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.