it's fairly cheap liquidity, the more the better. But no bank ever stops lending because they don't "have enough" deposits, because there is nothing of the mechanics of lending that relies on having existing deposits. They just need to be 1) solvent and 2) within their capital adequacy requirements and leverage ratios.
  - derriz 8y ago
    Of course they do. That's what fractional reserve banking is all about. Banks borrow money (e.g. from depositors, on the money markets, from other banks) and lend out the money they raise while keeping a "reserve". A typical bank's balance sheet will contain deposits on one side and loans on the other. Without deposits, or other sources of borrowing, a bank cannot lend money.
    - stephen_g 8y ago
bradleyjg 8y ago
The accounting view is a useful frame, but money is fungible so there’s a real sense it which that view doesn’t represent what is “really” happening. See, for example, the MMT take on government financial flows.
neilwilson 8y ago
For those wondering, here is an empirical paper on the subject demonstrating no connection between deposits and loans. "This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air"." https://www.sciencedirect.com/science/article/pii/S1057521914001070 https://www.sciencedirect.com/science/article/pii/S105752191...

empath75 8y ago

Money is fungible so it doesn’t really matter where they’re getting the money from. They certainly aren’t keeping those deposits in a vault somewhere.

zeroxfe 8y ago

> In reality they create the loan (asset) with a corresponding liability (the deposit). Isn't that just a book-keeping technicality? Fundamentally, the bank is still using deposits to leverage a loan. Or am I misunderstanding your point?

empath75 8y ago
So basically I deposit $1000. Someone else goes to the bank and says ‘I want to borrow $1000’ Great the bank says, approved. And they set up a bank account for you that says you have $1000 in it. Now they’ve got $1000 in reserves and 2 accounts that claim to have $1000 in it. Now when you withdraw $500 where does that money come from? I can assure you it’s not from the banker’s wallet. That’s coming out of my deposit. Not from my account because my account still says they have $1000 on hold for me, it comes from the actual cash I deposited. (Which of course isn’t actually cash in most cases) None of that matters in practice because unless everyone tries to withdraw all the money at once there’s plenty to cover all the withdrawals, but they are definitely using money from deposits to cover withdrawals.
- neilwilson 8y ago
  You can't deposit a $1000 unless either a bank or the state created it first. Those greenbacks are just receipts for a deposit at the Fed created by prior government spending.
- stephen_g 8y ago
  I think part of the problem to understanding is that you’re assuming that banks are places that store money. They aren’t really, they are places that hold various types of assets and manage IOUs between themselves and other parties (other Banks, the Government/Fed, and customers etc.) in either direction. Banks don’t really store money, you give them money and they give you bank credit, and then later on you exchange that credit back for money or transfer credit to someone at another bank and the two banks settle that with some asset (could be reserves etc.). I think this is the main confusion, of course the physical cash the bank gives you for a withdraw might have been given to the bank during a deposit transaction, but in terms of the transactions on the balance sheet it did not come from there.
- Applejinx 8y ago
  No, they say "I'm going to claim you can have $5000, because I can document that once I took in $1000 and I assert that I will take in $1000 again, perhaps many times". Never mind $500, they don't even need to touch the $1000 you put in. They are just making it up as they go because they're a bank and can credibly assert that they will be handling capital in future. They are using the FACT of having deposits to get the credibility to make up whatever loans they want. This is why leverage is like ten to one making the amount of capital in the world many times the assets of the world and everything in it. When you withdraw $500 _they_just_make_it_up_.
neilwilson 8y ago
It's a little more than a technicality. It's to do with the order of processes. Essentially there is nowhere in a modern bank where they go "if deposits <= 0 deny loan" Yet I see that time and again in economic models that supposedly have banks in them. Bank lending and the treasury backfill process that manages the equity buffer are parallel processes that are linked by price not quantity. That means that banks will and can lend to any and all creditworthy customers they get prepared to pay the current price of money. It's a dynamic system that can expand and shrink based upon the demand for credit.
- derriz 8y ago
  I'm not sure what you mean by "modern bank" - when is the cut off date for you? I can assure you that banks can and do end up in a position where they are unable to provide loans. Admittedly the process isn't "if deposits <= 0" because banks don't just access funds from depositors. A retail bank will typically have a blend of funding sources where deposit accounts make up 30-40% of the liabilities on the balance sheets. The rest of the funds are raised on money markets and through inter-bank lending or bond issuance. A bank's balance sheet looks like: - Liabilities: deposit accounts, issued bonds, borrowings - Assets: loans, reserves, equity. I can assure you that "if reserves < X" will mean that a bank is unable to offer a loan to a customer - credit worthy or not. I experienced a banking crisis first hand in the country of my birth and this is exactly what happened. This is why banking crisis are damaging to the economy as a whole - even creditworthy customers and businesses are starved of funds.
  - neilwilson 8y ago
    What do you buy capital Bonds/ equity with? Bank deposits. The more deposits there are the more demand there is for bank capital in aggregate. The system reaches an equilibrium at a price not a quantity. The quantity floats as required by the price of money. Reserves are always available since the other banks lend them out and the central bank as lender of last resort. They have no control function in quantity. Only in their price.
    - 8y ago
pgorczak 8y ago
According to GP's linked article it's true when looking at the banking sector as a whole. For a single bank it seems like more of a technicality. Also from the article: > For example, if all of the deposits that a bank held were in the form of instant access accounts, such as current accounts, then the bank might run the risk of lots of these deposits being withdrawn in a short period of time. Because banks tend to lend for periods of many months or years, the bank may not be able to repay all of those deposits — it would face a great deal of liquidity risk.
- neilwilson 8y ago
  Withdrawals go elsewhere and the central bank system then lends them back to the original source. In aggregate you just end up with a lot of label swapping. All that changes is the cost of the liabilities.
  - pgorczak 8y ago
    If I swap my labels wrong I can still go bankrupt though.
- deleted 8y ago
  [deleted]

fanzhang 8y ago

Banks absolutely do lend out deposits. An average bank will take a $100K in deposits, have $10K in equity, and then lend out $110K in a mortgage. > Banks lever their capital And with what do the banks lever up their capital? (What is the indirect object of that sentence?) The answer, of course, is deposits. Take an example of a bank local to me: http://ir.cambridgetrust.com/AsReported/Index http://ir.cambridgetrust.com/AsReported/Index They have about a $1.370B in deposits. Where do they put it? Look in the assets section and you'll see it's all commercial and residential mortgages.

stephen_g 8y ago
That’s a common misconception. What you have described is called the money multiplier model, and is absolutely incorrect. That’s exactly what the Bank of England paper is saying. An additional point of reference is the Basel rules, which are pretty clear on this, if you care enough to read a few dozen pages of banking regulation. > “And with what do the banks lever up their capital? (What is the indirect object of that sentence?) The answer, of course, is deposits.” Incorrect. It’a a little more abstract than that. Bank credit doesn’t exist as anything but numbers in a database. Deposits are IOUs from the bank, which are increased when the bank lends, and mortgages are IOUs from people to the bank. If everything just stayed within the single bank, they wouldn’t need any existing deposits at all, or any reserves! What you need the reserves for (one source of which is incoming deposits from other banks, or cash deposits, or cheques from the Government) is interbank settlement. But the bank needs only a small fraction of the actual volume of transactions, because they are generally going both ways, and transfers are only a small fraction of the actual amount of bank credit that exists. That’s how the bank maintains solvency.
- neilwilson 8y ago
  You don't need reserves for interbank settlement either. That's actually a centralised optimisation to reduce collateral requirements. At root if you transfer your deposit to another bank that target bank becomes the depositor in the source bank. Or the transfer can't happen. Banks then shuffle those deposits they have take on around until they are happy with the risk. That's interbank clearing.

barrkel 8y ago

Deposits have two sides on the books: liability to the depositor, and cash as asset. They don't lend out the liability, they lend out the cash. That converts one asset, cash, into another asset, loans. I don't see this as misleading to say that they lend out deposits. Yes, in a more realistic situation, they'll be using their assets as security for borrowing short term money that they lend out long term, so it's not exactly the same money, but it's still involved in the same risks.

stephen_g 8y ago
Nope, that’s not quite it, because if somebody puts $10 in the bank, it creates $10 of assets (cash or reserves) and $10 of liabilities (deposits) so it doesn’t give the bank anything they can do anything with, apart from liquidity. The only way it can work is if writing a mortgage creates an asset (the loan), and then a new liability is made to match it (a deposit of the same amount). The security is 100% the bank’s capital, since any assets (cash/reserves) from deposits have matching liabilities. The article I linked above from the UK’s central bank is confirming that all modem banks work the way I am saying.
- wodenokoto 8y ago
  It's been a long time since I did eco101, but I thought the multiplier was what made it possible for a bank to receive a $10 deposit and loan out $100.
  - stephen_g 8y ago
    The money multiplier has always been a simplified model that doesn’t actually explain how any modern real-world banks work.
- derriz 8y ago
  When someone puts $10 in a bank, it most certainly gives the bank something they can do something with. In this case they can lend $9 out - assuming 10% reserve. On the balance sheet the bank then has $10 on the liability side - the deposit - and $9 loan and $1 reserve on the asset side. I think that you're confusing accounting with business.

cm2187 8y ago

I am not sure where you saw that banks are not using deposits to fund loans. For instance if you look at lloyd's balance sheet [1]: loans 482,752 cash and afs (liquidity pool) 100,619 trading assets 163,878 other 64,860 total assets 812,109 Deposits 447,928 trading liabilities 50,877 wholesale funding & capital 140,828 Insurance liabilities 103,413 other 69,063 total liabilities & equity 812,109 I believe the trading assets, trading liabilities and insurance liabilities must have to do with their insurance business and sort of net each others. What is left is basically 450bn of deposits and 140bn of capital and wholesale funding, funding 480bn of loans and 100bn of liquidity. Now cash is fungible, and you cannot point to a particular asset and say that a particular liability is funding this asset. But overall, deposits are funding loans. [1] https://www.lloydsbankinggroup.com/globalassets/documents/investors/2017/2017_lbg_annual_report_v3.pdf https://www.lloydsbankinggroup.com/globalassets/documents/in...

stephen_g 8y ago
Only 1) the Basel framework of bank regulation which has been internationally adopted, and 2) explanations from the Bank of England (linked above) which categorically states that this is actually how banks work. The Deutsche Bundesbank has also published something to this effect, and the Governer if the Reserve Bank of Australia talked about it in a speech the other day [1]. 1. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html
- cm2187 8y ago
  I don’t want to get into some ad hominem attacks but I don’t think Basel 3 says that. Anyway, this is simple arithmetic, Lloyds could not have such a large loan book if it wasn’t funded by deposits. There are simply just not enough wholesale funding and capital liabilities. And the liquidity requirements are only a fraction of the deposits, particularly for retail deposits which are assumed to be sticky.

rfjakob 8y ago

I'm not really sure what you mean. The Bank of England article you linked says: > that would leave the buyer’s bank with fewer reserves and more loans relative to its deposits than before. [...] > By attracting new deposits, the bank can increase its lending without running down its reserves, as shown in the third row of Figure 2. So actually the banks need deposits to hand out loans. What you are saying is that the deposits get a new label before handing them out as loans?

stephen_g 8y ago
Banks need the liquidity from various sources (including deposits) because they lend, not to lend. On the bank's balance sheet, they cannot take deposits and lend them out.
- rfjakob 8y ago
  Don't banks take deposits because they want to lend?
  - stephen_g 8y ago
    Sure, it's fairly cheap liquidity, the more the better. But no bank ever stops lending because they don't "have enough" deposits, because there is nothing of the mechanics of lending that relies on having existing deposits. They just need to be 1) solvent and 2) within their capital adequacy requirements and leverage ratios.
- derriz 8y ago
  Of course they do. That's what fractional reserve banking is all about. Banks borrow money (e.g. from depositors, on the money markets, from other banks) and lend out the money they raise while keeping a "reserve". A typical bank's balance sheet will contain deposits on one side and loans on the other. Without deposits, or other sources of borrowing, a bank cannot lend money.
  - stephen_g 8y ago

bradleyjg 8y ago

The accounting view is a useful frame, but money is fungible so there’s a real sense it which that view doesn’t represent what is “really” happening. See, for example, the MMT take on government financial flows.

neilwilson 8y ago

For those wondering, here is an empirical paper on the subject demonstrating no connection between deposits and loans. "This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air"." https://www.sciencedirect.com/science/article/pii/S1057521914001070 https://www.sciencedirect.com/science/article/pii/S105752191...