In a working paper, issued by the Bank of England, they explore the fundamentals of how banks work. The traditional model is that banks are driven by deposit taking, and use these deposits to make loans, so there is a direct link between deposits (and their volume and interest rates) and capacity to lend. Indeed, some suggest most monetary policy assumes this, yet many central banks have a different perspective. Last year the Bank of England turned the model on its head by suggesting that actually banks have the capacity to create UNLIMITED amounts of credit, in fact creating money, unrelated to deposits.
Banks that create purchasing power can technically do so instantaneously and discontinuously, because the process does not involve physical goods, but rather the creation of money through the simultaneous expansion of both sides of banks’ balance sheets. While money is essential to facilitating purchases and sales of real resources outside the banking system, it is not itself a physical resource, and can be created at near zero cost. The most important limit, especially during the boom periods of financial cycles when all banks simultaneously decide to lend more, is their own assessment of the implications of new lending for their profitability and solvency, rather than external constraints such as loanable funds, or the availability of
central bank reserves. In fact, the quantity of reserves is therefore a consequence, not a cause, of lending and money creation.
This may explain why banking economics work they way they do. It also raises interesting questions in terms of banking regulation.
This paper, “Banks are not intermediaries of loanable funds – and why this matters” – Zoltan Jakab and Michael Kumhof looks at the two models, in some detail.
In the intermediation of loanable funds model of banking, banks accept deposits of pre-existing real resources from savers and then lend them to borrowers. In the real world, banks provide financing through money creation. That is they create deposits of new money through lending, and in doing so are mainly constrained by profitability and solvency considerations. This paper contrasts simple intermediation and financing models of banking. Compared to otherwise identical intermediation models, and following identical shocks, financing models predict changes in bank lending that are far larger, happen much faster, and have much greater effects on the real economy.
Note that working papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee or Financial Policy Committee.
