That $500k in the vendor's account is a liability which had to be immediately met by a transfer of funds from the loan issuing bank to the vendor's bank (probably via CB reserve accounts). That obligation on the loan issuing bank could only have been fulfilled if they had the funds available that they lent. The $500k appearing in the vendor's account must have previously existed and been available funds to the loan issuing bank. That supports the Count's assertion.
There is no new deposit. The $500k must have previously existed as reserves of the loan issuing bank in that bank's reserve deposit account with the CB or in some other account.
Edit add: I confess that I'm not always consistent on this issue. Pertly because I don't fully understand it and partly because I have trouble clearly expressing my understanding.
I haven't yet read through the rest of the thread, but this explanation is different to my recently gained understanding (which by the way I partly gained from you Strindberg).
The problem I have with your example in the closed system is the following: When we get to the point where one of the depositors wants to borrow the extra $100, I do now think (previously didn't until you and others deepened my understanding) that the bank can "create the deposit" into the bank account of the recipient of the borrowed funds, keeping in mind that it will also create a corresponding asset on the banks balance sheet (i.e. a receivable from the borrower). Granted it will change the ratio of capital reserves to assets for the bank that lends, and it may be unable to lend if it breaches capital reserve requirements, however assuming that is not the case my understanding is that the bank can create that deposit. The receivable from the borrower will be at a higher interest rate than the banks funding rate for it to be profitable for the bank, in their margin they will also need to factor in the running costs of the bank and bad debts percentage.
Perhaps "long winded", although the point of the "long winded" explanation was to walk through the mechanics based on your example.
Re accepting the point, think of it another way - what happens when the loan funds *are* deposited back into the same bank that originated the loan? Other than any future (and likely incremental) demands for some of that deposit (ATM/EFTPOS/cash withdrawals etc), the originating bank will have *immediate* demand from those funds that is far less than the full loan amount. Which means they don't need to have anywhere near the full amount available in current reserves from day one to fund the loan in that case.
Then extrapolate the above to a far larger, more complex system, with millions of transactions a day. The funding requirements are driven by the *net* demands on any particular bank, and day-to-day the net amount is always less than the potential gross amount based on the total loans written that day. The banks simply do this everyday, and they do borrow any net reserve shortfall or lend any excess on the over-night market every day - the RBA interest rate system ensures they will do this - this balances the whole system out, and helps maintain "financial stability".
The whole system works because most of the time most of the money is left in a deposit account somewhere in the banking system - even if the money is spent. It's only cash withdrawals that create an actual "physical" requirement to fund the transaction with reserves - in all other cases, the money *will* be availabe back to you on the over-night market - it's not a risk (other than a liquidity risk as we saw in the US after the Lehmans collapse - that's why this was such a big problem and all US lending basically haulted, regardless of reserve levels and credit-worthiness of wanna-be-borrowers).
PS: Blackrocks problem, and the problem in any bank run scenario, is that the other banks stop lending on the over-night market when this situation occurs - confidence gone, the music stops, the bank being run is unable to settle demands for funds and it's gone, just like that. Add to this Sober's point about other funding avenues such as bond/MBS issuance etc - same situation; if no-one will buy your securities - funding stops, bank screwed.
A fluke in your scenario perhaps, but at the scale we actually operate at, for a large proportion of funds this is exactly the outcome that occurs on a day-day basis. Only the net discrepancies need to be funded somehow each day, with is always an amount significantly less than the total of any loans written that day.
I agree with this to a point - funding is important yes, from an operational perspective. But the loans will be written if a) there is room to based on the capital adequacy requirements and b) there are credit worthy borrowers asking for loans. The net operational funding requirements each day will be met as described earlier.
I don't disagree with what you have written concerning loans coming back to the issuing bank and banks receiving a steady daily inflow of funds in the form of new deposits which can to some extent be anticipated and relied upon to support loan issuance. However, problems can arise when the steady long term outflow (loan obligations plus withdrawn deposits) exceeds the steady long term inflow (new deposits). You reckon that banks will always be able to cover the difference via overnight interbank lending, RBA overnight lending or longer term bond issuance. This may not always be possible. Interbank loans and bonds issues represent attempts by banks to obtain surplus funds from each other. Interbank loans and bond issuances do not increase funds in the banking system for the support of loans. There may be no surplus funds and every bank may need all the deposits they have. If the only recourse of banks is to get the CB to create them some new money then the shit is already hitting the fan.
Quote:
Another point - if it does work the way you are now suggesting (along with The Count), how then do you think the aggregrate money supply grows? It's chicken and egg your way isn't it?
I am not claiming that loans never create deposits. I am saying that banks need funding for the obligations arising from their loan issuance and they may not always be able to rely on that necessary funding being forthcoming from that loan issuance. The latter represents some peoples' glib understanding of the "loans create deposits" mantra.
propertymogul
6 Dec 2013, 10:44 AM
I haven't yet read through the rest of the thread, but this explanation is different to my recently gained understanding (which by the way I partly gained from you Strindberg).
The problem I have with your example in the closed system is the following: When we get to the point where one of the depositors wants to borrow the extra $100, I do now think (previously didn't until you and others deepened my understanding) that the bank can "create the deposit" into the bank account of the recipient of the borrowed funds, keeping in mind that it will also create a corresponding asset on the banks balance sheet (i.e. a receivable from the borrower). Granted it will change the ratio of capital reserves to assets for the bank that lends, and it may be unable to lend if it breaches capital reserve requirements, however assuming that is not the case my understanding is that the bank can create that deposit. The receivable from the borrower will be at a higher interest rate than the banks funding rate for it to be profitable for the bank, in their margin they will also need to factor in the running costs of the bank and bad debts percentage.
Where have I gone wrong?
Yes, the bank can create the deposit for the borrower. But the borrower will presumably wish to spend that $100 and writes a cheque for $100 to Fred who banks with a different bank. Fred will present that $100 cheque to his own bank who will then (overnight) submit it to the clearing process and the borrower's bank will be committed to settle that $100 with Fred's bank. The real $100 will move from the borrowers bank to Fred's bank.
This is why I keep distinguishing between the loan creation (which is a trivial double data entry) and the obligations arising from the loan creation (which requires banks to settle which each other with real money). The latter is the significant issue.
I don't disagree with what you have written concerning loans coming back to the issuing bank and banks receiving a steady daily inflow of funds in the form of new deposits which can to some extent be anticipated and relied upon to support loan issuance. However, problems can arise when the steady long term outflow (loan obligations plus withdrawn deposits) exceeds the steady long term inflow (new deposits). You reckon that banks will always be able to cover the difference via overnight interbank lending, RBA overnight lending or longer term bond issuance. This may not always be possible. Interbank loans and bonds issues represent attempts by banks to obtain surplus funds from each other. Interbank loans and bond issuances do not increase funds in the banking system for the support of loans. There may be no surplus funds and every bank may need all the deposits they have. If the only recourse of banks is to get the CB to create them some new money then the shit is already hitting the fan.
I am not claiming that loans never create deposits. I am saying that banks need funding for the obligations arising from their loan issuance and they may not always be able to rely on that necessary funding being forthcoming from that loan issuance.
I think what you are missing is that the creation of a loan also creates a deposit for the system so that there will always be supply of deposits available while loans are being created. The lending bank can compete for the situs of the deposit through offered rates or use the interbank market - the deposit holding bank will always want to make the deposit available to someone that will pay them interest.
And of course remember, that for retail banking, we almost have a closed system of 4 banks of broadly similar size so the net transactions between them each night to 'balance' the system don't amount to much (comparative to the total value of transactions).
North Rock situation occurs when there is a threat that they are not going to get access to the interbank market so deposit holders (rightly) get nervous that deposits will get drained to meet obligations so they queue up to get out hard currency.
“You Keep Using That Word, I Do Not Think It Means What You Think It Means” - Inigo Montoya
I haven't yet read through the rest of the thread, but this explanation is different to my recently gained understanding (which by the way I partly gained from you Strindberg).
The problem I have with your example in the closed system is the following: When we get to the point where one of the depositors wants to borrow the extra $100, I do now think (previously didn't until you and others deepened my understanding) that the bank can "create the deposit" into the bank account of the recipient of the borrowed funds, keeping in mind that it will also create a corresponding asset on the banks balance sheet (i.e. a receivable from the borrower). Granted it will change the ratio of capital reserves to assets for the bank that lends, and it may be unable to lend if it breaches capital reserve requirements, however assuming that is not the case my understanding is that the bank can create that deposit. The receivable from the borrower will be at a higher interest rate than the banks funding rate for it to be profitable for the bank, in their margin they will also need to factor in the running costs of the bank and bad debts percentage.
Where have I gone wrong?
Edit add: One for Sydneyite (or anyone else). I largely agree with what you're saying around the banking system. A question I'll put out there regarding the increase in money supply. There is no doubt in my mind that the money supply has increased over say the last 30 years, I don't think anyone could realistically disagree with that. My question is around the mechanics of how that increase has occurred (and will continue to occur). I agree that banks can now "create deposits" which I think is largely how the increase in money supply has occurred. However, where I start to question this is for every time a bank creates a deposit (i.e. lends money to a new borrower, and simultaneously deposits money into the bank account of the recipient of the borrowed funds), it is still a balance sheet neutral event i.e. it has created both a receivable and a payable. Essentially the money supply in this simple example has been increased by the borrower borrowing against their future earnings. Is this the only way that the money supply is increased? Has the money supply increased so dramatically purely through an increase in borrowers borrowing against future earnings? If not, in what other ways is the money supply increased? I know that both banks and governments can issue bonds, to me that is the same except on a larger scale i.e. the bank and/or the government issuing bonds is increasing the money supply by borrowing against future expected earnings.
Given that loans create deposits, then all credit (money) should have an equivalent loan. How then do reserves get created, which apparently is money that doesn't have a corresponding liability? I know that in the US the Fed makes sure there is adequate reserves in the system to ensure lending isn't constrained.
I am not claiming that loans never create deposits. I am saying that banks need funding for the obligations arising from their loan issuance and they may not always be able to rely on that necessary funding being forthcoming from that loan issuance. Yes, the bank can create the deposit for the borrower. But the borrower will presumably wish to spend that $100 and writes a cheque for $100 to Fred who banks with a different bank. Fred will present that $100 cheque to his own bank who will then (overnight) submit it to the clearing process and the borrower's bank will be committed to settle that $100 with Fred's bank. The real $100 will move from the borrowers bank to Fred's bank.
This is why I keep distinguishing between the loan creation (which is a trivial double data entry) and the obligations arising from the loan creation (which requires banks to settle which each other with real money). The latter is the significant issue.
In your example Fred's bank will be sitting on $100 too much money and will likely have an obligation to Fred to pay interest on his deposit so the bank will lend it overnight to the borrower's bank for more interest than it pays Fred (= accumulate revenue on the difference) so the money just goes straight back. The borrower's bank then pays Fred's bank interest on that money but is charging the borrower even more so it clips the difference as well.
“You Keep Using That Word, I Do Not Think It Means What You Think It Means” - Inigo Montoya
Given that loans create deposits, then all credit (money) should have an equivalent loan. How then do reserves get created, which apparently is money that doesn't have a corresponding liability? I know that in the US the Fed makes sure there is adequate reserves in the system to ensure lending isn't constrained.
A very good question Elastic, essentially what I was trying to get at but couldn't word it as well. I don't know the answer but would be very interested to hear the answer.
In your example Fred's bank will be sitting on $100 too much money and will likely have an obligation to Fred to pay interest on his deposit so the bank will lend it overnight to the borrower's bank for more interest than it pays Fred (= accumulate revenue on the difference) so the money just goes straight back. The borrower's bank then pays Fred's bank interest on that money but is charging the borrower even more so it clips the difference as well.
Banks can never rely on being able to borrow back their own loan issues. Other banks may decide that they think circumstances require them to keep deposits they receive as a result of other banks issuing loans. Interbank borrowing is not a banking right. The level of reserves kept is constantly changing with each bank's conditions and overall economic conditions and can't be fully anticipated. I'm suggesting that banks cannot be sure they will be able to meet the obligations arising from their loan issues if they don't already have the necessary funds, especially when the loan issuance level exceeds the difference in the level of new deposits and deposit withdrawals. Yes, they can somewhat rely on a steady stream of net deposits, but they can't rely on more than that for meeting loan obligations except for very short transient periods.
Banks can never rely on being able to borrow back their own loan issues. Other banks may decide that they think circumstances require them to keep deposits they receive as a result of other banks issuing loans. Interbank borrowing is not a banking right. The level of reserves kept is constantly changing with each bank's conditions and overall economic conditions and can't be fully anticipated. I'm suggesting that banks cannot be sure they will be able to meet the obligations arising from their loan issues if they don't already have the necessary funds, especially when the loan issuance level exceeds the difference in the level of new deposits and deposit withdrawals. Yes, they can somewhat rely on a steady stream of net deposits, but they can't rely on more than that for meeting loan obligations except for very short transient periods.
It's a simplistic example but in reality they can rely on borrowing back the loan issuance as it has to go somewhere - 1 persons loan is another's deposit. Of course, it's more complex to manage than simply borrowing back the same amount but, so long as they remain solvent, they can always access the interbank market and the RBA (as a last resort) if they are going to come up short overnight. They can rely on this being the case in the normal course of business so are free to lend without pre-funding, it's kind of like signing a contract to buy a house when you know you have a funding line available to draw-down at the appropriate time.
“You Keep Using That Word, I Do Not Think It Means What You Think It Means” - Inigo Montoya
This discussion focuses my mind on the question posed by David Llewellyn-Smith of MacroBusiness: can Australian banks run out of credit?
Of course they can. The banks are the middle men between creditors and debtors. And one can reach the limit on creditors. But in the present set up generally no. The bank lend some of their credit to financial entities lower down on the financial scale, if the banks pull these funds it is these lower entities that suffer. Generally the banks have the better quality loan portfolios and the non bank lenders chased the bread crumbs.
The next trick of our glorious banks will be to charge us a fee for using net bank!!! You are no longer customer, you are property!!!
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