Yes, exactly. It's amazing how people don't see that the _whole_ point of banks is to aggregate defaulting risks across a very large number of loans to power the economy.
Eg they also provide 'checking' accounts. There's no conceptual reason why that function needs to be bundled with the 'aggregating default risk' function; but it happens to be so in many countries.
To illustrate, on the one hand, think of an institution that takes deposits and lets you transfer money to pay your rent etc, but doesn't make any 'real' investments: all they do is park the deposits in government loans.
On the other hand, think of exchange traded funds that invest in a wide array of bonds (or even equities). They diversify defaulting risk across the economy, without taking deposits, like your typical bank does.
The ability to provide loans from nothing is the special feature of a bank, which is why they are so heavily regulated. The deposits are just the opposite half of the loan creation. No bank invest deposits - they're a liability to the bank.
(And if banks could create loans from 'nothing', so could any other company that can issues bonds.)
There have been episodes in history with very lightly regulated banks, and they were very stable banking systems by and large. See the 'free banking episodes' in eg Canada, Scotland, Australia and China. There was no 'creating loans from nothing' that needed to be regulated away.
If a company issues a bond and I buy it then I have to give my own existing money in exchange.
If a company takes out a loan from the bank, the bank isn’t putting up existing money, it just creates a new asset and starts accounting for it. Hence new money is created from nothing.
What stops the bank from creating too many loans is that the bank would become insolvent and all the workers have to carry their stuff out in cardboard boxes (except the execs they probably have someone to do that for them).
> If a company issues a bond and I buy it then I have to give my own existing money in exchange.
> If a company takes out a loan from the bank, the bank isn’t putting up existing money, it just creates a new asset and starts accounting for it. Hence new money is created from nothing.
Sorry, your analogy doesn't work out, because the roles are reversed.
Look at the situation where a company sells me a bond, to be paid back in ten years. But instead of me handing money over to them, I give them an IOU (or credit line) that they can draw down any time they wish to.
We can create this pair of bond and IOU out of nothing, just like the bank can create deposit-loan pairs out of nothing.
However, just like with the bank, people don't borrow money to let it just sit there. They want to invest.
So they spend their deposit, and draw down their IOU.
And once your customer does that, you better have some money in your 'safe' that you can hand to them.
In the classic case, that money comes from outside deposits.
> What stops the bank from creating too many loans is that the bank would become insolvent and all the workers have to carry their stuff out in cardboard boxes (except the execs they probably have someone to do that for them).
You can do that, sure. And if that was all there was to banking, it would be a fantastic business to be in.
Alas, the whole point of taking out a loan is to spend the money on something, eg to invest it.
And once the bank's customer withdraws the deposit half of that newly created pair of anti-particles, the situation isn't nearly as symmetrical and neat anymore: the bank better have some money in the vault to be able to satisfy that withdrawal request.
(Slightly less antiquated: the customer will likely spend their borrowed money electronically, but then just means that you need to have the funds available to settle with the bank who runs the account on the receiving end of that transaction.)
> Generally there is legislation that then brings these 'deposit holders' under specific requirements.
Even without legislation or specific requirements, you can't just keep creating these loan/deposit pairs out of thin air. At least not, if your customers are supposed to be able to spend their borrowed funds.
"And once the bank's customer withdraws the deposit"
Withdrawing is always just transferring to another bank - even if that bank is the central bank.
Banks settle with each other by the target bank taking over the deposit in the source bank. That is how correspondent banking has worked for at least four hundred years.
Everything else is a collateral optimisation.
There is never any "money" in a vault. There might be some receipts for money, but that's about it.
> Withdrawing is always just transferring to another bank - even if that bank is the central bank.
No. You can withdraw cash. But you are right, that the common case is a transfer.
> Banks settle with each other by the target bank taking over the deposit in the source bank.
That's one way they can settle. But at the end of the day (or whatever the relevant period is), they send each other the net difference in the underlying base money. These days, that's deposits at the central bank.
> That is how correspondent banking has worked for at least four hundred years.
Correspondent banking being important is mostly an American thing (and perhaps a 18th and 19th century English, but not Scottish, thing, too.)
> There is never any "money" in a vault. There might be some receipts for money, but that's about it.
These days, the 'vault' is (mostly) an account at the central bank.
A bank can just magic up an account with $1M in your name, sure, but when you show up to withdraw the money they have to source that currency from somewhere— Their loans won’t be held in very high regard if you can’t then use the loaned money to, for example, pay for all of the various labor and materials you need to build your new house.
Except that they don't have to source that currency from somewhere - it really is literally magicked up out of thin air! When you come to spend it, that amount is transferred to another bank, that they can then offset against their own magic money.
The only relationship with deposits (which are actually liabilities) and assets is that enforced by regulators.
This is how money creation works in the modern economy - so the money supply can grow as economic activity increases, all guided by central banks / governments with levers such as interest rates, open market activities (QE), and regulations.
Again - banks really do create money from nothing, all day, every day.
No they don't, banks have accounts with the central bank. They also have their assets and liabilities. They have to manage the system so that they can manage external withdrawals. When assets outweigh liabilities it's a bankruptcy. When current demand for withdrawals exceeds short term liquid reserves it's a liquidity issue. At no point do banks create base money. A balance in a bank is just an iou for base (central bank's) money.
The only entity that creates money is the central bank. They may even accept mortgages from banks as collateral (including repurchase agreements) to inject new money into the system.
Regulations are supposed to prevent bankruptcy and liquidity issues, but even without any regulations regarding asset ratios, banks can go bankrupt or illiquid.
So if someone pays you using a credit card, or using money they derived from a bank loan, presumably you don't accept that money because it's not a loan from the central bank - it's not "base money"?
Incidentally, the only claim you as a lowly individual ever have on central bank money in most (all?) current currency areas is as physical currency, and even then for the most part you only ever get to exchange it for commercial bank money. For the purposes of this discussion, all digital money between most normal entities is commercial bank money. Commercial bank money _is_ money.
I trust that my bank is well-enough managed to provide me with physical currency up to the amount of my account balance, so I’m happy to accept any form of payment that results in an appropriate increase in that number— Just because I draw a distinction between currency and commercial money doesn’t mean that I don’t believe that the latter is money.
And I rarely exchange physical currency for digital money these days— Usually I’m exchanging it for food instead.
> I trust that my bank is well-enough managed to provide me with physical currency up to the amount of my account balance
It (probably) is, but if all of your bank's account holders asked for that at the same time it would be what's known as a "run on the bank" and you'd very quickly find out that they don't have anywhere near enough physical currency to cover even a fraction of their account holders.
Citation needed. I do not believe this for even a single moment.
The only institution that can "create" money from thin air is the government. And even that is a polite fiction when you realize that "printing more money" also inherently devalues the money already in the system.
I only skimmed this briefly (no time), but things operating as suggested (eg the banks loaning money they do not have) would fall into the category of fraud IMO.
Whether that's currently legal or not is another matter that I cannot comment on.
What he wrote is a popular myth that originated in a misunderstanding how fractional reserve works, it just means they have long term assets to cover short term liabilities. There's a lot of this stuff on youtube.
If it was true no banks would ever fail, qed.
Ultimately being fundamentally wrong in how the financial system works is extremely unlikely to impact anyone's daily life.
You can only really hold the "printing more money" analogy in your head, if you are prepared to balance your thinking and accept that taxation and loan repayment "shred money" and that financial savings is "putting money in a drawer".
At which point you will realise there can be no devaluation since money is destroyed as it moves around, and money in drawers may as well not be there.
I see money as units of resource allocation. There are only so many available resources at any given moment. More units of allocation means less resources allocated per unit.
There isn't and never has been a one-to-one relationship between money and stuff. At best it is inductive.
Just as with electrical engineering, the real world requires a reactive supply, which is what allows electrical innovation beyond direct resistive loads.
Electrical supply engineers hate reactive power, but without it we don't get iPhones.
The power triangle gives the best engineering analogy to the way the monetary system works.
Clearly that's not true as the bank note analogy shows. If you print trillions of £50 pound notes and stuff them into an empty coal mine guarded by many competent people with guns, that's not going to have any impact on prices whatsoever.
While I disagree with somewhereoutth and mostly agree with you, it is true that banks can create money.
However banks don't create money out of thin air. However they can create it out of assets.
As a silly thought experiment: if your bank has a vault full of valuable assets, like diamonds and deeds to houses in prime real estate, stocks etc, they can in principle create loan/deposit pairs (ie make loans and credit the borrowed funds to the borrower account).
When people make withdrawals, especially when they make more withdrawals than the bank has reserves, they just sell some of their assets to cover the difference. That's all pretty normal and boring.
Customers think of their deposits of 100% like money and economically behave as if that was true, but in practice they are backed by 10% money, ie reserves, and 90% other assets.
(The percentages are for illustration only.
Also we ignore minimum reserve requirements and other laws here. Many countries don't have minimum reserve requirements anyway.)
That's a long PDF. What do you want to refer to in particular?
Btw, you might want to study the section 'Managing the risks associated with making loans'.
The pdf is pretty vague about the limits of creating these loan/deposit pairs in general. But there's eg this:
> One way in which they do this is by making sure
that they attract relatively stable deposits to match their new loans, that is, deposits that are unlikely or unable to be withdrawn in large amounts. This can act as an additional
limit to how much banks can lend. 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.
In general, the limit to loan/deposit pair creation is withdrawals and transfers of the new deposits.
---
Btw, I agree that fractional reserve banking can create money. (Just not base money, and not without limits.)
Fractional reserve banking does not work like this.
You still need assets in fractional reserve banking. Those assets just don't need to be reserves.
Ie 90% of your assets could be diamonds in the vault, and 10% could be reserve cash in the vault. That would be fractional reserve banking, but you still have 100% assets. (In practice, you have more than 100% assets. The excess is your equity cushion.)
If your liabilities outstrip your assets, that's when you are bankrupt. Fractional reserve banking doesn't help you there.
Yes, IOUs of credit worthy people can be part of your assets. But so can be diamonds or stocks.
> B borrows $500, which for simplicity's sake he deposits in his account.
If you stop there, your analysis is indeed correct. However, people don't typically take out loans to stuff the borrowed money into their accounts until the loan comes due.
They go out and buy stuff with the proceeds. So B withdraws the money.
So now you have:
- Assets: 1000$ cash in your safe plus an IOU of 500$ from B = 1500$.
- Liabilities: 1000$ deposit from A + 500$ deposit from B = 1500$.
So far so good.
You can repeat that game two more times, and then you run out of cash to withdraw.
So if you repeated it a third time, you'd need to sell the loan from B to a third party for cash, so you can fulfill B's withdrawal request.
If B is credit worthy, you will generally be able to make that sale. (But it takes time and hassle to organise.) Ie you have short term liquidity trouble, but you ain't insolvent.
If B is a deadbeat, you won't be able to sell that loan for enough to cover the withdrawal request, and now you are insolvent, and go into bankruptcy.
B is creditworthy. That’s why I leant it to him. If I have an issue with liquidity I go to the discount window of my central bank and they will lend me the money.
That’s why central banks typically make the rules about reserves, etc.
> B is creditworthy. That’s why I leant it to him. If I have an issue with liquidity I go to the discount window of my central bank and they will lend me the money.
Yes. But that means you got newly created base money from the central bank. Which sort of goes against the original claim.
> When you come to spend it, that amount is transferred to another bank, that they can then offset against their own magic money.
No. The other banks demand settlement in outside currency. In the olden days, they shipped gold around every so often. Nowadays, in the end you settle in central bank deposits.
You go to a bank with an asset. In this case the new house. The bank then creates a new financial asset called a 'mortgage' that goes on the asset side of their balance sheet. Against that they create a liability called an 'advance' that they give to you.
You then give the advance to the builder in return for the house, where it becomes a deposit of the builder than they can then transfer to anybody else in payment for goods and services.
If any of them happen to be at another bank then all that happens is the deposit is transferred to the bank and it becomes an 'inter bank loan'. The target bank then simply creates another deposit in its books to balance that loan and that is allocated to the customer being paid.
It's all just debits and credits. What limits bank money creation is the assets they are prepared to discount and the creditworthiness of the individuals they choose to advance to and whether the bank believes they can pay the current price of money.
I think you’re glossing over some important details regarding the inter-bank loans. As far as I understand, they are not automatic and must be negotiated in the same way as any other bank loan.
Modulo some amount of transaction batching, when one bank’s customer initiates a payment to an account at another bank, reserves are actually transferred between the two banks (these days, in the form of central bank account transfers).
Each bank’s main concern is managing its daily cashflow— They need to have sufficient reserves each day to cover that day’s net outflow of payments. But holding reserves is expensive; they would much rather use that currency as an advance payment for a new loan if they can, so that somebody else is stuck with the currency.
And here’s where the inter-bank loans come into play: Because most of a bank’s outflows happen on an irregular schedule as directed by their depositors, and they have an incentive to hold as few reserves as possible, they may find themselves in a position where they would need to suspend payments. When this happens, they borrow reserves from another bank in order to continue operating. If the borrowing bank is considered trustworthy by the banking community, they generally have no trouble securing such a loan on standard terms.
Of course, if a bank systematically misjudges the default risk of their borrowers, they may have a bigger problem that their assets (future loan repayments) won’t cover their liabilities (future withdrawals by depositors). If that imbalance isn’t corrected quickly, they will eventually find themselves unable to secure future inter-bank loans because they will have become an unacceptable default risk to the other banks.
"As far as I understand, they are not automatic and must be negotiated in the same way as any other bank loan."
Not in the slightest.
If the bank doesn't take over the deposit in the source bank, then their customer doesn't get paid. At which point they will close their account and move to the source bank. That's a deposit outflow they won't want to have.
Both the source and the destination bank have an interest in ensuring the payment clear. Therefore it does.
Inter bank loan negotiation is about shuffling the risk around for a price afterwards.
"reserves are actually transferred between the two bank"
Reserves don't exist in aggregate. Central banking is a collateral optimisation of correspondent banking.
There was no such thing as reserves in the UK banking system for three hundred years, for example.
Correspondent banking is the base for payments, and is still used for most international currency payments - even with the advent of the CLS central clearing mechanism.
> If the bank doesn't take over the deposit in the source bank, then their customer doesn't get paid. At which point they will close their account and move to the source bank. That's a deposit outflow they won't want to have.
The destination bank can demand to withdraw that balance. And they typically do that with the net flows at the end of the settlement period.
(And they don't withdraw physical currency these days. The 'withdrawal' comes in the form of a transfer of electronic central bank reserves.)
> Reserves don't exist in aggregate. Central banking is a collateral optimisation of correspondent banking.
No? This is easiest to see in a gold standard system: your physical gold are your reserves.
In typical modern fiat system, the reserves are account entries at the central bank (and vault cash, but that's a small-ish amount).
Private commercial banks can create 'money' via their normal commercial operations. But they can't create central bank reserves that way, nor are they allowed to print central bank notes.
> There was no such thing as reserves in the UK banking system for three hundred years, for example.
Citation needed. And also an explanation of exactly what you mean by reserves.
(Btw, talking about the 'UK banking system' over the last three hundred years already makes me very suspicious of your argument. During most of that time, Scottish banking differs remarkably from English banking. So there are not many blanket statement about the 'UK banking system' that are true.)
