Bank Lending and the Use of Deposits

In response to my last couple of posts about when and why we might want to model banks, one commentator questioned my view that bank lending and non-bank lending have largely the same effect.  He asked what I thought about the alternative view (not necessarily his own) expressed as :

"[D]eposits are generally owned by other people than those who initiated their creation by taking loans. And as deposits cannot be destroyed by people who did not take loans, this creates a “hot potato” effect, as these people can only get rid of these deposits by spending them, partly on other assets, which will lead to asset inflation. This is quite different from loans provided by non-banks, that do not increase the supply of deposits."

Assume Bank makes a loan to X.  X then spends the proceeds with Y.  X ends up with the loan liability; Y ends up with the deposit.  Maybe Y now feels richer and decides to spend as well.  We could call this a hot potato effect.

Compare this with the following:

Z has money on deposit with Bank.  Z makes loan to X.  X then spends the proceeds with Y.  X ends up with the loan liability; Y ends up with the deposit.

If we had a hot potato effect before, there's no reason to suppose we wouldn't have it now.  Y is in exactly the same position.  The only reason the second situation might differ is if Z changed his spending behaviour, because it is only Z who is in a different position from the first scenario.

Z has the same level of financial assets as before, but there has been a change in the composition of his portfolio.  He now has a loan to X, but his bank deposits are correspondingly reduced.  Will he now reduce his own spending?

It is conceivable to me that he will.  But on the whole, I think it is unlikely.  Why would Z make such a loan, if it meant compromising his own spending behaviour?  A private loan is less liquid than a deposit for sure.  If Z has given up the last of his liquidity in making the loan, he may now be unable to fulfil his spending plans.  But why would he ever put himself in that position?  When such people make loans, they do not do it out of funds that they need to cover their current spending.  They do it out of funds that they intend to hold anyway.

We also need to bear in mind that whilst banks are major providers of liquidity transformation, they are not the only entities doing so.  Loans made or held outside traditional banking can be represented by highly liquid assets, even if these are not suitable for payment use.

If bank deposits were in chronically short supply, so that everyone needed to hang on to their deposits else they might not be able to make payments, then it might be a different matter.  We might reasonably conclude that any non-bank making a loan must be forced to compromise their own spending as a result.  But in most developed economies, this is just not the case.  Bank deposits account for a significant share of household financial assets and the vast majority of that is just parked as savings, not held for day-to-day transaction use.

If I was to push the hot potato analogy, I might say that deposits in the hands of wealthy investors are like cold potatoes.  Lending them to people with a high propensity to spend is like taking those potatoes and heating them up.  This has the same effect as creating a new hot potato.

So, I do think that the distinction between bank lending and non-bank lending can make some difference, because it does impact on the general liquidity position.  But I think it is wrong to suggest that only bank lending can have a hot potato effect.

An Example Case for Modelling Banks: The Rise and Fall of Market-Based Finance

In my last post I asked whether we needed to include banks in macroeconomic models.  My conclusion was that we might only need to do so if we wanted to explicitly model the way things like regulatory issues might shape the terms on which credit was extended.

As an example, I have looked here at the sort of developments that we might be able to represent and map out within a model.  This relates to shift between traditional banking and market-based finance that, in my view, played an important role in the financial crisis.  We could construct some balance sheets and behavioural rules and develop this into a model with a list of equations, but it's a lot easier just to look at some balance sheet movements.

The following draws on my distinction between traditional banking and market-based finance, as described in this post.

Shift to Market-Based Finance

The first development is an industry trend towards greater use of market-based finance.  The main driver within the business is the more attractive capital treatment.  At the same time, investors facing large exposures on unsecured bank risk are creating greater demand for collateral that can be used to back deposit substitutes.

The process takes time, but accelerates as deeper market makes assets more liquid and therefore more effective as collateral.

The diagram below shows the changes in the balance sheet of the financial sector.  Loans are securitised and used to back issues of secured funding, with deposits repaid in the process.  We can map this by refering to different capital costs and funding costs.

Balance Sheet Expansion

Liquid securitised loans can be held with a lower capital requirement, so the trend to Market-Based Finance leads to a reduction in capital usage.  However actual capital levels are unchanged, leaving excess capital in the industry.

Rather than repay capital, banks try to use it by expanding their loan base.  This requires relaxing credit criteria and reducing prime lending margins.  (Average margins on new business may go or down, because of the increased share of sub-prime loans).  Again, we can model this by making some assumptions about bank behaviour or deriving results from assumptions about profit maximisation with frictions in capital issuance.

A fall in prime lending margins on new business increase the book value of existing securitisations, as these are on mark-to-market valuation.  This enhances bank profitability and contributes further to bank capital.

New loans create new deposits and the sectoral balance sheet grows as shown below.

Liquidity Crisis in Market-Based Finance

As average credit quality and margins decline, the system becomes more fragile.  

If certain securitised portfolios cease to be acceptable as collateral, financial institutions dependent on secured funding may be forced to sell these assets.  This further reduces the liquidity of the assets, which further reduces their use as collateral.  It also reduces their market value.

Banks are forced to take assets back onto the traditional banking book incurring a higher capital charge.  At the same time mark-to-market losses reduce actual bank capital.

These developments are shown below.  Unsecured funding is repaid, expanding the stock of unsecured deposits.  The value of securitised portfolios is written down with a corresponding reduction in capital.

Banks now face the following:

- Reduced actual capital levels

- Higher required capital

- Increased funding costs due to increased reliance on unsecured funding

They respond to this combination of factors by cutting back on lending.

All of this can be neatly modelled in a stock-flow consistent modelling format, although the number of equations required is quite large, as there's actually quite a lot going on here.  This can be a useful exercise, as it helps form of sense of how these things play through and why they matter.  However, I think it would be extremely difficult to use this to make forecasts.  We can examine history and maybe also track and analyse current developments, but working out where it will go next is a different matter.

Do We Need Banks in Models

The Bank of England's recent conference on its One Bank Reserach Agenda has prompted a few comments on the issue of the inclusion of banks in macroeconomic models.  Various people have observed that it is rather odd that the models used by central banks seem to completely ignore the role of banking.  So why might it matter whether we explicitly model banks or not?

Before we even think about including banks, we need to have a model with financial assets and liabilities, so at the very least we need some agents that are borrowers and some that are lenders.  Let's assume we have this.

Some people might think we need banks, as they can make loans without first needing to attract funding, when non-banks cannot.  It might seem that without banks in the model, we have no way for financial assets and liabilities to grow, they can only be passed around.   

However, in general this is not the case.  Most models with financial assets allow for the quantity of those assets to expand and contract in response to spending and saving decisions.  Although these are not generally modelled to the level of the individual payments, it is easy to add a payment system in and when you do, it makes no difference.  So, on this point, we can rely on an implicit banking system - we don't need to explicitly model it.

A more likely possible answer is that we need banks because some part of their liabilities constitute money.  Exactly what part depends on how we want to define the term.  

This would be the monetarist position - that banks matter because they influence the growth of the money supply.  Whether this means we needs banks in models would then come down to our view of the quantity theory - the question of whether money supply growth causes growth in nominal GDP.

For banks and money to matter in this way, we must assume people view holdings of money differently to holdings of other assets.  For example, we might assume that people want to hold money only in some proportion to their income, but that they have an infinite appetite for other financial assets.

The problem with this comes down to drawing the line between money and those other financial assets.  Balances which can be used in payment processes might be considered to be special, but these represent only a small part of bank balance sheets and they tend to respond to demand with a highly elastic supply.   Modelling bank behaviour, specifically lending behaviour, won't tell you much about these balances.

On the other hand, modelling bank lending might tell you about the overall size of bank liabilities.  But you then need to explain why these bank liabilities are so different from non-bank liabilities.  How much is it going to affect behaviour if someone has a Treasury repo, say, with a non-bank as opposed to with a bank?

So far none of this seems to me to suggest there is much to be gained by adding banks explicitly into models.  Where I think it does matter is when we come to think about the terms on which loans are made.

In the simplest model with borrowers and lenders, anyone who wants to borrow can borrow as much as they like at the same interest rate.  This is a model that ignores credit risk and for some purposes this is OK.  However, incorporating credit preferences into the model can help provide a lot of insight.  Once we include credit limits and credit spreads, the borrower's spending pattern increasingly depends on the preferences of the lender as well.

We still don't necessarily need banks to include credit preferences.  Savers will have their own preferences and if we believe banks' actions merely reflect the credit preferences of their depositors, then they would indeed be no more than intermediaries, whose existence could be safely ignored.

However, this is not how it works in the real world.  Bank lending decisions are considerably removed from the preferences of depositors and are shaped by other factors, including notably their regulatory structure.  Capital and liquidity regulations play an important role in determining how bank lending develops and these can only properly be captured in a model where banks appear explicitly.  This to me is the real reason why we might need to model banks.

In conclusion, I think that for many purposes, we don't need to include banks in models - we can just treat them as implicit.  We certainly don't need to include them simply because we believe in "endogenous money".  Indeed the whole point about endogenous money is that money is not an important causal factor as the quantity theorists would have it, but merely a by-product.  However, once we want to think about how credit limits and credit spreads might develop in a modern economy (and these are important things to think about), we need to start saying something about banks.