How banks make money

Banks make money. Literally, money is their output. But social guarantees are their input. Should they be the ones making money?
Peter Johnson
3 February 2010

“The fact that banks are required to keep on hand only a fraction of the funds deposited with them is a function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to create money.” – Federal Reserve Education.

This exposition by an unimpeachable source of the function of banks in regulating the monetary economy is standard university economics.  It focuses on the role of banks as providers of capital in a free-market system and the way in which the fractional reserve system allows greater increases in the money supply and so faster economic growth than would be possible in its absence. It does so, to compress the argument hugely, by allowing banks – once central-bank-created cash has been deposited with them – to re-use the money as many times in aggregate as is allowed by their minimum capital requirements.

The end result is that given today’s regulatory minimum capital requirement of 8%, each £1 coin deposited in a bank can be expanded into £12.50 of money. This 12.5:1 ratio is called the money multiplier and is determined as 1 divided by the 8% capital requirement. There is some debate amongst economists about whether this expansion happens by progressive circulation of money or, as Richard Werner of Southampton University (who is attributed with inventing the term “Quantitative Easing”) argues, spontaneously by banks, given the right conditions to create credit.

Most students of economics will spend a week or two with some attractive technical descriptions of how banks play this numbers game with the central bank as croupier, and how all that lubricates the economy. What is often forgotten, though, and what I’d like to think about for a moment, is the institutional and social position of banks.

First, as the Fed says, banks in a competitive shareholder market end up having to use up all their regulatory surplus, whether or not they agree with the regulator’s capital requirements. This can only lead to one outcome: banks’ behaviour is biased towards taking the maximum permissible risk. What is asserted to be necessary in an efficient money market can in fact be extremely inefficient because what goes on in the money market is strongly influenced by competitive investor pressures, which need not tend in the same direction. I’ve argued elsewhere on oD that only a revision of our idea of the relationship of shareholders and society will change this.

Secondly, the truly momentous consequences of changing the capital requirements, which through the multiplier could lead to drastic increases or decreases in the money supply, are largely ignored in public debate as merely technical. They certainly never reach the front pages. Yet little in economic policy could be more significant. The capital requirements are set, so it is said, at a level that enables banks to lend more than their deposit base and yet have sufficient to meet any withdrawal demands. If they are, or are believed to be, unable to meet likely withdrawal demands, a bank run may follow, which will generally lead to the failure of the bank and the shareholders losing their capital.

But as we now know, banks don’t fail: they get bailed out. So a change in the capital requirements is a change in the risk exposure of the taxpayer public. No capital reserve requirement could possibly be set that guarantees money creation with zero risk of failure. No government statement that significant banks will be allowed to go under is credible. The banking industry has a clear interest in pushing reserve requirements down, since this increases the sums on which it can turn a profit. Thus any discussion of bank reserve requirements is very material to the public, who by the same token should be clamouring for more disclosure, intelligible debate, and influence.

There are, of course, radical free-marketeers, perhaps influenced by the Austrian school, who would argue that regulation and capital requirements are pointless, provided market participants can assess the relative stability of different banks. Banks would then only issue as much money as their balance sheets could safely sustain – if they didn’t, they would quickly be found out and reform or go bust. Usually the instinct for self-preservation would keep everything on track. This argument was eloquently made by Hayek (for example in his 1976 book “Denationalisation of Money”), and I was long sympathetic to it. It’s pure and radical. But the problems posed by power relationships, hugely complex and imperfect information networks, and all kinds of human desires and human failings, whilst they might be expressed in markets, cannot be solved there. Even a Hayekian solution would require regulation of the size and scope of banks, to prevent them from holding society to ransom. Hayek could not have foreseen that banking would become the vast and indispensable component of economic activity that it now is. His focus, understandably at the time, was on the damage the state rather than business could inflict on the economy.

So I think we have to accept that public regulation is necessary. Since the public is the guarantor of the financial system, it is reasonable to ask what the public gets in return for licensing private banks to make money. This isn’t really an accounting calculation: growth, taxes, employment, and so on minus the cost of re-furbishing the system every now and again. It’s also about the way power is distributed, how investment and lending decisions are made, the costs of managing the system (my pension fund is managed for 0.5% of the fund value – what is the long-run cost of the banking sector as a proportion of the funds it lends out? I don’t know, but I’d be interested in the answer).... and it’s about whether this could all be done differently.

Thirdly, we should appreciate the equally momentous effects of increasing bank reserves by Quantitative Easing. Through the 8% fractional reserve system, any adjustment is potentially magnified by 12.5 times. So the increase in the money supply that could follow an injection – to use the UK example – of £200bn from the Bank of England is £2,500bn, more than the entire reported M4 monetary stock (the broad measure used in the UK). On the other hand, if capital has been depleted and banks want to rebuild it, then QE will not flow into lending, but simply into the balance sheet, with bits -- oddly enough -- going to bonuses and shareholders. The fact that the UK economy has not zoomed into inflationary orbit gives support to Richard Werner’s view that printing money has no effect if the banks won’t lend: they need to feel safe first.

Finally, I’d like to bring out further the role of banks as distributors of social capital, since that is what the numbers in their balance sheets that are underwritten by society are. The entrepreneurship that is enabled by the provision of this capital is a social good, whatever explicit social purposes it might aim at, and irrespective of whether it ends up actually making a profit. In the meantime, people have been employed and perhaps technological or social innovations have been developed.

There is a tension between the banks’ profit and shareholder return motives and their lending decisions. It’s not obvious that banks are best placed to decide how much publicly underwritten money should be created and how or to whom it should be dished out, and it must be possible to design better incentives than profiting from the lending itself. That being so, we might start to think of ways of distributing society’s wealth that do not involve the banks, and might be able to make some sensible decisions about the long-term public purposes of lending, and the balance between central government, commercial banking, and perhaps local or non-profit agencies in achieving a better social return.

This, I believe, is the political ground on which the debate about banking should take place.


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