How Banking Actually Works In Fiat WorldSubmitted by Molusk on Mon, 03/25/2013 - 23:33
After a long and fruitless discussion in a recent post's comment thread, I figured I would start a new post on the subject of how banks actually operate in the current regime. The details are slightly different in different countries and regulatory regimes, but it all follows the same basic rules.
1. Loans create deposits. When a bank creates a loan, it simultaneously creates a deposit. This is how credit grows, by banks expanding their balance sheets.
For example. You walk into a bank and want a car loan. The loan officer approves you. He does not go get some depositors funds and transfer them to your account. He credits your account with a deposit, and creates a receivable or asset, the loan. The bank has a new asset, the loan, and a new liability, the deposit. They created the deposit by making the loan. Two new entries have been added to the ledger, and the bank has created the money you get in your account.
2. Bank lending is not constrained by bank reserves. The process described above is never interrupted by the bank manager worrying about reserve requirements. The bank will get its required reserves later by borrowing them in the interbank market, or trying to attract depositors. System wide, if banks are short of required reserves, they will bid up the fed funds rate above the target, and the Fed will supply reserves to hit the target rate. Reserves are provided to the banking system, with a lag, following bank credit expansion. The Fed acknowledges this, it is well know by people involved in banking operations, and it has been empirically shown in a number of studies.
3. The money multiplier (one dollar of base money leads mechanically to 10 dollars in loans, with the new dollar leading the cycle) is an exploded myth. Banks never make lending decisions on the basis of their reserves. As described above, if a bank needs to meet its reserve requirement, it borrows them at the fed funds rate. The Fed will always supply reserves at the target rate, and so banks don't worry about this. If a bank is in trouble with solvency and other banks refuse to lend to them, the bank will hit up the discount window and borrow at a penalty rate. But in normal conditions when a bank's solvency isn't questioned, banks will acquire reserves through the overnight loan market from other banks, and the Fed will provision whatever reserves are required by the system-wide demand to meet their target rate.
Banks create loans, and worry about reserves later. Reserves follow private bank credit expansion, they do not lead it.
4. Excess reserves are not inflationary or hyper inflationary. Reserves do not factor into loan decisions. They are a policy tool of the Fed and act to settle balances between Fed members. Banks don't look for reserves to loan out. They make whatever loans walk in the door, based on their capital position, and acquire reserves in the market, via borrowing or attracting new deposits. They make loans, and then fund them. It is not difficult, since a new loan adds a new deposit, and reserve requirements do not restrain them. The Fed always supplies adequate reserves.
5. Quantitative easing is not inflationary, but slightly deflationary, because it reduces interest income to treasury holders and it swaps bank reserves for treasuries. The banks get the new reserves in exchange for the treasuries they held, and the Fed gets the treasuries, and their interest, which reduces income and spending in the economy.
6. The government spends money first and then borrows/taxes.
The federal government spends by crediting bank accounts (wherever it spends it, on drones, Rapescan machines, etc.).
When it spends or credit accounts, it is creating "money," which ends up in the banking system as reserves. Selling treasuries then drains these reserves from the banking system, swapping them for treasuries. This reserve drain allows an overnight positive interest rate on reserves (the Fed funds rate) to be hit or targeted.
7. The Fed's primary dealers (20 or so big commercial banks w/ reserve accounts at the Fed) facilitate this process, and are required to do so. Treasury auctions never fail. The money for the treasuries is with the banks in the form of reserves, before the treasuries are ever auctioned. Spending comes first, borrowing comes after. There are no bond vigilantes.
8. Treasury auctions do not fund the government in reality. They drain the reserves added to the banking system after the government as spent. They are required legally but are not necessary operationally, and are not needed for the government to fund itself. It could spend without issuing treasuries.
9. Excess reserves are a side effect of QE. The fed expands its own balance sheet, by buying bank held treasury securities with newly created reserves. These reserves then sit with the banks. The reserves do not lead to new lending because having excess reserves is not any incentive to issue a loan. Bank lending is not constrained by reserves, and their ability to create loans is not increased by possessing excess reserves.
10. The Fed pays interest on reserves to maintain a positive overnight rate in the presence of these excess reserves. This is the fed funds rate for interbank loans. Banks borrow reserves from other banks at this rate. Because of the excess reserves created by QE, the fed funds rate would fall to zero if the Fed did not create a rate floor by paying interest on reserves.
11. The government is required by statute to maintain an account with the Fed with a positive balance before it spends. This is a legal fact, but it is not an operational constraint. What this means is that if the law were changed or ignored, the treasury could spend without having to issue treasuries. It doesn't actually need to sell the bonds, let alone tax.
12. The US government is the sole supplier of US dollars. It creates them at virtually no cost. It does not rely on taxes or on selling bonds to fund its operations. Taxes and issuing treasuries serve other purposes, and their presence as policy tools is a hold over from pre-fiat structure of institutions, when money was tied to gold. The purposes they serve today are different from when US dollars were redeemable in gold.
Just some food for thought!
Further reading: http://www.winterspeak.com/2009/09/loans-create-deposits-how...
Disclaimer: None of this should be construed as an approval or a judgement on the virtues or non virtues of this system. It is just a description of how things work that most here probably have not been exposed to before. The USA is a monetarily totalitarian state, in the sense that it claims the monopoly right to control money. As we transitioned from a gold based, private monetary system to a state regulated fiat monetary system, the rules and nature of the system changed. A lot of the institutions visible to us remain superficially similar to how they looked on the gold standard, but everything is different in fact.