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29 May 2015

BoE Working Paper: Banks are not intermediaries of loanable funds - and why this matters

This paper contrasts simple intermediation and financing models of banking. Compared to other 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.

By Zoltan Jakab and Michael Kumhof

Since the Great Recession, banks have increasingly been incorporated into macroeconomic models. However, this literature confronts many unresolved issues. This paper shows that many of them are attributable to the use of the intermediation of loanable funds (ILF) model of banking. In the ILF model, bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers. But in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor. The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever. Third parties are only involved in that the borrower/depositor needs to be sure that others will accept his new deposit in payment for goods, services or assets. This is never in question, because bank deposits are any modern economy’s dominant medium of exchange.

Furthermore, if the loan is for physical investment purposes, this new lending and money is what triggers investment and therefore, by the national accounts identity of saving and investment (for closed economies), saving. Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does. To argue otherwise confuses the respective macroeconomic roles of resources (saving) and debt-based money (financing).

The paper shows that this financing through money creation (FMC) description of the role of banks can be found in many publications of the world’s leading central banks. What has been much more challenging is the incorporation of the FMC view’s insights into dynamic stochastic general equilibrium (DSGE) models that can be used to study the role of banks in macroeconomic cycles. DSGE models are the workhorse of modern macroeconomics, and are a key tool in macro-prudential policy analysis. They study the interactions of multiple economic agents that optimise their utility or profit objectives over time, subject to budget constraints and random shocks.

The key contribution of this paper is therefore the development of the essential ingredients of DSGE models with FMC banks, and a comparison of their predictions with those of otherwise identical DSGE models with ILF banks. The result of authors’model comparison exercise is that, compared to ILF models, and following identical shocks to financial conditions that affect the creditworthiness of bank borrowers, FMC models predict changes in the size of bank balance sheets that are far larger, happen much faster, and have much greater effects on the real economy, while the adjustment process depends far less on changes in lending spreads, the dominant adjustment channel in ILF models. Compared to ILF models, FMC models also predict pro-cyclical rather than countercyclical bank leverage, and a significant role for quantity rationing of credit rather than price rationing during downturns. Authors show that these predictions of FMC models are much more in line with the stylised facts than those of ILF models.

The fundamental reason for these differences is that savings in the ILF model of banking need to be accumulated through a process of either producing additional goods or foregoing consumption of existing goods, a physical process that by its very nature is slow and continuous. On the other hand, FMC 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. In other words, the ILF model is fundamentally a model of banks as barter institutions, while the FMC model is fundamentally a model of banks as monetary institutions.

The fact that banks technically face no limits to increasing the stocks of loans and deposits instantaneously and discontinuously does not, of course, mean that they do not face other limits to doing so. But 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.

This finally takes authors to the venerable deposit multiplier (DM) model of banking, which suggests that the availability of central bank high-powered money imposes another limit to rapid changes in the size of bank balance sheets. The DM model however does not recognise that modern central banks target interest rates, and are committed to supplying as many reserves (and cash) as banks demand at that rate. The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.

Full working paper

© Bank of England

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