Friday, 9 February 2018

What is the Benefit to Banks from Money Creation?

In a response to a recent post by Brian Romanchuk, somebody made the following comment:

"If private banks are ..... allowed to create and lend out their own money, they can undercut the ..... free market rate of interest, and for the simple reason that printing money is cheaper than having to borrow it or earn it."

This seems to suggest a kind of model in which banks choose whether to finance themselves with someone else's money that they have to pay to borrow, or money they create for themselves for free.  I think the problem is that this confuses two distinct ideas: that there is a benefit from having monetary liabilities and that bank lending increases deposits.

The potential benefit that accrues to banks by virtue of their status as money issuers arises through a reduced rate of interest on monetary liabilities.  If a particular type of bank deposit, such as a positive current account balance, is readily available for making payments, then it typically carries a lower rate of interest than other deposits. 

Sometimes the rate of interest on such balances is zero, but it need not be.  The important point is that there is a benefit to the bank through a reduced funding cost.  Set against this is the cost to the bank of providing current account services in the form of the costs of premises, staff and equipment.

At this point it is worth noting that these costs and benefits are based on the level of the bank's outstanding monetary liabilities.  It is nothing to do with which bank makes the loan that creates the deposit.  It is quite possible to have banks making lots of loans, but having minimal liabilities in the form of immediately available deposits, because that bank relies on different funding techniques.  These banks would be creating new money, but not getting any of the potential benefit that arises from having monetary liabilities.

On the other hand, it would be possible to have a bank with very large current account liabilities but which never engaged in deposit creation.  This would happen if the bank was simply taking deposits through payments received in from other sources and making all of its loans in cash[1].  The potential benefit of operating current accounts would be very important to such a bank.  

The point here is that it makes no sense to say that it is cheaper for a bank to print money than borrow it.  What the bank does at the point of making a loan is irrelevant.  What matters is how it chooses to manage its liabilities going forward and in particular the extent to which it chooses to compete for current account deposits.

The extent of the benefit depends then on how competitive that market is.  Under perfect competition, banks would have to offer interest rates on current accounts that would simply leave them with normal profits.  However, it is likely that there is a degree of monopolistic competition in the provision of banking services, particularly at the retail level, and this means that there is some supernormal profit that accrues to banks as providers of monetary liabilities.

It is difficult to assess how profitable it is for banks to have monetary liabilities, largely because many of the costs are shared with other activities.  Even for the banks themselves, it is somewhat arbitrary how costs get allocated.  However, the point here is that any such profit is just regular monopolistic profit in the market for current account services and not something to do with money being created out of thin air.

[1] Making loans in cash does in fact "create money" in the sense of increasing the broad money supply, but it is not what people usually have in mind when they talk of banks "printing money".