19 votes

How Banking Actually Works In Fiat World

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.




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Complications

to FRB discussions include:

1) The rules are changing all the time, and thus any fixed explanation will fall victim to this moving target.

2) They don't follow their own rules. Big banks get a wink and a nod. Sometimes small and medium sized banks do too. Except when they don't.

3) We tend to describe the pure case where the system follows the rules as written to the letter when explaining any topic, especially an unnecessarily complicated one and therefore are open to the criticism of oversimplification.

4) We sometimes blur the lines and throw in how we think the system should operate not how it actually does or is compelled to by regulation and statute.

For all these reasons I think it is wise to show each other respect in these discussions. When you use insulting references it dramatically weakens the appeal of your argument and is counterproductive. Unless of course disinformation and discord are the goal.

Money Multiplier

has the potential for expanding the money supply up to the money multiplier limit but this does not mean the banks are compelled to exercise their reserves and loan up to that limit, it simply represents an opportunity for expansion.

Don't see what the beef with Tom Woods is.

I do applaud you guys getting into the weeds of how this Ponzi scheme is actually run.

I went back to working on patients and writing code after reading Modern Money Mechanics from the Chicago Fed.

What a racket.

If we get what we want

these are the conversations that will occur when we re-impliment and economy.

If not...certainly hope feelings aren't ruffled.

South is the new way up! Major trend for 2014: Latin America. Start checking out South American investment, it's part of our future now.

Except reserve requirements are 0% for most transactions.

Reserve Requirements

Transactions from $0 to $12.4 million, the reserve requirement is 0% as of 12-27-12.

Transactions more than $12.4 million to $79.5 million, requirement is 3% as of 12-27-12.

Transaction more than $79.5 million, reserve requirement is 10% as of 12-27-12

Nonpersonal time deposits, 0%, 12-27-90.
Eurocurrency liabilities, 0%, 12-27-90

http://www.federalreserve.gov/monetarypolicy/reservereq.htm

good info. plus, canada,

good info. plus, canada, australia, and others that run their own fiat currencies operate w no reserve requirements. leverage has to do with capital vs. assets ratio, and is part of both prudential management as well as regulatory requirements.

so much of the problem here is the confusion of requirements to maintain reserve balances with the central bank, and capital requirements. capital is not reserves, reserves are not capital. reserves today are a tool of the Fed to manage interest rates and manage clearing operations (settling balances between banks). it has no role analogous to the role it played when banks had to hold gold or gold notes to redeem deposits. reserves today can be created or uncreated by the central bank at will, and that is how it manages the basic interest rate, the fed funds rate.

Master Pretzel Twister
https://twitter.com/MenckensGhost

The Basel Accords attempt to regulate capital requirements. Basel III is supposed to strengthen bank capital requirements by increasing bank liquidity and bank leverage after the 2008-2009 blurp.
https://en.wikipedia.org/wiki/Basel_III

I earned a 1430 out of 1600

I earned a 1430 out of 1600 on the GRE and I still have trouble following this scheme. What we need is massive education about this. We need to simplify it for the layman, with info about where to get the details. Create cartoons, videos, you name it, let's get the word out there!

We just need to drop

this insane nonsense like a bad habit. It is complicated for the sole purpose of hiding criminal activity and giving them total control behind this veil of noise.

The most powerful Law of Nature is Time. It is finite and we all will run out of it. Use this Law to your advantage, for it offers you infinite possibilities...

Allow me to introduce myself. I am the reason Bill

is losing his mind trying to peddle this crap.

This started because Bill made some disparaging comments about Tom Woods speech this weekend in which Tom Wood basically put a dagger through the hearts of the “Greenbackers.

Bill posted these comments:

There is no money multiplier. Reserves don't lead to loans, they are provided with a lag to keep up with bank money creation.

The fed targets an interest rate on overnight interbank borrowing. That is the fed funds rate. If bank loans are expanding and banks need reserves, they brrow from each other. If there is a shortage of reserves, the rate goes above the Fed funds target and the Fed plays catch up by adding new reserves.

Don't know why Tom is still promoting this nonsense

I responded by:

Your analysis

Is so flawed I don’t even know where to start. Establishing the proper function of banking and loan creation is as good as any.

This is complete nonsense. The reserves requirements are a way to curtail leveraging up the banks’ balance sheet with loans. Reserves do lag loan creation, but not for the purposed you stated. In a 100% reserve system…..a bank could not make a loan. In a 50% reserve system a bank could make a loan while maintaining 50% for their reserves…..that loan would be deposited at another bank and that bank could only make a loan of 50% of that deposit. So there is a money multiplier in the form of loans in any factional reserve system.

You can read the debate for yourself.

http://www.dailypaul.com/279375/tom-woods-why-greenbackers-a...

And I will admit Bill is a good debater, but he cannot refute my original point and that is this:

Reserves in a factional reserve system by definition are for the liabilities on the banks’ balance sheet and by default curtail credit expansion of assets (loans). If you didn’t have to meet a reserve requirement then you could loan to infinity and beyond.

If “A” is a true axiom, than all the propositions that can be deduced from this axiom must also be true. For if A implies B, and A is true, then B must be true.
The antitheists of this logic is if “A” is false then everything that follows “A” is false.

Bill your theories start with a false premises…..oh these are not you theories, but the theories of a left wing radical associate professor from Wartberg College by the name Scott Fullwiler.

http://www.nakedcapitalism.com/2012/04/scott-fullwiler-krugm...

No disrespect to this gentlemen and I am not speaking for Tom Woods, but I bet Tom Woods would debate him at any time.

"If you didn’t have to meet a

"If you didn’t have to meet a reserve requirement then you could loan to infinity and beyond."

This was essentially the question I had just asked Bill. Even if banks just went and borrowed reserves from other banks, those other banks would be limited in what they could loan out because of their reserve requirements, no? So in the end, maybe one bank isn't limited by it's reserve requirement, but the entire system is limited by the total reserve requirement of the system as a whole.

Then if the fed is buying treasuries from the banks to boost their reserves, then the Fed is creating inflation by adding to the amount of capital that exists for the banks to lend.

Yeah I tried to get through to this guy

……but he won’t listen. What he is really talking about is over leveraged financial institutions maintaining their reserve requirement on the “margin”…….that’s margin in utility…….not borrowing as in stock margin. He hears antidotal evidence like the huge amount of excess reserves without any new loans being created by the banking system and jumps to the conclusion because loans are not being created…… it must be because of bank discretion. When in reality the regulators have increased lending standard which has dried up the comstomer pool. The people that can qualify for a loan don’t need one and the people that want a loan can’t get one. This is the reason the banks are sitting on the reserves and therefore reserves don’t look like they have much to do with loan creation.…..he also concluded because of the lack of loan creation that the money multiplier doesn’t exist and therefore will not or cannot create inflation or hyperinflation. When I saw this happening I knew it would only be a matter of time before this hypothesis came bubbling up. I commend him for having a good understanding of the Fed Fund System, buts that a far cry from understanding the entire banking system. This would be like having a fatal accident occur on the interstate and a very young naive accident investigator arriving at the scene of his first investigation. He does all the work he has been taught to do by his professors at accident investigator school and sees an engine that has been ripped from the car still running laying on the road. Because he has a complete understanding of the combustion engine he concludes that the engine is want caused the accident and by default all accidents on all interstate is caused by the combustion engine. During his investigation he failed to interview the three expert eyewitnesses standing on the side of the road that happen to be retired accident investigators…….because what they know does not matter because they only have knowledge and experience and wisdom to offer……like Murray Rothbard and Tom Woods and quite frankly me.

Bill only wants to want to looks at the antidotal evidence (although he claims there is empirical evidence but never supplies it) of what is happening in the system right now and what his professor taught him while dismissing all the people that have been around all these years looking at how the system was created.

Bill’s professor
http://www.nakedcapitalism.com/2012/04/scott-fullwiler-krugm...

My first point was to state the context of the “reserve” idea at the point of the banks creation:

The reserves requirements are a way to curtail leveraging up the banks’ balance sheet with(assets) loans. Reserves do lag loan creation, but not for the purposed you stated. In a 100% reserve system…..a bank could not make a loan. In a 50% reserve system a bank could make a loan while maintaining 50% for their reserves…..that loan would be deposited at another bank and that bank could only make a loan of 50% of that deposit. So there is a money multiplier in the form of loans in any factional reserve system.

Therefore his original premises false:

There is no money multiplier. Reserves don't lead to loans, they are provided with a lag to keep up with bank money creation.

Don’t the last three words in fact contradict the first five words? Just say’in?

Then I provided this, which he has yet to challenge, because if he tried to explain the system…..he will have to admit by definition a “factional reserves system”…….in deed has to have….. reserves for the bank liabilities.

If “A” is a true axiom, than all the propositions that can be deduced from this axiom must also be true. For if A implies B, and A is true, then B must be true.
The antitheists of this logic is if “A” is false then everything that follows “A” is false.

I did offer an explanation to the antidotal evidence Bill hears about…..but he ignored it and told me I didn’t know the difference between capital reserves and reserves requirements (which are the reserves of this discussion, capital reserves are held on the banks’ balance sheet as “loan loss reserves” but they are reserves none the less held either in cash or cash like instruments)

Here are the points I made:
You are right that the banks do have trillions in excess reserves right not, but the reason is far from what you stated. The reason this is happening is because the Fed is giving the banks time to heal their balance sheets. By buying toxic assets, to the tune of about 3 trillion dollars.The Fed has taken bonds off the banks’ balance sheets that was technically making them insolvent and put cash (FRN) on their balance sheet……or tier one capital, which also carries a lower reserve requirements but that not the point…….cash is dead weight to a banks. They are getting it free of charge but it’s not earning them anything. So the Fed wanted to speed up the healing process so for the first time ever in their 100 year history, The Fed decided to pay interest on reserves. This is part of “quantitative easing” few understand.

This was his rebutal:

You are right that the banks do have trillions in excess reserves right not, but the reason is far from what you stated.<<
I didn't state a reason
When I said there's no money multiplier, I mean that a dollar of reserves/base money does not lead to 9 or 10 dollars in bank money, as the myth goes that T. Woods repeated.

But I found this footnote from a “white paper” Bill referenced that points at what I am saying.

Keister and McAndrews (2009), while conceding that both the unprecedented growth in banks‘ excess reserve holdings and the related collapse of the money multiplier were consequences of the Fed‘s October 2008 ―policy initiatives, including its decision to begin paying interest on reserves, also insist that ―concerns about high levels of reserves are largely unwarranted on the grounds that the reserve buildup ―says little or nothing about the programs‘ effects on bank lending or on the economy more broadly. Perhaps: but bank lending and nominal GDP data do say something about the programs‘ broader effects, and what they say is that, taken together, the programs were in fact severely contractionary.

But on the margin…..in an over leveraged system……excess reserves can lead to loans, but it’s like pushing on a string……it’s doesn’t have to happen but it certainly can and this would lead to the money multiplier effect. After the banks heal from the effects of the credit bubble the Fed will and has talked at length of an exit strategy. If the system was all about reserves as you say….the people that would know is the Fed……why are they consistently talking about this exit strategy? The Fed has continued the bubble by taking the toxic assets on to their banks balance sheet at “par” and will need the private banks to be healthy and vibrant when the bond bubble burst…..that is the motive.

Bill the axiom remains

If “A” is a true axiom, than all the propositions that can be deduced from this axiom must also be true. For if A implies B, and A is true, then B must be true.
The antitheists of this logic is if “A” is false then everything that follows “A” is false.

>antidotal evidence< hey

>antidotal evidence<

hey what's antidotal evidence, is that like evidence that cures a disease? do you get paid for the comedy act or is it free?

Master Pretzel Twister
https://twitter.com/MenckensGhost

Don't deflect Bill

that what bothers you with what i said

Don't deflect Bill

that what bothers you with what i said

Sorry sometimes I stutter

Sorry sometimes I stutter and repeat myself

and don't spell so well but you still have not

refuted my statements

“Anecdotal evidence' means reports of one kind of event following another. Typically, the reports are obtained haphazardly or selectively, and the logic of "post hoc, ergo propter hoc" does not suffice to demonstrate that the first event causes the second. Consequently, while anecdotal evidence can be suggestive, it can also be quite misleading.”

but i know you understood.....and thats the best you got

and don't spell so well but you still have not

refuted my statements

“Anecdotal evidence' means reports of one kind of event following another. Typically, the reports are obtained haphazardly or selectively, and the logic of "post hoc, ergo propter hoc" does not suffice to demonstrate that the first event causes the second. Consequently, while anecdotal evidence can be suggestive, it can also be quite misleading.”

but i know you understood.....and thats the best you got

and what was your name before

and what was your name before you were married?

Master Pretzel Twister
https://twitter.com/MenckensGhost

Mudd

just dumb mudd

don't flatter yourself,

don't flatter yourself, buddeh.

Master Pretzel Twister
https://twitter.com/MenckensGhost

>If you didn’t have to meet a

>If you didn’t have to meet a reserve requirement then you could loan to infinity and beyond.<

this is easily refuted. a bank cannot leverage up to infinity because of a thing called capital. nothing to do w reserves.

goldspan u have this terrible habit of framing a challenge like this "you can't refute such and such" in which you include things i never challenged or tried to refute, and mix in things that are easily refuted. that's why our discussion produced nothing positive.

Master Pretzel Twister
https://twitter.com/MenckensGhost

you chopped up my comment

you chopped up my comment like a goldman sachs cdo packager!

but yes for more detailed exposition you guys can refer to me and goldspans endlessly telescoping comment thread on the Greenbacker post.

for the record, i'm not a greenbacker.

Master Pretzel Twister
https://twitter.com/MenckensGhost

Thank You

Some of what you've said is a little different than what I have read elsewhere, but you make sense, it makes sense. I'll have to read through it again about 100 times or so, but it seems pretty logical.

I do have a question though.

If lending decisions are not based on reserves and banks borrow whatever they need after making the loans to meet their reserves, what happens if no banks have enough reserves and they all need to borrow but no bank has the reserves to lend them? They go to the discount window, correct? Would the discount window operations then be the inflationary force? Since without it banks could collectively lend only what the collective have in reserves?

But further, the discount loan has to be repaid with interest. This interest then would be deflationary?

I guess my main question would be that it all seems to balance in terms of inflationary, deflationary, so where is the inflation coming from and what's the end game?

if a bank is short reserves

if a bank is short reserves at the end of the day or at the end of some accounting period, it will attempt to borrow them in the overnight fed funds market, from other banks. if the whole system is short reserves, they will bid the rate above the Fed's target rate. let's say the Fed's target for the federal funds rate is 5%. they will bid it up to 5.5 or 6. The Fed will provide reserves by purchasing treasuries from the banks. these are called open market operations. they use them to hit the target rate. this would generally happen before banks rushed to the discount window, unless the fed stopped supporting the target rate. what that would actually mean in practice is that the Fed would be abandoning its own policy of setting the rate. if they chose to adopt a policy of fixing the supply of reserves, and letting the interest rate float, that would be closer to a free market approach. but then the Fed would be giving up its role as "securer" of the payments system, and if there was a run on deposits, banks would have to liquidate assets at the market price to raise cash to meet the reserve requirements. or depositors might not be able to get cash.

Master Pretzel Twister
https://twitter.com/MenckensGhost

Made good sense until point

Made good sense until point 6.

In regards to number 12, the US government is the sole supplier of dollars? Then what is a FRN? I thought the fed issued FRNs....

yeah, to keep the post less

yeah, to keep the post less drawn out i didnt get into the nuances of distinction between the Fed and the government. by government i am saying the fed + the treasury. they are joined at the hip and act in unison. its possible to imagine a scenario where the fed was at odds with the government, but for the time being, both the fed and the government (treasury dept) are in the employ of the banking cartel interests. so when i refer to the government, in the context of the monetary policy, banking, budgets, etc., i mean fed + treasury. the Fed is chartered by congress, its heads are appointed by the president. they don't work without each other.

now, a president who tried to push the fed and its banking cartel out of the monetary regime, would indeed be opposed by a banking led opposition. or it would just co opt the fed and push out the ny banking clique and run monetary policy for a so called "public purpose." but this is america, thats hard to imagine happening. and supposing it did, it wouldn't necessarily be any better.

Master Pretzel Twister
https://twitter.com/MenckensGhost

So Just Keep Cool, And Keep Coolidge

In The White House four years more! We have a chance to do it, in this year of '24! A lot of politicians cannot do a thing but talk! But now we have a chance to *dunno rest of lyrics*