January 08, 2020
Marc Lavoie, University of Ottawa
We are being asked whether we support the traditional intermediation view of banking or the money-creation view. The second scholarly article that I ever published, 37 years ago, was a presentation of the arguments providing support to the so-called endogenous theory of money, as post-Keynesian economists like to call it, or what Richard Werner calls the credit-creation theory of banking. Thus, in response to the question put to us, influenced by my readings of some French monetary specialists, in particular Jacques Le Bourva, I would answer that I have long rejected the traditional intermediation view and endorsed instead the money-creation view. This view of banking denies that banks are constrained by prior deposits or by the amount of reserves in the system, since the causal arrow goes from loans to deposits to reserves. When making new loans, loan officers don’t phone up other departments to find out whether there are enough deposits in the bank or whether there are excess reserves. Relative to the traditional intermediation view, there is reversed causation. There is no money multiplier; at best one could speak of a credit divisor.
Reading several papers written by Carolyn Sissoko, I have recently discovered that this post-Keynesian view of banking was also that of US monetary experts at the beginning of the 20th century as well as that of British experts of the 19th century. Making a reference to discount banking, Sissoko argues that “the deposit or issue of bank notes that offsets the loan for accounting purposes is literally created by the loan, and what acts as a source of funds supporting the creation of this deposit is the willingness of the community to circulate the banker’s liabilities as money. Needless to say, in the early 20th century this was clear to both banking practitioners and banking theorists”. For some reason, with the advent of Friedman and monetarism, and under the influence of Tobin, the money-creation view of banking was wiped out from mainstream textbooks.
Central bankers seem to have rediscovered this truth in the aftermath of the 2008 crisis. Everybody now cites the paper by researchers at the Bank of England, who point out that “rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits…. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators.” This is post-Keynesian monetary theory in a nutshell. Indeed, there is a long list of central bankers (McAndrews, Martin, Borio, Bindseil) who express regret that their academic colleagues are still stuck in the textbook fairy tales based on the fractional-reserve system and the money multiplier.
For advocates of the credit-creation view of banking, banks are special for several reasons. First, as already pointed out, they are not financial intermediaries – their main role is to create new credit, ex nihilo, or rather more often than not, based on some collateral, which may be financial, physical or more simply based on trust. Their main role is not to be an intermediary between savers and borrowers. Whereas other financial institutions can provide credit, the main feature of banks is that they can provide new credit without having earlier collected funds or without having to borrow from some other agent.
The second specific feature of banks is that their deposits are part of the payment system. They are the means through which debts are irrevocably discharged, through custom or regulation. Non-banks ultimately have to transfer funds to some bank account for the final payment to go through. Payment is final, or settlement occurs, once the bank payment goes through the books of the central bank, or in some countries through the clearing house run by a bankers’ association, as in Canada. This is not the case for non-banks, as they issue liabilities which cannot be used for settlement purposes. Because the payment system is under the overarching responsibility of the central bank, banks have access to central bank advances (the central bank credit facilities) to settle payments when banks in a deficit position in the clearing house get an insufficient amount of overnight loans from other banks in the interbank market. I would argue that these advances exist to protect the payment system and to allow settlement, not to protect banks as such, and hence are not a specific feature of banks (as the interventions of central banks during the GFC has demonstrated). Moreover, neither are the state-insured deposits of banks – a relatively new feature in several countries anyway.
A key feature of banks, as related to the payment system, is that as they move forward in step, banks can increase credit creation without limit. Thus the laws of supply and demand don’t really apply. This was long ago recognized by Keynes and Le Bourva. This is not the case of non-banks, since, if they wish to create more credit, they must first get either more deposits from the public or new loans from banks. One could argue that the situation is similar for banks: if their depositors decide to transfer their bank deposits at accounts in non-banks, then the banks in their turn will need to borrow funds from non-banks. The difference, however, is that when non-banks borrow, they need financing to start with; when banks borrow, this occurs after the fact. The distinction between initial finance or financing on one hand, and final finance or funding on the other hand, is also now being picked up by various central bankers.
It is important to see that this money-creation view of banking goes beyond the credit-channel view advocated by Bernanke and the New Keynesians, for whom banks are special, but only because they are financial intermediaries which can provide credit to borrowers who cannot get it on financial markets. Their banks cannot lend more than what they have acquired in the form of deposits or reserves.
Providing a proper definition of banking appears to be especially relevant when trying to understand the role of what has come to be called shadow banking or market-based banking. The term shadow banking may be a misnomer if the institutions figuring within the definition of the shadow banking system do not carry the major features of bona fide banks, which is my position in what follows. Along with Sissoko, I would argue that the shadow banking system is not an alternative to bona fide banks, but rather an extension of the traditional banking system.
To start with, take the case of money-market funds. These financial institutions can certainly provide credit to the economy. But does that make them comparable to banks? To provide credit to the economy, money-market funds must first acquire funds from economic agents by issuing and selling shares to investors. But where do these funds come from? They arise from the deposits that had been previously created by banks. It is undeniable that money-market funds can grant loans and add to liquidity, but this extension in the balance sheets of financial institutions could just as well have been initiated by banks.
Things are even clearer and less ambiguous in the case of securitization. Loan origination – initial finance – is performed by banks, not by non-banks. However, funding – final finance – as it will appear at the end of the process, is now partly in the realm of the market financial system. It seems that banks are losing out to non-banks as the relative size of bank balance sheets keeps falling: this is true from the standpoint of stocks, but it is not when considering flows: the flows of credit do indeed originate from banks.
It is sometimes argued that without securitization or without the repo system, the economy would lack the ability to finance economic expansion. It is then argued that securitization allows banks to extend loans beyond the limits set by their capital adequacy requirements. But this is a mistaken interpretation. What securitization does is to allow banks to increase their rate of return on internal funds. If banks wish to lend more to creditworthy borrowers, they can always do so as argued earlier; they could raise more capital by issuing new shares, distribute a smaller proportion of their huge profits to their shareholders, or increase the spread between their lending and deposit rates.
Briefly put, shadow banking enters the game only after loans have already been granted by the traditional banking system, with the means of payment having already been created. In addition, the entire shadow banking system, based on ABS, CDO, ABCP or repos, is entirely dependent on the lines of credit and guarantees being provided by the banks operating in the traditional banking system. This became quite evident in 2007 when there was a run on the conduits striving on the spreads between long-term ABS and short-term ABCP: only those supported by explicit lines of credit provided by commercial banks managed to survive.Clearly, how the financial system needs to be regulated to avoid other episodes of chaos and instability must certainly depend on whether banks should be considered as peculiar financial institutions and on whether the shadow banking system resembles or not bona fide banks.