Private banks do lend on money they receive from depositors.

Advocates of the view that “loans create deposits” have been getting too uppity of late. That is, they’ve been claiming that the view that banks lend on deposits is old hat. That’s going too far. What commercial banks do is actually a mix of the latter two activities.

As an example of the latter “uppitiness”, Positive Money quotes Mervyn King, former governor of the Bank of England who said “When banks extend loans to their customers, they create money by crediting their customers’ accounts.”

The reality is that the commercial bank system cannot increase loans unless there are people out there prepared to lend: i.e. leave money for relatively long periods in bank accounts. That is, assuming the economy is at capacity, one person cannot consume more (i.e. raise demand) unless someone else cuts their consumption (i.e. cuts demand).

Moreover, those who “leave money for relatively long periods” in bank accounts will tend to put their money into so called “term” accounts: that’s accounts where there is no instant access to the money. And that so called money is often not counted as money – though the EXACT practice there varies from country to country.

Of course banks engage in a certain amount of maturity transformation: i.e. lending on money placed in instant access accounts. But certainly if loans rise, that will to a large extent be funded by so called money in term accounts, which is not really money. And to the extent that loans are funded out of instant access money, there has to be an increase in instant access deposits to enable banks to lend.

So do loans create deposits or do depositors make loans possible? It’s a chicken and egg question.



4 thoughts on “Private banks do lend on money they receive from depositors.

  1. I agree with you but please clarify one doubt. When you write: “The reality is that the commercial bank system cannot increase loans unless there are people out there prepared to lend”, you are referring to an economy at full capacity, and implicitly assuming that inflation is not an option. Is that correct?

    • Yes. I’m assuming government doesn’t allow excess inflation. But even if inflation WERE allowed, the outcome would be the same, seems to me. I.e. if commercial banks extend too many loans with inflation being the result, than that inflation reduces the REAL WORTH of existing loans, so I’d guess there is as a result no increase in the real value of loans.

      • Thank you for the response Sanjay. To make sure I understand then, you agree that as a matter of accounting, loans create deposits, and the issue then becomes how does that bank fund that loan, for if the deposit ever leaves that bank, it must credit the account of the other bank (now involved in the process) with Central Bank reserves, equivalent to the value of the deposit moving between the banks.

        Regarding funding, I understand that the bank has a number of options. If there are excess reserves in the system, it can borrow them from another bank. This would be your situation, whereby there is “someone willing to lend”.

        However, even if there were no excess reserves, the loan transaction could still take place. The bank that just created the new loan, could borrow the needed reserves from the Central Bank (this form of funding tends to be the most expensive, but if the spread were large enough, it could still be a viable option for the bank). In this case, the Central Bank, in order to fulfill it clearing duties, would end up having to indeed make these new reserves available. I am a student of all of this, so please correct me if I am wrong up to now.

        Continuing from the above, it follows that banks can create money out of thin air (as some say), and this independently of whether there are people out there willing to lend. Obviously, the more an economy is at full capacity, the more inflationary any lending activity will be. Are we saying the same thing?

  2. Alex,

    Sorry about the slow response again. I’ve got a million things to do other than attend to this blog!! Anyway….

    I’m not happy with your second paragraph which suggests that a bank can “fund” a loan by getting reserves from another bank. If you Google the phrase “banks do not lend out reserves” or something like that, you’ll find plenty of material explaining why reserves are near irrelevant to commercial banks’ ability to lend.

    Absent legally imposed minimum reserve requirements, banks only need reserves as a means of settling up between themselves. And to take the point even further, I’d guess that an economy with commercial banks but no central bank at all could function OK: commercial banks would just settle up using other assets: property, shares, etc. In fact that’s more or less what advocates of so called “free banking” claim (e.g. George Selgin, Lawrence White, etc). See Selgin’s “free banking” blog.

    I agree with your last paragraph. I.e. if the economy is not at capacity, then a commercial bank can lend money into existence, so to speak, and that serves a useful purpose: it increases demand. Unfortunately, that increase in demand is TEMPORARY, seems to me. That is, once someone has borrowed and spent the newly created money, and the recipient of that money simply lodges the money in their account and leaves it there, the demand increasing effect comes to a halt.

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