Tuesday, 17 March 2015

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.


  1. Nick,

    I think the general notion which you quote from the commenter you quote:

    "... as deposits cannot be destroyed by people who did not take loans ..."

    is quite inaccurate as not just loans create deposits and the reverse (destruction), bank bond buys also changes the money stock. Banks are dealers in the government bond markets and many other markets and a simple way for deposits to be destroyed is a purchase of a government bond to a bank who is quoting a bid/ask. I think this is not a minor point as it plays a role in theoretical arguments. (Very few people point out this mechanism).

    Also, there is a mechanism for people foregoing consumption to make a loan. It can be argued that consumption function can be a function of interest rates and if the interest rate adjusts, some economic units will lend instead of consume and if it adjusts more, more units will consume less to lend more. But it's just that this mechanism has less relevance. A lot of things neoclassical/monetarists say are true, it's just that these things are minor compared to a bigger dynamics at play.

    So while I obviously don't disagree with you, I think one also has to argue that this "price-mechanism" is wrong intuition: one really needs super-high lending rates for this to have any sizable effect.

    1. "purchase of a government bond to a bank"

      should read:

      "purchase of a government bond from a bank"

    2. I think I'd agree with all of that.

  2. A couple other (perhaps too obvious) points:
    1) Banks don't need to originate loans to create deposits (they can buy somebody else's bond)
    2) Bank loan origination need not increase the supply of deposits (since banks can fund themselves with bonds and equity).

  3. Nick, thank you for writing an entire post in response to my question! But I am afraid that it does not quite cover what I meant, probably because I did not use the correct wording. What I meant is a hot potato effect in terms of portfolio choice, based on a post of Steve Waldman:

    Maybe I can explain it best with an example. Assume that people have a certain aggregate portfolio preference, and that they would like to have X% of their financial assets in deposits, and the rest in other financial assets. Furthermore, assume that the people who own these deposits (group B) are generally other people than those who take bank loans (group A), and that the volume of bank loans provided to group A is not related to the preference of group B to hold deposits.

    In that case, if the volume of bank loans provided to group A increases relative to other financial assets, group B is confronted with an amount of deposits which is larger than they want to hold. And thus they will start using these deposits to buy other types of assets, driving up the price of these other assets in the process, until the relative amount of deposits in their portfolio is back to X%.

    To us an example from my home country (The Netherlands; private domestic + government sectors):
    - from 1995 to 2013 the amount of deposits increased a factor 3,4
    - in the same period, the amount of deposits increased a factor 1,7 relative to GDP
    - but as a fraction of total financial assets, the amount of deposits remained at approx. 10%

    Furthermore, I am aware of the fact, as Ramanan and Max point out, that banks can net create/destroy deposits by buying/selling assets.

    What do you think about this view?

    1. Hi,

      You may be interested in this post


    2. "..they would like to have X% of their financial assets in deposits.."

      That analysis assumes X is fixed and part of what I've been trying to say here is why I think that in reality X can be very variable, because there are very close substitutes for most bank liabilities. People sometimes think bank liabilities are special because they are money, but the vast majority of these liabilities are not in transaction accounts. My last post on market-based finance was very much to do with changing portfolio preferences. Although there will be examples where the ratios remain stable, one of the key characteristics of the crisis was the relative growth rates of traditional bank lending and alternatives (see e.g. Gallin, J (2013) Shadow Banking and the Funding of the Nonfinancial Sector)

      If you assume X is fixed then you can directly link total lending to bank lending, because they will stay in strict proportion. But that is then another case where you may not need to (explicitly) model banks because you can deduce bank lending from total lending, just as you can the reverse.

      I notice that I commented on that Steve Waldman post (comment 33), and my comment was broadly in line with what I've been saying in these last posts.

    3. Nick, I wouldn't dare to say that X is constant. The point I tried to make is that if:
      - net bank lending leads to the creation of extra deposits (contrary to net non-bank lending),
      - deposit owners have limited control over the amount of deposits (hot potato effect),
      - deposit owners prefer to hold a certain (variable) fraction of their portfolio in deposits,
      - this (variable) fraction is not (significantly) related to the propensity of banks/lenders to create loans/deposits,
      that deposit owners, when confronted with an increasing fraction of deposit in their portfolio (due to increased bank lending), may start buying assets with these deposits, which may lead to higher asset prices.

      In fact, thinking about it somewhat more, I could even imagine that in case of very high net non-bank lending relative to net bank lending, the opposite could possibly happen: the fraction of deposits in aggregate non-bank ownership goes down, which could induce asset holders to sell asset to increase their deposits fraction, which may lead to lower asset prices.

      And Ramanan, thank you for your link. I am already a frequent visitor of your website!


    4. I certainly believe increased lending can lead to higher asset prices. In fact, this is a feature of my UK macro model. But that model does not include banks and makes no distinction between lending by banks and lending by non-banks. What I have called household monetary assets (and I admit have labelled "deposits" in the balance sheet) is just a measure of total household financial assets excluding equity and pension rights.

      In my opinion both types of lending would tend to lead to higher asset prices. For example, I am pretty sure that the expansion of lending through shadow banking contributed to the rise in house prices pre-crisis.

      But I would not go so far as to say that bank lending and non-bank lending were equivalent. This old post of mine may be what you are getting at. http://monetaryreflections.blogspot.co.uk/2013/09/banks-non-banks-and-interest-rate-effect.html

  4. Interest rates that attract deposit holders to lend the deposits do reduce the lenders spending on consumption or spending on other investments.
    That is why banks as intermediaries models are wrong and endogenous models are correct. Credit creation and banks have to be modeled differently from non banks.

  5. This comment has been removed by the author.

  6. This is a good post. In general, we should be translating any statement about quantities of money into a statement about the liquidity position of balance sheets as a whole. This is not always easy to do, I think.

    1. Thanks. And yes, that would be very much my view too.