Stanley Dundee

Back: Full Employment Drives Inflation? Uh, No Top: Getting Money Right

Banks Lend Deposits? Naah

Recall the lifecycle of fiat money: created when the government makes payments to subjects. Circulating among subjects in transactions exchanging money for resources in the society. Destroyed when taxes, etc. are paid to the sovereign. The residual of creation (spending) over destruction (taxation) providing the only financial asset free of default risk, hence the bedrock of private wealth.

Now consider private banks. Like the sovereign, banks create money, but banks loan money into existence, while the sovereign spawns money by spending. The distinction is important. The sovereign can never involutarily default on its obligations in its own currency as fiat money is unbounded. But the parties to which a bank lends can and do default. Upon such defaults are financial panics made! Moreover, the lack of oversight with which banks operate and the amazing power of money creation creates a dangerously crimogenic environment.

When a bank makes a loan, it simultaneously creates an asset and a liability on its balance sheet. The asset is the promise of the borrower to repay the loan, with interest (which will provide revenue and eventually profit to the bank). The liability is effectively a deposit made to the credit of the borrower which is money the borrower may use to claim salable resources of society. Money is created for use by the borrower, subject to a promise to repay by the borrower. This is money creation by a private institution. Loans create deposits. Note also that the money created by the loan issuance is destroyed as the loan is repaid: the asset and the liability both shrink with each repayment of the loan principal.

As with so many other monetary events, the conventional wisdom is inverted from the reality. We are told to think of banks as taking deposits from savers and investing the savings in loans to borrowers. While it is true that banks take deposits, those play very little role in the issuance of loans. The decision to issue a loan has mainly to do with the banker's perceptions of the credit-worthiness and business prospects of the potential borrower and the value of any underlying collateral, which the bank may seize in the event of default by the borrower. Deposits are liabilities of the bank; they are promises by the bank to repay the depositor. When banks fail, those promises may go unfulfilled.

Banks are subject to a lax regulatory regime in which they are required to maintain a modest cushion of equity capital as a safeguard against their own insolvency when their money creation goes wrong, but that equity cushion is typically a mere five or ten percent of their overall balance sheet, or even less. It doesn't take much to overrun that sliver, and that's what's happened so many times in history when banking panics have ensued with realizations that the assets of a bank (the loans it has issued) are dramatically mispriced in light of defaulting borrowers and overvalued collateral. Curious readers might want to explore the notion of the Minsky moment when lenders to banks (depositors, bond holders, etc.) suddenly and catastrophically perceive the likely insolvency of the banking system.

What I will emphasize pertaining to policy alternatives in a democracy is the private, undemocratic nature of money creation by banks. Unlike the sovereign, which is at least nominally subject to the will of its citizens, banks exercise sovereignty -- the creation of claims on society's resources -- but are not directly subject to much in the way of social control. Consider the possibility that it's banks that control society, and not the other way around! All this is possible because the power to create money is the power to commandeer any salable resource in the society, and that includes the direct and indirect purchase of corrupt politicians, media, and so-called public servants (beaureacrats, adminstrators, regulators, etc.). Bankers are unelected sovereigns who create money by issuing loans entirely at their own discretion with the only the slightest oversight by the rest of society.