“Loans Create Deposits” – In Context

By JKH (cross posted at Monetary Realism)


Loans create deposits. We’ve heard it many times now. But how well is it understood? The phrase is typically invoked accurately, in conjunction with a rejection of the ‘money multiplier’ fable found in economic textbooks. From an operational perspective, banks do not “lend reserves” to their non-bank customers. “Loans create deposits’ is an operation in endogenous money. And where central banks impose a level of required reserves based on deposits, the timing of the demand for and supply of reserves in respect of such a requirement follows the creation of the deposit – it does not precede it. The money multiplier story is bunk. And ‘loans create deposits’ is correct as an observation.

Nevertheless, there is a larger context for deposits, which includes their fate after they have been created. Deposits are used to repay loans, resulting in the ‘death’ of both loan and deposit. But there is more. As part of the birth/death analogy, there is the lifetime of loans and deposits to consider. This sequence of birth, life, and death in total may be helpful in putting ‘loans create deposits’ into a broader context. There is potential for confusion if ‘loans create deposits’ is embraced too enthusiastically as the defining characteristic, without considering the full life cycle of loans and deposits. Indeed, we shall see further below that ‘deposits fund loans’ is as true as ‘loans create deposits’ and that there is no contradiction between these two things.

Monetary Systems

The monetary system and the financial system are constructions of double entry accounting. It has been this way for a long time. This did not start in 1971. The fact that there was gold serving as a fixed value backstop for certain monetary assets shouldn’t obscure the fact that a monetary system is a fiat construction at its foundation. Gold at one time was a hard constraint on the behavior of the monetary authorities. But the authorities will inevitably create paradigms of operational constraint and guidelines in any monetary system. These restrictions include central bank balance sheet constraints (e.g. gold backing; Treasury overdraft constraints; supply and pricing of bank reserves that are consistent with the monetary policy interest rate target) and other guidelines (such as the reaction function of the policy rate to various measures of inflation, output, or employment). The full category of potential constraints is broad and varied. But none of this alters the fact that a monetary system is basically a bookkeeping device for the intermediation of real economic activity. It is a construct that enables moving beyond a barter economic system that can only be imagined as a counterfactual.

The Choice for Banking

Starting from this monetary bookkeeping foundation, a fundamental choice exists. Will the system include a competitive banking sector? More broadly, will financial capitalism exist in substance and form? Will there be competition? Within this landscape, will there be more than one bank? While a banking singularity (a single, concentrated, nationalized institution) is usually considered to be non-pragmatic, it serves as a useful theoretical reference point for understanding how banks actually work. The competitive framework that is often taken for granted is in fact a choice for banking system design – including the presence of a reserve system that enables active management of individual bank balance sheets.

‘Loans Create Deposits’

When we say ‘loans create deposits’, we mean at least that the marginal impact of new lending will be to create a new asset and a new liability for the banking system – typically for the originating lending bank at first. A bank makes a loan to a borrowing customer. That is a debit under bank assets. Simultaneous, it credits the deposit account of the same customer. That is a new bank liability. Both of those accounting entries represent increases in their respective categories. This is operationally separate from any notion of reserves that may be required in association with the creation of bank deposits.

In another version of the same lending transaction, the lending bank presents the borrower with a cheque or bank draft. The lending bank debits the borrower’s loan account and credits a payment liability account. The bank’s balance sheet has grown. The borrower may then deposit that cheque with a second bank. At that moment, the balance sheet of the second bank – the deposit issuing bank – grows by the same amount, with a payment due asset and a deposit liability. This temporary duplication of balance sheet growth across two different banks is captured within the accounting classification of bank ‘float’. The duplication gets resolved and eliminated when the deposit issuing bank clears the cheque back to the lending bank and receives a reserve balance credit in exchange, at which point the lending bank sheds both reserve balances and its payment liability. The end result is that the system balance sheet has grown by the amount of the original loan and deposit. The loan has created the deposit, although loan and deposit are domiciled in different banks. The system has expanded in size. The growth is now reflected in the size of the deposit issuing bank’s balance sheet, with an increase in deposits and reserve balances. The lending bank’s balance sheet size is unchanged from the start (at least temporarily), with loan growth offset by a reserve balance decline.

Money Markets

In this latter example, it is possible and even likely, other things equal, that the lending bank additionally will seek to borrow new funding from wholesale money markets and that the deposit issuing bank will lend funds into this market. This is a natural response to the respective change in reserve distribution that has been created momentarily for the two banks. Without further action, the lending bank has lost reserves and the deposit bank has gained reserves. They may both seek to normalize these respective reserve positions, other things equal. Adjusting positions through money market operations is a basic function of commercial bank reserve management. Thus, this example features the core role of bank reserves in clearing a payment from one bank to another. The final resolution of positions in this case is that the balance sheets of both banks will have expanded, indirectly connected through money market transactions that follow on from the initial ‘loans create deposits’ transaction. However, this too may be a temporary situation, as the original transaction involving two different banks will inevitably be followed up by further transactions that shift bank reserves between various bank counterparties and in various directions across the system.

The Money Multiplier Fable

The money multiplier story – a fable really – claims that banks expand loans and deposits on the basis of a central bank function that gradually feeds reserves to banks, allowing them to expand their balance sheets with new loans and reservable deposits – according to reserve ratios that bind the pace of that expansion according to the reserves supplied. This is entirely wrong, of course. In fact, bank balance sheet expansion occurs largely through the endogenous process whereby loans create deposits. And central banks that impose reserve requirements provide the required reserve levels as a matter of automatic operational response – after the loan and deposit expansion that generates the requirement has occurred. The multiplier fable describes a central bank with direct exogenous control over bank expansion, based on a reserve supply function – which is a fiction. The facts of endogenous money creation have been demonstrated by empirical studies going back decades. Moreover, the facts are obvious to anybody who has actually been involved with or closely studied the actual reserve management operations of either a commercial bank or a central bank. In truth, no empirical ‘study’ is required – the banking world operates this way on a daily basis – and it is absurd that so many economics textbooks make up stories to the contrary. The truth of the ‘loans creates deposits’ meme is pretty well understood now – at least by those who take the time to learn the facts about it.

Central Bank Reserve Injections

A central bank that imposes a reserve requirement will follow up new deposit creation with a system reserve injection sufficient to accommodate the requirement of the individual bank that has issued the deposit. The new requirement becomes a targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the central bank. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. Thus, there is a lag between two system growth impulses – ‘loans create deposits’ as the endogenous feature and a subsequent central bank reserve injection as an exogenous follow up. The required reserve injection is typically small by comparison, according to the reserve ratio. The central bank can provide the reserves in different ways, such as by purchasing bonds or by conducting system repurchase operations with investment dealers. In the case of either bond purchases or system repurchase agreements, additional system deposits might be created when the end seller (or lender) of the bonds is a non-bank. And that second order creation of deposits may be reservable as well. But what might appear to be a potentially infinite series of reserve injections is in fact highly controlled in the real world – because the reserve ratio is relatively small. Some countries such as Canada have no such required reserve ratio. Indeed, the case of zero required reserves nicely emphasizes the nature of the money multiplier as an annoying analytical error and distraction from accurate comprehension of how banks actually work. But as a separate point, central bank injections of required reserves illustrate how not all deposits are necessarily created by commercial bank loans. ‘Loans create deposits’ is true, but not exclusive. This aspect is made clear also by the example of central bank ‘quantitative easing’, noted further below.

The Growth Dynamic

The ‘loans create deposits’ meme is best understood as a balance sheet growth dynamic, distinct from any reserve effect that might occur as part of an associated interbank clearing transaction at the time (e.g. the second example above) or as part of a deposit ratio requirement that might be activated at a later date. The banking system can be visualized in continuous time, punctuated by discrete banking transactions that are reflected as accounting entries. If one divides time into very small time intervals, individual banking transactions can be isolated as the only transactions that occur during a given interval of time. Thus, the growth dynamic of ‘loans create deposits’ can be conceived of as an instantaneous balance sheet expansion at the point of corresponding accounting entries. As noted in the examples above, this expansion may then migrate across individual banks when the lending and deposit issuing bank are different.

‘Deposits Fund Loans’

Some interpretations of the ‘loans create deposits’ meme overreach in their desired meaning. The contention arises occasionally that ‘loans create deposits’ means banks don’t need deposits to fund loans. This is entirely false. This is the point that requires emphasis in this essay.

There is no inconsistency between the idea that ‘loans create deposits’ and the idea that banks need deposits to fund loans. Bank balance sheet management must respond to both growth dynamics and steady state conditions in the dimension of nominal balance sheet size. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types – including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the central bank is not a mere slush fund that provides unlimited funding to the banking system. In fact, active liability management is important in private sector banking – in the system we actually have. Other systems have been proposed, in which central banks intervene in some way to adjust the landscape of competitive liability management (e.g. the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the MMT Mosler plan). These are ideas for significant change that should not be confused with the characteristic of competitive banking as it now exists. Some analysts tend toward language that conflates factual and counterfactual cases in this regard. To repeat – bank liability management is very competitive in the system we have, by design. The ‘loans create deposits’ meme, while true, only touches on this competitive dynamic.

We note again that loans are not the sole source of deposit creation. A commercial bank’s purchase of securities from a non-bank will typically result in new deposit creation somewhere in the system. There are cases where deposit creation results from other liability or equity conversion – commercial bank debt redemption and stock buybacks are examples of this. Existing fixed term deposits can convert to demand deposits and vice versa. And central bank quantitative easing most often results in new deposit creation – because the bonds that the central bank purchases are typically sourced from non-bank portfolios, and exchanged for deposits. Nevertheless, ‘loans creates deposits’ is a reasonable reference point and standard for the process of deposit creation.

Bank Asset-Liability Management

The ‘loans create deposits’ dynamic comprises the production of much of the money that serves as a basic source of liquidity in a monetary economy. The originating accounting entries are simple – a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital – especially equity capital – to take risk – and to take credit risk in particular.

Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The ALM function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance (e.g. the fed funds rate) has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities.

The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity.

In examining all of these effects, it is helpful to consider the position of the banking system in its totality, in conjunction with the position of individual banks that constitute the whole. For example, the US commercial banking system is composed of thousands of individual banks. Between discrete ‘loans create deposits’ events, the banking system is in continuous balance sheet churn. Specifically, deposits are moving back and forth between individual banks, as a matter of normal payment system operations. They are also moving and inter-converting in the form of term deposits at both the retail and wholesale level. This overall liquidity churn feeds economic activity of all sorts, where households, businesses, and governments are making payments to each other for various goods and services and other types of transactions, and are making choices about the portfolio structure of their liquid assets. This is the core liquidity provided by the banks to their customers. And this is the stuff that involves a good deal of transferring of reserves back and forth between banks, in order to affect accounting completion of balance sheets that are in continuous flux in size and composition.

Bank Reserve Management

The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets that are in balance, institution by institution – and where deposits fund loans, alongside various other asset-liability matching configurations. The reserve system records the effect of this balance sheet activity. The reserve account is the inverse exogenous money image of the nominal configuration of the rest of the balance sheet. The balance sheet requires asset liability management coordination in order to match up assets and liabilities both in nominal terms and in a way that is financially effective. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis.


In summary, the original connection by which deposits are created by loans typically disappears at some point following deposit creation – at the micro bank level and/or the macro system level. The original demand deposits associated with specific loan creation become commingled as they move back and forth between different banks. And they not only move between banks, but they can change in form within any bank. They can be converted into term deposits or other funding forms such as bank debt or common and preferred stock. The task of dealing with this compositional flux falls under the joint coordination of bank asset-liability management and reserve management. The overarching point of observation is that both system growth and system competition for existing balance sheet composition are in constant operation. ‘Loans create deposits’ only describes the marginal growth dynamic at the inception of deposit creation. ‘Deposits fund loans’ is the more apt description that applies to a good portion of what constitutes ongoing balance sheet management in competitive banking.


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  • http://coppolacomment.blogspot.co.uk Frances Coppola

    Brilliant explanation, JKH. I don’t think anyone who hasn’t seen what ALM departments do can fully appreciate just how complex the loan/deposit/reserves flux is.

  • SS

    I am still confused on this point. You say deposits fund loans, but loans create deposits. How can it be both at the same time? If the bank funds it loan book by acquiring deposits then there seems to be a missing piece in this explanation?

  • GLG34

    That makes two of us. I enjoy the depth of JKH’s explanations, but they are so far over the head of a layman that it makes it hard to digest.

  • http://www.concertedaction.com Ramanan

    Any loan creates new deposits equivalent to the amount of the loan (with minor differences such as charges for stamping etc.) But once the loan and made and the deposit created, the funds move around and it is one important task of the bank to attract the lost funds back. So one – and the best way – is to attract deposits (and also keep the current customers attracted to not shift funds)

  • Jake

    This part confuses me…

    “And central bank quantitative easing most often results in new deposit creation – because the bonds that the central bank purchases are typically sourced from non-bank portfolios, and exchanged for deposits”

    I was always under the impression that the central bank only transacts with banks. Is the Fed buying up securities directly from folks like you and me?

  • http://www.orcamgroup.com Cullen Roche

    Most of the bonds purchased during QE come from the non-bank private sector. So non-banks on-sell the bond to the bank who on-sells to the Fed.

  • Jake

    The two statements aren’t mutually exclusive. Loans create deposits. Deposits do fund loans, but only as a matter of preference, not necessity.

  • JK


    I think this is the line that is confusing: “because the bonds that the central bank purchases are typically sourced from non-bank portfolios”

    What does “sourced” mean?

    If the Fed is only transacting with banks, then are banks purchasing bonds from non-bank portfolios in order to sell them to the Fed?

    Also, is there a ‘why’ to: why are “the bonds that the central bank purchases…typically sourced from non-bank portfolios” as opposed to bank portfolios?


  • Geoff

    JK, I think the banks are just doing what they do best. They are acting as middle men (people?) and a taking little bit for themselves in the process. Never putting their own butt at risk, of course.

  • JK

    I’m not sure what you mean by this: “Never putting their own butt at risk”

    I’d expect the banks are just doing standard Asset Liability Management in response to QE.

    My questions above remain though.. “sourced” needs deeper explanation.

  • Johnny Evers

    I had thought the Fed was using reserves to buy bonds, meaning no money was being added to the system.
    But if the Fed is really buying bonds from non-banks, then that wouldn’t appear to be so?

  • http://www.concertedaction.com Ramanan

    Yeah true but let us say a depository institution doesn’t pay attention to its deposit raising activities. It can try to fund by other means as well. It is however much “safer” to do so with deposits. (It also helps the bottom line).

    This is especially true when other lenders may look at the deposit levels to decide whether to fund or not or to decide if the price is worth paying.

    If you are a bank and on a road show to raise some funding via bonds or something, people will still ask you how much deposits you have etc.

  • Geoff

    The Fed purchase of bonds from non-banks does indeed add money to the system in the form of deposits, but it doesn’t add NFA.

  • JKH

    that’s pretty smooth

    plus Ramanan just below



    Loan creates a deposit at Bank A.

    Bank A loses the deposit to Bank B.

    (i.e. the borrower moves his deposit to Bank B, or makes a payment to a third party who deposits the funds in Bank B)

    Bank A attracts a new deposit from Bank C

    (i.e. a customer moves his deposit from Bank C to Bank A).

    The new deposit is now funding the original loan.

  • JKH

    thx Frances

    I know you’ve seen this stuff close up as well

  • Johnny Evers

    It turns an NFA into a deposit?

  • Geoff

    Yes, it swaps one type of financial asset for another, i.e. a Tbond for a deposit.

  • JK


    Right. As an unrealistic example: If there are $100 in Treasurys and $100 of inside money deposits “in the economy” …there is $100 of NFAs, right?

    If the Fed then does a QE, resulting in $200 in deposits, there is still only $100 in NFAs in the economy, those NFAs are just in a different form, i.e. no longer Treasurys and now Reserves/Deposits.

    In either case, if all the inside money ($100 worth of Loans create Deposts) were to be paid back and destroyed, there would still be $100 of NFAs no matter the composition.

  • Pyrite

    Banks are not competing by deposit interest rates. A bank offered 0.005% interest.

  • Frederick

    Nice to see you guys doing more on banking. Am I wrong to think that JKH has a very positive view of modern banking? I get the impression that he thinks the system designed around private banking is ideal?

  • LVG

    Cullen previously mentioned that JKH has a banking background. So he’s probably biased towards private banking.

  • Geoff

    JK, yes that’s my understanding, too. Nice example.

  • Stephen

    Great article JKH. H/T to Ramanan for providing clarity on the deposits funding loans question.

    At this point, based on the extensive research you guys have undertaken and presented, it’s pretty clear how “money” or “credit” is created within the traditional commercial banking system.

    I proposed this question to Cullen a few weeks back, and am still anxiously awaiting a response (hopefully in the form of a lengthly article): with regards to “money” or “credit” creation, where do shadow bank liabilities such as MBS, ABS, GSE liabilities, repos, commercial paper, money market mutual fund shares, etc. come into play?

    While these shadow bank liabilities do not have the ability to cause the inflation in consumer good prices that traditional bank deposits do, they sure do have the ability to cause inflation in financial asset prices.

    I’d love to hear how the opaque world of shadow banking meshes with the views of MR.


  • Geoff

    I’m just guessing, but don’t shadow banks just redistribute existing inside money as opposed to create more?

  • JanVerR

    This explanation is not correct. Banks do not need deposits to “fund” their loans. In fact, banks don’t “fund” their loans at all. They acquire cheap sources to settle the payments for their customers (as needed). Deposits also happen to be a good source for fees and other profits. Regarding payments, deposits just so happen to be the least expensive liability that allows them to settle payments for their customers. None of this has anything to do with allowing the banks to make loans.

  • http://www.orcamgroup.com Cullen Roche

    I think “fund” is a confusing word in this context especially for novices. If we’re going to make this stuff mainstream it needs to be digestible and I find this terminology more confusing than anything as it implies that a bank needs deposits in order to be able to make loans, which is not true. So this terminology is bound to confuse people as is clear from the comments here. But I am not sure how best to rectify the terminology.

    I prefer to talk about banking as a spread business where the banks must match assets and liabilities in order to meet their stated goals of helping clients settle payments at a rate that their liabilities are less expensive than their assets (ie, the bank makes a profit). I need to think about this one a bit more, but any suggestions on terminology here would be greatly appreciated. I hate to confuse people on this sort of stuff and it’s a crucial piece of the puzzle here. Thanks in advance to anyone with thoughts.

  • Geoff

    Cullen, I like your description of banks as a spread business (at least the lending division of a bank). Any novice can understand a spread business.

    Also, deposits may not be crucial, but capital is. Capital equals Assets minus Liabilities. Deposits are pretty good liabilities.

    Finally, I would be careful about using the word “need”. I don’t believe JKH said that banks “need” deposits, just that they can be used to fund deposits as an option (a very good, cheap option).

  • jt26

    In the end is banking just market making? Matching those who desire credit and those who want to extend credit (in some very broad definition of credit; in the end, labour/time.) Does it matter whether the buyer came first or the seller? The market maker essentially makes a bet that there are buyers and sellers at some price. From an accounting POV, the “credit” transaction is captured as a loan and deposit. Do we ever ask does making hamburgers create hamburger eaters? At the margin and at genesis it may be true for the first hamburger, but afterwards? The success of the hamburger creation event is because restauranters know that people want to eat and new foods at that. In creating a loan, banks know people want to extend “credit” (expend their current time/labour for some future time/labour), perhaps not for a specific loan, but loans in the aggregate.

  • Geoff

    JT26, that is brilliant. Regarding hamburger (and other meat) eaters, I’ve often wondered if they came first or the cows? Most of the cows today were created (i.e. breeded by man) for the purpose of eating them. I’m not sure vegetarians understand this point :)

  • Tom Brown

    Cullen, I’m finding it difficult to improve on JanVerR’s description. I like that he points out that deposits can be a source of income as well (e.g. through fees).

    I think it should be emphasized that assets and liabilities are almost always obtained as offsetting pairs. And while it’s to a bank’s advantage to obtain an asset w/o an offsetting liability, it’s never the case that obtaining a liability w/o an offsetting asset is an advantage, even if it does generate fees, since the immediate impact to

    equity = assets – liabilities

    would be negative. So it’s never the case that deposits (or any liabilities) are desired by themselves… it’s because they come with offsetting useful or high interest rate bearing assets that’s important. Even if the deposits are attractive due to high fees, they must be bundled with offsetting assets otherwise they’ll negatively impact equity.

    A mathematical analogy is E = A – L, and the bank wants to increase E, by increasing it’s time rate of change:

    E’ = A’ – L’

    So the bank wants to acquire pairs {A,L} where A >= L and A’ > L’. Generally it has to settle for A = L, but it can often find A’ > L’. So even if A’ L’ it looks like an attractive pair.

  • Tom Brown

    That last sentence should read:

    So even if A’ L’ it looks like an attractive pair.

  • Tom Brown

    Wow… I guess that last sentence was an escape sequence of some kind… it won’t print! So in words:

    Even if A’ is negative as long as A’ is greater than L’ it looks like an attractive pair.

  • http://www.orcamgroup.com Cullen Roche

    I’m all ears on how best to explain this stuff so people can understand it. MR is an evolving set of ideas and I need feedback on how best to present it in a manner that is understandable. So your input is definitely valued here Tom.

  • Tom Brown

    Well I hope that helps. I don’t think my “mathematical analogy” is an exact description for several reasons*, but I think it might be useful. It’s another way of stating your “spreads” description.

    Also, I’d change this sentence of mine:

    “…and the bank wants to increase E, by increasing it’s time rate of change”


    “…and the bank wants to increase E, by establishing a positive time rate of change”

    *reasons analogy is not exact: one is that it’s not the case, for example, that

    A(t) = A(t0) + A’*(t-t0)

    The curve is more complicated than a straight line (A’*(t-t0)) with an offset (A(t0)). Also, it’s not really the case that A itself follows this formula for any one kind of A. Actually the change in A comes in the form of OTHER kinds of assets (i.e. a loan generates interest payments, not “more loan” … well except for negative equity loans I guess!). Same goes for L.

  • Tom Brown

    So rather than saying “deposits fund loans” perhaps you could say “banks want to attract {reserve-asset, deposit-liability} pairs, because the reserves are useful (for settling customer payments, etc) and the deposits bundled with them require a low interest payment.”

    Hmmmm, still kind of long winded and clunky sounding, … still needs some work!

    How about “The only sense in which a bank want’s to attract a deposit* is in that it can make use of the asset that comes with it, and deposits don’t cost much in interest, so they are attractive relative to other liabilities.

    *Except in the case of a fee-generating deposit, but this still needs an offsetting asset so as not to immediately decrease equity.”

    Still, long winded perhaps, but more understandable? Well, get rid of my * footnote and it’s better maybe, and still accurate enough.

    BTW, sometimes I see “deposits are cheap” which was clear enough to me in the context I first saw it (Fullwiler’s paper), but sometimes I think that might make people think that deposits are somehow purchased, when actually deposits are what the accompanying assets are purchased with. That’s why I like to stress that it’s the interest on the deposit that is “cheap.”

    Yet another way to say it is that banks purchase reserves, loan papers, and other assets with IOU’s called deposits. A customer might be tempted to exchange his IOU at one bank for an IOU at another bank, thus giving the new bank what it was really after: reserves.

    Well that’s all I got. Maybe there’s a useful bit amongst those scraps!

  • Tom Brown

    I’m not sure I like my last two paragraphs above… because they give the impression that you can purchase something with a liability. You can purchase something by CREATING or issuing a new liability, but the only pre-existing item on your balance sheet that you can use to make a purchase with is an asset.

    I don’t know Cullen… this is a tough concept to communicate!

  • http://www.orcamgroup.com Cullen Roche

    It’s tough. It’s a weird concept. I’m usually okay at communicating complex things into easily understood ideas, but this one’s got me stumped….Maybe we should just work with the spread concept and the idea that banks need cheap liabilities to settle payments? I am not sure.

  • Tom Brown

    I like to always think about the offsetting assets moving around too. This allows me to always think “assets are good, liabilities are bad.”* So instead of

    “Bank A loses the deposit to Bank B”

    I’d say

    “Customer moves deposit from A to B, and A loses reserves backing the deposit, but keeps the loan on it’s books as an asset. It may have to borrow reserves to clear the transfer (and thus replace the low interest rate deposit-liability with a higher interest rate reserve-borrowing-liability).”

    If it weren’t for the reserve-assets moving too, then A would say “good riddance!” to it’s deposit-liability and it wouldn’t have to borrow any additional reserves, and it would also experience an immediate increase in its equity!

    and instead of

    “Bank A attracts a new deposit from bank C”

    I’d write:

    “Bank A obtains reserves backing a deposit at bank C by convincing customer at C to move his deposit to A”

    and instead of

    “The new deposit is now funding the original loan.”

    I’d say

    “The reserve-assets that came with the new deposit moved from C to A allow A to pay down its reserve borrowings it needed to clear the transfer of the reserves from A to B. Paying down this borrowing allows A to increase its spread (assuming the new deposit requires less interest than the reserve borrowing).”

    It amounts to the same thing you write, but I think it’s crucial to always keep in mind that for every liability there’s an asset. If there weren’t the banks wouldn’t be interested in “attracting” deposits (or any liability) in the first place, because a liability w/o an offsetting asset is just an immediate loss of equity. Assets acquired w/o offsetting liabilities, on the other hand, are an immediate increase in equity for the bank, and thus are desirable. Now beyond that there’s the returns or losses (interest payments, fees, etc.) associated with each asset and liability (I like to think of that as a rate of change of the asset or liability, even though that analogy isn’t perfect), which factors into the game of spreads that Cullen refers to.

    *Note: really I should qualify my statement: “assets are good, liabilities are bad” because it’s true that an asset could have a negative rate of return, and a liability a positive rate (through fees, etc). But in terms of the *principal* amount, the quote holds (as long as we’re talking positive valued assets and liabilities here). Thus a deposit could have a positive rate of return through fees, but the bank still wouldn’t be interested unless it came with a backing asset to offset the principal amount… otherwise it’s just amounts to an immediate decrease in equity for the bank.

  • Tom Brown

    My way of thinking of it may be overly pedantic for most people, but it allows me to keep my “assets = good, liabilities = bad” mindset, because some of the language associated with this subject implies the opposite, which is confusing.

    Now a deposit, however, can be either an asset or a liability depending on who’s viewing it of course! To the customer it’s a asset, to the bank a liability. So that’s another thing that perhaps causes confusion… looking at the deposit from different viewpoints in the same sentence or paragraph.

  • johnw

    Indeed; banks do indeed need cheap liabilities to settle payments but, have you considered this:

    When the Feb prints and creates QE money and buys T-bills from a none bank, such as a pension fund, that same pension fund will deposit the said funds with a commercial bank. Now, since the Institution managing the pension fund is an important, and maybe demanding, customer of the commercial bank it will demand a higher return on this deposit than the commercial bank will receive on it when it is deposited into its reserve account at the Fed. Consequently, it would seem, some deposits can turn out to be an unwanted “chalice”, since it ensures that the commercial bank suffers a loss for the duration of this deposit. Consequently, it occurs to me, the only way that commercial banks can cover this loss is to “load” it onto its lending rate and, in so doing, making the cost of aggregate borrowing more expensive.

    Your view on this Cullen would be appreciated.

  • Tom Brown

    In times of substantial excess reserves (like now), I find it difficult to believe that banks would ever offer interest on deposits to ANY customer exceeding the IOER. Do you actually know for a fact that this happens?

  • http://www.orcamgroup.com Cullen Roche

    Yes, that ultimately is what banking comes down to. A bank is only profitable if it can pass on the cost of its liabilities in the lending spread. In general, banks don’t have to pay people to hold deposits with them. And given the generally inexpensive cost of capital today this shouldn’t be a big problem for banks since the yield curve is at a pretty healthy spread for them.

    But I believe this happened in Europe on a much larger scale in 2012 when deposit rates were soaring as periphery banks were trying to keep more deposits from leaving to northern banks. That was more of a fear based and unusual environment rather than the sort of thing you’re discussing though….

  • johnw

    Here in the UK it is possible and suspect the same may apply in the US.

  • johnw

    The point I am making, Cullen, is the effect that QE can have on the cost of borrowing which, here in the UK, is extortionate considering a base rate of a mere 0.5%. QE, it appears to me, debases the currency and causes higher than necessary lending rates leading to higher inflation and a stagnating economy. I apologise if my comment has caused your article to go, somewhat, off track but, I appreciate you thoughts.

  • Tom Brown

    johnw, just curious: do they call it QE in the UK as well? Wow… that’s a mixed bag you’re describing. The Market Monetarists (MMers) would say “yes, good” to higher inflation rates, but not to higher interest rates at least while you still have a “stagnating economy.” Do you have MMers over there? What are they saying about what’s going on? Just curious how they explain that. Probably their explanation is “not enough QE.” Or “not enough resolve to do QE to raise NGDP to the target.”

  • http://www.orcamgroup.com Cullen Roche

    Yeah, that’s a reasonable view of things. You could say that QE has a few major effects. Not only could it have the impact you’re describing because it creates deposits for non-bank sellers, but it also reduces the net interest margin of banks because it pulls income out of the banking sector. All of these pressures on margins result in a more expensive banking environment for consumers.

    I can’t be sure how much this is causing loans to increase in price. I don’t think there’s strong evidence of that, but it means the banks are forced to gouge their customers more. Hence, the end of free checking….


  • Tom Brown

    So Cullen, along those lines, if the Fed were to stop paying IOR, do you agree with JKH when he states that he doubts the banks would try to make up the difference by increasing the volume of loans? (in the response to Morgan Warstler comments to his Say’s Law article at monetaryrealism)


  • JKH

    I think that’s all roughly OK, Tom, but for emphasis:

    I’d say the reserve account is a record of the mismatch in net flows and resulting stocks due to movement of other assets and liabilities.

    So very roughly speaking, the movement in assets and liabilities is the cause of the reserve change, and the reserve change is the effect of the movement in assets and liabilities.

    And it’s the movement in assets and liabilities that is the primary focus of banking, with all that has to do with credit risk, liquidity risk, interest rate risk, and spreads. That’s what banking is about – not the reserve effect. The reserve effect is interesting, but it’s essentially an accounting for what’s going on in the net position of the rest of the balance sheet.

    So the purpose in replacing a deposit outflow with a deposit inflow is just that – it’s not just to get the reserve account back to square. The fact that the reserve account goes back to square is the effect of successfully having obtained new funding. It is the measure of success. But the effort that goes into getting that new deposit is what matters. And that activity is all captured at the highest level of what is called asset-liability management.

    So roughly speaking in terms of causality, asset-liability management is the cause, and reserve management is the effect. That’s a bit crude as a characterization, but starts to get at the difference between the two functions and the connection between the two functions.

    What the bank is really managing top-down is assets and liabilities – the reserve account is the way in which it keeps track of its net position in doing that. But the reserve net position always reflects the mirror image position of assets and liabilities.

  • johnw

    Hi again Tom,

    Yes quantitative easing is referred to over here as QE or, more commonly as money printing. Regrettably there are very few people, including mainstream media journalists, who understand exactly how it works or, indeed, how the monetary system itself works. I am pleased that I recently discovered Pragmatic Capitalism since it reiterates my researched understanding of the system and has given me confidence to pass on what I have learned.

    There are a few MMers who comment in the main stream media and who, basically, re-iterate Cullems views but, alas, they are often derided as nutters or lefties but, they are, in my opinion, the only people who are able to intellectualise with any understanding about our current problems. Yes, they do see QE as the best solution to get NGDP on track.

  • Tom Brown

    MMer’s lefties?? They re-iterate Cullen’s views?? Are we sure we’re talking about the same group? I don’t think Cullen is an advocate of QE, although he definitely advocates viewing it for what it really is (an asset swap) and not calling it “money printing.”

    By MMer, I mean people like Scott Sumner & Lars Christensen. Those folks tend to self-identify on the right or at least as libertarians… Milton Friedman types. Although what they advocate is very far removed from what Austrian libertarians advocate. In fact these two kinds of libertarians are almost diametrically opposed. They would both agree that fiscal policy is counterprodutive, but I think Austrians would also say monetary policy is also counterproductive, and what MMers classify as monetary policy a lot of other folks might regard as fiscal policy.

    The MMers are basically mainstream neo-classicals who believe that the central bank should target NGDP levels (or growth… I’m never sure which, but I think the former, since I believe they think it should be a cumulative growth… i.e. if you miss the target by 1% one year, you should really target making that up the next). As such the MMers see themselves as “heterodox” since mainstream Monetarists still think inflation should be the CB’s target. But it sounds like you knew that since you do mention NGDP.

    Since NGDP is inflation + Real GDP, and since a typical target advocated by MMers is 5%, that means if we achieve only 1% Real GDP growth, they’re basically advocating a 4% inflation rate. The mechanism for doing this is by threatening to do as much QE as is needed in order to accomplish it. That’s why I associate MMers with QE: They’re for QE-4-ever essentially, and think the problem is there hasn’t been enough of it, and the threats haven’t been there to make it clear what the Fed is after (if indeed it WAS after an NGDP target, which it’s not).

    They are very different from MR: they don’t accept the balance sheet recession concept or that banks should enter into macro models.

  • http://www.orcamgroup.com Cullen Roche

    He might be referring to MMTers. MMTers aren’t exactly on the same page as MR either though. In fact, they’re pretty far off since their views of the world are almost entirely govt centric while MR is private sector centric. As many people know, I battle it out here with MMT people on a regular basis, which is unfortunate and something I should probably stop engaging in….

  • Tom Brown

    Yes, most of us do know about those battles Cullen… Ha! They’re hard to miss!

    I thought perhaps johnw meant MMT too, but he did mention NGDP… so maybe not.

  • johnw

    What I am saying, Tom, is that Monetary Realists are often confused with Modern Monetary Theorists which is why they are derided as nutters or lefties in the comments section of the MSM.

    As you may be aware Mark Carney from Canada has been appointed as the new governor of the BoE who has indicated that he favours NGDP targeting which, according to my understanding, may involve more QE to increase the monetary base. this tends to be favoured by monetary realists over here who may sometimes be known to you as market monetarists.

    There is an article in this mornings Telegraph newspaper (link below) about the prospect of more QE. You may find the comments section interesting since it illustrates the publics understanding and perception of QE.


  • Tom Brown

    johnw, thanks for the link. I didn’t see where NGDP was mentioned in that particular one though.

    MMer’s don’t like the non-opened ended nature of previous QE rounds here… they really do think QE should be forever and the purpose publicly made known: to hit a specific NGDP growth rate target, which is fixed year to year.