The paper challenged the “central proposition” of mainstream “research”:<\/p>\n
… that monetary policy imparts a direct impact on deposits and that deposits, insofar as they constitute the supply of loanable funds, act as the driving force of bank lending. These ideas are manifested most clearly in conceptualizations of the bank lending channel of monetary transmission, as first expounded by Bernanke and Blinder (1988). Under this view, tight monetary policy is assumed to drain deposits from the system and will reduce lending if banks face frictions in issuing uninsured liabilities to replace the shortfall in deposits. Essentially, much of the driving force behind bank lending is attributed to policy-induced quantitative changes on the liability structure of bank balance sheets.<\/p><\/blockquote>\n
If you read almost any university-level macroeconomics or monetary economics textbook you will find narrative along these lines. The story is that the central bank controls the money supply via open market operations (buying and selling bonds) and that bank lending is reserve (deposit) constrained.<\/p>\n
This narrative employs “either on the concept of the money multiplier or a portfolio-rebalancing view of households’ assets”.<\/p>\n
To see the MMT view of the money multiplier – please read my blogs – Money multiplier and other myths<\/a> and Money multiplier – missing feared dead<\/a>.<\/p>\n
The BIS paper notes that the mainstream believe that “changes in the stance of monetary policy are implemented through changes in reserves which, in turn, mechanically determine the amount of deposits through the reserve requirement”.<\/p>\n
Alternatively, the mainstream “portfolio-rebalancing” approach posits that “monetary policy actions alters the relative yields of deposits (money) and other assets, thus influencing the amount of deposit households wish to hold”.<\/p>\n
Whichever approach is adopted, the narrative says that monetary policy tightening reduces the deposits in the system, which means that banks have to rely on more expensive wholesale funding, and as a result the supply of credit declines.<\/p>\n
In other words, “changes in deposits are seen to drive bank loans”.<\/p>\n
MMT has provided a comprehensive challenge to that view of banking based upon a thorough analysis of how banks actually operate and practical experience of banking which reinforces the conceptual development.<\/p>\n
Please read (among other blogs) – The role of bank deposits in Modern Monetary Theory<\/a> and Building bank reserves will not expand credit<\/a> and Building bank reserves is not inflationary<\/a> – for further discussion.<\/p>\n
Banks do not need reserves to lend? The mainstream view is that reserves are deposits that haven’t been lend yet. Banks do not lend reserves!<\/p>\n
The commercial banks are required to keep reserve accounts at the central bank. These reserves are liabilities of the central bank and function to ensure the payments (or settlements) system functions smoothly. That system relates to the millions of transactions that occur daily between banks as cheques are tendered by citizens and firms and more. Without a coherent system of reserves, banks could easily find themselves unable to fund another bank’s demands relating to cheques drawn on customer accounts for example.<\/p>\n
Depending on the insitutional arrangements (which relate to timing), all central banks stand by to provide any reserves that are required by the system to ensure that all the payments settle. The central bank charges a rate on their lending in this case which may penalise banks that continually draw on the so-called “discount window”.<\/p>\n
Banks thus maintain reserve management units to daily monitor their status and to seek ways to minimise the costs of maintaining the reserves that are necessary to ensure a smooth payments system.<\/p>\n
Banks may trade reserves between themselves on a commercial basis but in doing so cannot increase or reduce the volume of reserves in the system. Only government-non-government transactions (which in MMT are termed vertical transactions) can change the net reserve position. All transactions between non-government entities net to zero (and so cannot alter the volume of overall reserves). I explain that in more detail including the implications of that point in the trilogy of blogs – Deficit spending 101 – Part 1<\/a> – Deficit spending 101 – Part 2<\/a> – Deficit spending 101 – Part 3<\/a>. The blogs helps to explain why budget deficits place downward pressure on interest rates – which is contrary to the mainstream macroeconomics textbook depiction captured by “crowding out”.<\/p>\n
The important point is that when a bank originates a loan to a firm or a household it is not lending reserves. Bank lending is not easier if there are more reserves just as it is not harder if there are less. Bank reserves do not fund money creation in the way that the money multiplier and fractional-reserve deposit story has it.<\/p>\n
Bank loans create deposits not the other way around. These loans are made independent of their reserve positions. Adequately capitalised banks lend to any credit-worthy customers.<\/p>\n
At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se<\/em> will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window (the worst case scenario) is sufficient, the bank will lend.<\/p>\n
So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves does not capture the way the banking system operates. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank. <\/p>\n
The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.<\/p>\n
So it is quite wrong to assume that the central bank can influence the capacity of banks to expand credit by adding more reserves into the system. If “economic activity is too slow” then the central bank can do very little to expand private credit other than to cut interest rates. The availability of reserves will not increase bank lending. This is the old fashioned money multiplier version of banking where there the “money supply” is some multiple of the monetary base (provided by the central bank).<\/p>\n
The BIS paper agrees with this assessment. It says:<\/p>\n
… the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Under a fiat money standard and liberalized financial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulfill the demand for loans if it wishes to.<\/p><\/blockquote>\n
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