I understand fractional-reserve banking is the current form of banking in all countries worldwide.
What is confusing is the various theories that explain how money is created. Is it not definitely known?
“There are two suggested mechanisms for how money creation occurs in a fractional-reserve banking system: either reserves are first injected by the central bank, and then lent on by the commercial banks, or loans are first extended by commercial banks, and then backed by reserves borrowed from the central bank. The “reserves first” model is that taught in mainstream economics textbooks,[1][2] while the “loans first” model is advanced by endogenous money theorists.”
Start with what I’ll call the conventional story. Wikipedia calls this the reserves first model of money creation. It can also be found in many intro textbooks. This is an explanation of money creation that starts with a new deposit given to a bank. The bank then lends out most of the cash it received for a loan, with the percentage of the cash that the bank can lend out determined by reserve regulations created by the central bank. The cash that was loaned out returns to the bank (or to the banking system in general), and then the process repeats itself.
This explanation is not correct. Money creation doesn’t work in this way.
It’s an intro story used to get the definitions straight, to explain the basic idea of reserve requirement regulations, and to show how a central bank inserting more cash into the system or relaxing reserve requirements might possibly lead to more loans from banks. Some people complain that this textbook story is unnecessary, that it’s incomplete (for instance, there’s nothing about capital requirement regulations), or even that the textbook story is so commonly circulated without clarification that even the people teaching it in freshman classes don’t actually know the true story. I honestly couldn’t say whether that last is true or not. A further problem is that people who have some small notion of a different story often get their version wrong, too, so there can be two wrong stories circulating in any given conversation. It’s sometimes the case that people who try to explain the deeper processes are accused of making things by people on both sides. Weird.
The problem is that the real story is hideously complex. Any intro textbook has to start somewhere simple. Wikipedia has a section called the loans first model, which is a poor title but at least strikes closer to the truth for at least one part of the process. The problem is that their explanation is only one paragraph long. We can do better than that here, but the thing to keep in mind is that the explanation could be indefinitely elaborated upon. There are always new things to add.
So to establish that this isn’t all fiction, let’s start with Alan Holmes, a former Senior Vice President of the New York Fed.
Let’s flesh that out.
The problem with the conventional story is that reserve requirements are not strictly enforced. The conventional story starts with an infusion of cash from on high. Reality is the other way around.
Imagine a bank hard up against its required reserves. It has 100 dollars of deposit liabilities, and a reserve requirement of 10%. True to the requirement, for the moment, it has 10 dollars of cash. “O noez”, we might think, “This bank can’t lend any more money!” Except that it can and it will. If this bank sees an investment opportunity, you damn well better believe that it will extend a loan, to hell with the reserve requirement. Why? The Fed only checks reserves every two weeks (pretty sure it’s every two weeks). The bank can extend the loan today, and then find the reserves tomorrow.
The loan is 5 bucks, and that check is deposited at another bank. The bank now has 100 dollars of deposit liabilities, and 5 dollars of cash. “Breakin the law, breakin the law!” Except the bank just asks another bank before judgment day for a interbank loan, “federal funds” in the US. They ask for, and receive, a 5 dollar loan from another bank.
The bank has 100 dollars of deposit liabilities, and 10 dollars of cash on hand. Legal requirement satisfied. The bank also has 5 dollars of interbank liabilities, but federal funds have no reserve requirement. If we want to oversimplify the story, we can tell ourselves, “Well, of course there were five dollars of available funds on the interbank market! The check was cashed at another bank, and that bank should have the funds!” And I guess that’s true in a way. There’s always money somewhere out there.
Always money to be lent somewhere, at some price. The problem for a bank is NOT finding reserves to meet the requirement before the regulators check again. Cash can always be found somewhere. The problem is the price. A bank wants to find wholesale reserves at a cheap enough price that they were justified in issuing the retail loan. Which is to say, if there’s a lot of pressure on the interbank market as banks scramble to find required reserves, the banks will be bidding up the interest rate on that market. There is a limited amount of monetary base out there, and if all the banks are scrambling for reserves at once, they should be increasing the price.
Except… who controls the interest rate of the interbank market? The central bank does. And if the banks are scrambling for reserves and bidding up the interest rate, and the central bank has a specific interest rate target in mind, then the central bank itself can provide the liquidity to keep their interest rate lever at the proper place.
The banks loan first, and then the liquidity can come later.
Just as the conventional story indicates, all of this lending behavior is extremely dependent on central bank behavior. But it works the other way around. The new monetary base generally comes after the new loans. A bank can look at how much it’s paying for deposits and also how much it’s paying on the interbank market, and say to itself, “That’s a good rate to borrow money.” That can be a good rate not just for the bank’s own bottom line when borrowing but also good for the general health of the business community, which increases the chances of getting paid back. So the bank thinks “I’m happy to make loans if I can borrow money at that rate.” But if the central bank committee meets and raises rates by half a percent next week, that might have been a really crappy loan they just made, for more than one reason. Finding the funds for the loan could be more expensive than they initially anticipated, and a general decrease in business activity will increase the risk of the loan going bad.
Also interesting: In the US, at least, the Fed often didn’t keep quite as short a leash on the interbank market rates in the past. Which is to say, the interbank market was much more volatile. Banks that had good loan opportunities would make those loans. Banks that lacked good loan opportunities and had cash available would attempt to gouge other banks on the interbank market before Fed judgment day. Interbank rates could spike during the scramble for funds, then come back down very quickly.
If you look at the data for the interbank rate, and you click on “daily, not seasonally adjusted”, you can see that volatility even on the multi-decade graph. You can even see when the Fed made the deliberate choice to reduce that volatility. Very interesting graph there.
Money can be considered “endogenous” because in a practical sense banks clearly start the process themselves by looking for good opportunities today and hoping to find cheap cash later. However, banks make loans based on their expectations about future funding, and future business conditions, and the central bank clearly has its thumb on those things. The point that I would personally make is that even if the creation of private-bank-money can be accurately described with an endogenous model, the central bank nevertheless has exogenous targets it can strongly influence, like the inflation rate or nominal spending.
One last point to keep in mind is that banks don’t just create new money with new loans. The creation of a new loan will increase assets and equity simultaneously, but any accounting expense for a bank is going to be paid for initially with the creation of new private-bank-money, which will change the equity of the bank instead of changing their assets. Of course, for a profitable bank these expenses will be more than matched by their interest income, which should be simultaneously decreasing their deposit liabilities while also increasing their equity.
One last point to keep in mind is that banks don’t just create new money with new loans. The creation of a new loan will increase assets and liabilities simultaneously, but any accounting expense for a bank is going to be paid for initially with the creation of new private-bank-money, which will change the equity of the bank instead of changing their assets. Of course, for a profitable bank these expenses will be more than matched by their interest income, which should be simultaneously decreasing their deposit liabilities while also increasing their equity.