Whose money is the bank lending?

A reader asked this question today. It might seem shocking to those unfamiliar with the answer: Nobody.

Q: “I am a bank and I make loans. Whose money am I lending?”
A: Nobody

You create new money. Lending creates money out of thin air, and that money gets deposited somewhere, creating deposits.

Look at the table below.

Total Credit Owed vs Base Money

Total credit vs. base money, St. Louis Fed data, chart by Mish

Total credit owed exceeds $90 trillion. Base money is just over $6 trillion.

The Federal Reserve defines the monetary base as “The sum of currency in circulation and reserve balances (deposits held by banks and other deposit-taking institutions in their accounts with the Federal Reserve).”

bank reserves

Bank reserves were 3.3 trillion at the end of May.

They are a function of QE.

Through QE, the Fed shoved money down the banks’ throats, which the banks park with the Fed and collect interest on.

Hooray, free money

The Fed pays interest on all reserves. At the end of May, total reserves were $3.318 trillion.

The Federal Reserve currently pays 1.65% interest on reserves IOR.

If the Fed moves up to the 2.25-2.50 percent range in July as expected, expect an IOR jump to around 2.40 percent.

Q: How much free money per year are we talking about?
A: 2.40 percent of $3.318 trillion is $79.63 billion!

Q: We’re giving the banks $79.63 billion in free money?
A: It’s a moving target.

The IOR keeps rising, but reserve balances keep falling.

That $79.63 billion reflects an increase that hasn’t happened yet. If the Fed continues to hike at a pace that exceeds QT, the amount will continue to increase. If not, the actual amount of free money goes down.

Bank Credit Restrictions

1: Bank cannot be capitalized (too many non-performing loans)

2: Individuals or companies want to take out loans

3: The bank must assume that the loan will be repaid (believe the customer is a good credit risk)

The bank may very well be wrong on point 3, but they will make a loan if they think the customer is a good risk (or that the asset will appreciate if the customer defaults).

Think of point 3 and the real estate crisis. The banks knew damn well they were giving liar loans, but they didn’t anticipate a collapse in house prices or people leaving their homes

Bank loans create money that didn’t exist before. To the extent that “reserves” are needed, the Fed can manufacture them at will and then some via QE, as the chart above shows.

Banks used to collect free money on “excess reserves”, now it’s “reserves”

Reverse Repos Hit New Record High of $2.33 Trillion: Plus Free Money Q&A!

I talked about free money and also about reverse repos.

This post is a follow-up to the above after a reader asked what money banks lend.

I also added a note to the above post that it is mainly non-banks, especially money market funds, that use the reverse repo facility.

Addendum Q&A

These are reader questions and my answers.

Q: I just don’t understand how the temporary sale of Treasuries and MBS to banks for short periods allows the Fed to keep the Fed Funds Rate within its target range?

A: Deposits are liabilities of banks. As silly as it sounds, and I think it’s silly, banks need to hold capital for these deposit liabilities.

In any case, the banks will act to get rid of these excess cash reserves (a perverse term), and they do so by buying whatever short-term assets they can, typically short-dated government bonds.

When the Fed had interest rates near zero, competition for short-term government bonds was so intense that the federal funds rate fell below zero. Not only did this force interest rates below the Fed’s target rate, it also pushed them into negative territory, killing almost every money market fund unless the funds started charging interest on deposits!

In response, the Fed began allowing non-banks access to the repo facility, previously only allowing banks and market makers such as Goldman Sachs.

Bernanke understood that this was going to happen and lobbied to get Congress the right to do so, and Congress obliged.

Instead of getting rid of enough of those “excess reserves” (a term that’s probably out of use because it’s pointing the finger at the Fed), the Fed reverse repos and pay interest on reserves.

The Fed needs to do this to force rates up at the bottom of the curve, as the effect of QE is to push rates downbelow the Fed’s target.

This is what the competition for short-dated government bonds has done to the market. “The system is working as designed,” the Fed said. And I mocked this design in my previous post.

What the Fed should be doing is phasing out all this damn quantitative easing as soon as possible. Instead, it drags out the process by years.

Q: If banks don’t lend my bank accounts, time deposits, etc., how does my money at the bank become a loan?

A: Don’t!

Deposits are a liability.

The only reason some banks actively seek deposits is so they can park deposits with the Fed at higher rates than they pay out on the accounts. The big banks have so much QE that they don’t even bother to attract small depositors. Small peony deposits are rather annoying.

Smaller lenders also hope that the deposit customers they attract will eventually become borrowers.

Q: Mish, are we headed for a deflationary or inflationary recession? Or maybe both? Perhaps asset prices are falling while food, gas and commodities remain high?

A: We will have another round of wealth deflation, in fact it has started. Whether that translates into CPI-measured inflation is another question. But if you factor housing into the equation properly, it sure seems likely.

Historical perspective on CPI deflations: how harmful are they?

What matters is asset price deflation. I’ve written about this many times. See Historical Perspective on CPI Deflations: How Harmful Are They?

A BIS study concluded “Deflation can actually boost production. Lower prices increase real income and wealth. And they can also make export goods more competitive. Once we control for ongoing asset price deflation and country-specific average changes in growth rates across sample periods, durable goods and services (CPI) remain Deflations do not appear to be statistically significantly associated with slower growth, even in the interwar period.”

The central banks’ fight against the beneficent routine deflation has started again to create the very deflation central banks should fear!

Virginia C. Taylor