Bank Lending – A Short Primer

A Short Banking Primer

The basics of how banking works are really quite simple for the average person to understand. Commercial banks decide beforehand who they deem to be creditworthy and once a borrower fitting that description is found, they create their own special IOU and then denominate it in the unit of account. What this means, in layperson’s terms, is that a bank will first determine its own standard for creditworthiness, which that bank can change at any time. It can make its standards stricter or more relaxed. When a person goes into a bank to obtain a loan, the bank will look at income, past credit history, etc., and should the person be deemed worthy of credit according to those standards, the bank will approve a “loan” and simultaneously create a deposit for the borrower by simply typing numbers in an account with a “$” symbol attached. The “$” symbol is the unit of account. In the UK, banks will simply denominate loans in British Pounds. The unit of account is the exclusive product of the national government, not commercial banks. For this discussion, we will use the US as our example, so in this case, the unit of account is US Dollars. Before we continue, let’s have a word about reserves.

US Dollars, or what we refer to as High Powered Money (HPM) exist in accounts held at the Federal Reserve called “reserve accounts”, which commercial banks each possess. Commercial banks do not issue HPM nor do they lend out these reserves to customers. Reserves remain on the balance sheet of the Federal Reserve. The Fed also stands ready to ensure that payments will clear by providing reserves to banks when the need arises. Reserves also affect monetary policy.

The Fed sets a target interest rate and seeks to maintain that desired rate. Excess reserve balances can thwart monetary policy. Contrary to popular belief, commercial banks generally do not wish to hold excess reserves over and above that which they require to ensure payments clear. Those with excess reserves will try to lend them to other banks, not customers, which are short of reserves. On the other hand, the Fed wishes to maintain a target interest rate. With the presence of excess reserves in the system, the Fed risks losing control of its target rate since the reserve lending activity between banks can cause the overnight rate to fall. So, through what is known as “open market operations” or (OMOs), the Fed buys and sells US Treasury bonds to alter the level of reserves, up or down, in the system in order to maintain its target rate. As a side note, this is why the Fed sets the target rate at or near zero prior to conducting QE. If it didn’t do this, then interbank competition would drive down the overnight rate and the Fed would only have to intervene to drain off the excess reserves that it created to begin with in order to defend the target rate. The purpose, then, of treasury bonds is to add or drain off excess reserves and the purpose of paying interest to banks on their excess reserves is to encourage commercial banks to hold onto their excess reserves. Either way, that is how the Fed maintains control of monetary policy. Now then, back to bank lending.

Reserve Shifts

As we’ve discussed earlier, when a bank creates a deposit for the borrower, that deposit consists of numbers typed out of thin air and denominated in the unit of account. In short, they are bank IOUs. Let us assume a loan of $30,000. When the borrower spends the deposit, the recipient deposits the $30,000 in her bank. What happens is that the borrower’s account drops by the number 30,000 and $30,000 held in the bank’s reserve account at the Fed then shifts to the recipient’s bank’s reserve account also held at the Fed. The recipients personal bank account then rises by exactly 30,000 numbers and the payment clears. In this manner, the bank’s IOUs behave as ‘money” in the private sector. So, this reality manifests itself with the reserve shift. The spent bank’s IOUs caused US Dollars held in a reserve account to shift over to another bank’s reserve account. The reason why they behave as “money”, is because the bank denominated its IOUs in the government’s unit of account. When it did so, it made the IOU acceptable to satisfy any tax liabilities owed to the US government, because the US government will only accept its unit of account as payment for taxes.

What is very important for you to understand is that the lending bank did not worry about the level of reserves that it had on hand prior to creating a loan. It simply lent out its IOU. Later on down the road, if that bank found that its reserves were too low to clear payments, guess what? As we’ve discussed, it will either seek reserves from banks who have excess or simply get them from the Fed itself, which must stand ready to ensure that payments will always clear by providing reserves when needed. Even though a bank might be lending and so, reserves are shifting out of its reserve account into the reserve accounts of other banks, we must not forget that it is also receiving reserves too through deposits and other transactions throughout the business day. So, reserves go up and down all the time, regardless of lending activity. For instance, a customer might swipe their debit card and buy a $1,200 refrigerator and so, $1,200 in reserves will shift over to another bank’s reserve account. An employer will direct deposit an employee’s pay in their employee’s account, shifting reserves from the employer’s bank’s reserve account to the employee’s bank’s. It is only when both lending and typical daily transactions result in reserves being short, that the bank will worry about its level of reserves on hand.

For the privilege of using the bank’s IOU to make purchases, the bank charges you a fee, called “interest”. Not only do you have to pay back the loan amount, but also extra. Hence, bank credit results in private debt. Whereas, when the US government deposits a $5,000 tax refund in your account you do not incur private debt, a bank IOU is a different beast entirely. So, why then does a bank charge interest? Obviously, because that is how a bank makes a profit. This, then, explains why a bank lends: a bank does not lend to act as an intermediary, bringing savers and investors together, but to make a profit.

Because the government’s unit of account (US Dollars) exists, a commercial bank will then take what we call “an asset position” by lending its IOU to you, which is the act of leveraging US Dollars to earn a profit. The interest it charges over and above the amount lent to you is then profit for the bank. So, by creating an IOU, the bank shifts the government’s HPM to another bank’s reserve account and then waits for you to shift HPM back plus extra by making regular payments. Clever, right? Maybe, but it’s not exactly a good thing. If, at the same time all of this lending is going on, the fiscal stance of the US government is one of deficit reduction, that means that additional US Dollars created by the US government and spent into the domestic economy are being deliberately reduced and so, private debt to consume goods and services is rising. In other words, the US government is forcing the population into using credit cards and loans to live beyond its means. As the level of bank credit rises to consume production, the domestic populace becomes increasingly indebted until it simply cannot continue spending more than its income. At that point, consumer spending contracts and business then loses income. As a result, business begins laying off employees and unemployment then rises. Without their former income, the unemployed contract their spending as well and finally, a recession occurs. Reversing the situation requires the US government to abandon deficit reduction and begin deliberately reducing taxes or crediting bank accounts with its own IOU (the US Dollar), whether that be purchasing goods and services in order to provision itself or simply giving people US Dollars in order to take the pressure off of consumer savings, thus allowing them to begin spending again.

That is the reality of banking and how it affects the domestic economy. Over reliance on low wages and part-time employment in the face of deficit reduction leaves a spending gap that must be filled. Filling that gap with bank credit to consume goods and services is particularly dangerous and makes for unsuitable macroeconomic policy.