Guest Post: The REAL Battle Over America’s Banking System

By George Washington of Washington’s Blog.

The battle to reform the American banking system needs to include reimposing the barrier between investment banking and depository banking (Glass-Steagall), pay incentives based on what is best for Americans and not just the top executives, the end of too big to fail, and other changes which are frequently discussed by financial writers. These are vital issues.

But there is more to the battle for reform than you might know.

New York Versus the Rest of the Country

If you are happy with the banking system, and don’t think it needs to be reformed, then you probably work for one of the banks headquartered in New York.

Indeed, the banks outside of New York have acted much more conservatively, used more conservative capital ratios and less leverage and gotten less involved in credit derivatives and other speculative investments.

Buy a banker in the Midwest a drink, and he will probably rail against the giant New York banks for causing the financial crisis, costing the smaller, better run banks a lot of money and huge fees, and driving many smaller banks out of business.

And even within the Federal Reserve, what the New York Fed and Bernanke are saying is wholly different from what the heads of the regional Fed banks are saying. The Fed banks in Philadelphia and Kansas City and Dallas and elsewhere disagree with what the New York Fed and Fed’s Open Market Committee are doing. See this and this.

So the battle isn’t between bankers versus outsiders. It is between the giant New York money-centered banks and the rest of the country.

Reserve Requirements

Congresswoman Kaptur said last week:

We used to have capital ratios. We need to get back to them. Ten to one. For every dollar in your bank, you can lend ten. You know what J.P. Morgan did? A hundred to one. And then with derivatives, who knows how much?

Remember, Milton Friedman – the monetary economist worshipped as the guy with all of the answers in the latter part of the 20th century – advocated for 100% reserves.

Friedman has been deified as the economist to follow. But his views on reserve requirements have been completely ignored.

Goldman Using Taxpayer Dollars to Buy Stock in China?

As everyone knows, Goldman became a “bank holding company” in September, to be able to access funds from the Fed at essentially zero percent interest.

But in a new interview with Bill Moyers, Simon Johnson noted that in August of 2009, Goldman switched again – to a “financial holding company”.

What’s the difference?

Johnson says that being a financial holding company means that Goldman can borrow money from the Fed at essentially no cost, and then invest it in any thing it wants. For example, Johnson says that Goldman has bought a large share of the stock of a Chinese automaker. Johnson says that if the investment succeeds, Goldman will reap the profits; but if it fails, the taxpayers are on the hook.

Banks Have the Power to Create Money

Congresswoman Kaptur also said last week:

Banks have the power to create money. And decide how much that is worth.

What is Kaptur talking about?

Here Comes the Judge

Well, in First National Bank v. Daly (often referred to as the “Credit River” case) the court found that the bank created money without having the reserves:

[The president of the First National Bank of Montgomery] admitted that all of the money or credit which was used as a consideration [for the mortgage loan given to the defendant] was created upon their books, that this was standard banking practice exercised by their bank in combination with the Federal Reserve Bank of Minneaopolis, another private bank, further that he knew of no United States statute or law that gave the Plaintiff [bank] the authority to do this.

The court also held:

The money and credit first came into existence when they [the bank] created it.

(Here’s the case file).

Nobel Economists, Congressmen, the Fed and Treasury Agree

Still confused?

Well, let’s hear from some top economists.

As PhD economist Steve Keen pointed out recently, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:

The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.

Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.

As Mish has previously noted:

Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.

This angle of the banking system has actually been discussed for many years by leading experts:

“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts.”
– 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”

“The process by which banks create money is so simple that the mind is repelled.”
– Economist John Kenneth Galbraith

[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.
– Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

“Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.”
-Congressman Wright Patman, Money Facts (House Committee on Banking and Currency, 1964)

The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented.
– Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created — brand new money.
– Graham Towers, Governor of the Bank of Canada from 1935 to 1955

Monetary reformers argue that the government should take the power of money creation back from the private banks and the Federal Reserve system.

Indeed, PhD economist and candidate for Florida governor Farid Khavari wants to create a Bank of the State of Florida, to create credit without burdening the state and its citizens with high interest charges by private banks.

The state of North Dakota already has such a bank.

The bottom line is that monetary reformers argue that letting banks create credit and money and then charge high interest rates creates massive levels of debt for states and taxpayers. They argue that the power to create money should be reclaimed by the government and taken away from the private banks.

Personally, I agree with the monetary reformers. But even for those who think this is too radical a proposition, the question is whether a system where debt has to constantly and continually expand to keep the economy afloat is sustainable.

The Ever-Expanding Bubble

In a hearing held on September 30, 1941 in the House Committee on Banking and Currency, then-Chairman of the Federal Reserve (Mariner S. Eccles) said:

That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.

Indeed, Robert H. Hemphill, Credit Manager of the Federal Reserve Bank of Atlanta, said:

If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.

America’s banking system needs to be fundamentally reformed.

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  1. vlade

    Err. I beg to differ re creating money. There’s a difference between bank lending more than depositor’s funds and creating money. Banks still have to square their accounts at the end of the day – usually by borrowing from someone else (and if all else fails, from the central bank). This is why we had the liquidity squeeze last year – if banks were able to “create money”, hey, why should they need to borrow from central banks????? They could just create money out of the thin air, yes? Bank that can “create money” can never, ever, default.
    See WMC and others for historical counterexamples.

    If I can create money out of the thin air for borrowers, surely I can do the same for depositors, so I don’t have to worry about a run on the bank. I might not be able to pay the depositors in cash, but I wouldn’t be able to do it with borrowers either. Would depositors complain if their money were repaid to an account with a different institution? I doubt it (and if we want run on M0, then again the same holds – only CBs can print paper money).

    This is not to say that the reserves don’t come after lending, but banks don’t “create money” in the sense people are talking about – i.e. that they just put a number into “debit” column when they give the money to whoever borrowed them (creating an asset for them). Anything else is (even now, under current laws) fraud, and can be actually very easily audited for.

    By confusing these two, people are
    a) misleading others (intentionally or not);
    b) weakening the argument that loans create reserves not vice versa, which is an important argument

      1. BS

        Vlade you have clarified the misnomer that money is created out of thin air. I have asked about this issue before and it was never answered:

        Posed here is my response to the issue raised on Washington’s blog on 9-24-09:

        “Anonymous said…
        I beg for someone to connect the dots for me. I follow the story about the creation of money out of thin air but I question how a bank can lend out money by just making a book entry. If someone borrows $100 from a bank and the bank makes the entry on the books how does the borrower get the $100 in cash unless the bank has cash in reserve to give out. The bank may have cash from depositors or it may go to a federal reserve bank to get the physical cash but then it should have an offsetting entry on its books to show the liability to the depositor or the FRB, correct? In the bigger picture, if the cash comes from the depositors and the bank is able to lend out say 15 times the amount held in reserve then what happens when the bank over-lends its reserve? It is out of physical cash correct? Without a loan from the FRB or some other lending facility it should then be unable to lend out any more cash correct? So to be accurate, the banks can only create money out of thin air to the extent they can supply physical cash, i.e. to the extent they can lend from reserves or borrow from the Fed, correct?
        SEPTEMBER 24, 2009 10:11 AM”

        I hope GW takes up the issue in greater detail than simply responding that he has removed “out of thin air” from the matter. The issue involves the insolvency of banks with the regulators looking the other way. This issue is where we should be focusing our investigative efforts. This is the ponzi scheme of banking and it is high time that Matt Taibi and others should be taking a closer look. What do you say GW?

        1. George Washington

          Initially, the bank can always create a loan on paper, and then borrow the money later on the market or from the Fed.

          But creating more loans means having willing borrower.

          Consumers are tapped out, and don’t want to borrow more.

          As I have repeatedly written, I think the giant banks ARE insolvent. If they could restart consumer demand, they could re-start the Ponzi scheme.

          But they can’t, because there has been a generational change in consumer psychology towards frugality.

          My 2 cents, anyway…

          1. BS

            These are good thoughts but they address a different issue. The theories that money can be created out of thin air were posed before consumers lost the ability to borrow further. I’d like to see more investigational reporting about the ponzi scheme because sooner or later, without regulatory changes, the ponzi scheme will restart. In reallity it has never stopped; I do not have the statistics but I imagine borrowing is just down a certain percentage rather than having been eliminated. Isn’t the whole idea behind quantitative easing to get the scheme going again so we can grow out of insolvency. So here it is, we have a broken system yet we are hoping the system will restart so we can keep going. Then the second remedy will be inflation causing the value of existing debt to melt away. Trouble is all those existing debts are going to be eliminated by huge new debts.

    1. Fed Up

      It seems to me that banks create debt and that the fed/treasury create currency/bank reserves.

      It also seems to me that the banks and the fed need to be fighting price deflation for this create debt first and worry about reserves later idea to work.

      They need to be fighting price deflation because if too much debt goes bad the fed can then print reserves and/or currency to make the loans “whole”.


      “This first major paper on this approach, “The Endogenous Money Stock” by the non-orthodox economist Basil Moore, was published almost thirty years ago.[4] Basil’s essential point was quite simple. The standard money multiplier model’s assumption that banks wait passively for deposits before starting to lend is false. Rather than bankers sitting back passively, waiting for depositors to give them excess reserves that they can then on-lend,

      “In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.[5]

      Thus loans come first—simultaneously creating deposits—and at a later stage the reserves are found. The main mechanism behind this are the “lines of credit” that major corporations have arranged with banks that enable them to expand their loans from whatever they are now up to a specified limit.

      If a firm accesses its line of credit to, for example, buy a new piece of machinery, then its debt to the bank rises by the price of the machine, and the deposit account of the machine’s manufacturer rises by the same amount. If the bank that issued the line of credit was already at its own limit in terms of its reserve requirements, then it will borrow that amount, either from the Federal Reserve or from other sources.

      If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:

      refuse to issue new reserves and cause a credit crunch;

      create new reserves; or

      relax the reserve ratio.

      Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.”

  2. winterspeak

    The non-govt sector can expand assets and liabilities simultaneously (through banks extending credit — as you describe).

    But the Fed Govt has to run deficits to enable the private sector to increase the equity line on its balance sheet (net non-govt savings).

    vlade is not correct — banks do create money ex-nihilo by creating an asset and a liability at the same time.

    Bank runs are a problem because of capital requirements and maturity mismatch. You confuse capital requirements with reserve requirements in this piece.

    1. JKH

      Right on, Winterspeak!

      “Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.”

      That’s interesting. I think Warren Mosler showed it in about 2.5 seconds through double entry book keeping.

    2. Mike S

      Here is the math to prove that government deficits create money:

      GDP = C + I + G + NX

      Y + T = C + I + G + NX

      Y + T is the gross domestic production (national income plus taxes), C is
      private domestic consumption, I is private domestic investment, G is government
      expenditures and NX is net exports (exports – imports)

      To find the identity subtract T from both sides

      Y = C + I + (G – T) + NX


      Y = C + I + DEF + NX

      with DEF the government deficit. Then substract C from both sides

      Y – C = I + DEF + NX

      Y-C is national saving (S):

      S = I + DEF + NX

      Rearrange to get the identity

      (S – I) + SURP – NX = 0

      S-I is the PDFB (net saving by the private sector), SURP (government surplus, or net saving by the government) is GFB and -NX is the RWFB (the net saving of the rest of the world):

      PDFB + GFB + RWFB = 0

      This is a national accounting identity.

      In a global market, there is no “Rest of world fiscal balance” so RWFB = 0


      PDFB = – GFB

      or private sector savings = total government deficit.

      Government Deficits create Money in a fiat currency.

    3. BS

      What Vlade is discussing is physical money it does not matter whether it is reserves, deposits or loans. You cannot make a loan unless you have physical money. Suppose I am a borrower and I request a loan of $100 from a bank. The bank may put whatever they want on their books but it is not a loan to me unless I get the physical money in my pocket. An entry on the books is not money in my pocket. If there is no money there is no loan. So where does the bank get the physical cash? Depositors, FRB bank other sources?

      1. steve

        The bank expands its balance sheet by adding an asset on one side (an IOU from the borrower), and an equal liability on the other side (by creating a checking account in the borrower’s name, for the amount of the loan). Physical cash is not required. Of course, you can immediately cash a check for physical cash, but only a small percentage of loan recipients do this. At least, I haven’t seen such a thing at the mortgage closings I’ve attended.

        1. BS

          Sure some money may stay in the bank but that is merely float. Borrowers do not borrow to invest in savings and checking accounts they borrow to get the money and use it somewhere else.

    4. vlade

      Can you explain how then? Sure, bank create asset (on their side) and liabilities (on the other side) by making a loan.

      The loan will end up deposited somewhere-eventually, but it doesn’t have to be the same institution. Given that the bank had to borrow the money from somewhere first (to square their accounts – this is a fact, the bank must have squared their accounts, or they are commiting fraud, which I’m assuming we don’t consider right now), so the flow just flows around until the balance is reached again.

      Bank run caused by mismatching maturities – sure, although I’d call it lack of liquidity, which is not exactly the same (you can have perfect maturity match, and still suffer from a run because of credit event of your debtors reducing their liquidity, or even perceived credit event. And they could have been holding assets with matched or shorter maturities, doesn’t matter).

      But if you can create spot money ex-nihilio, you don’t have problem with maturity mismatch. To claim that creating a spot loan creates money ex-nihilio implies that the bank can create spot ex-nihilio money, ergo cannot have maturity mismatch. Maturity mismatch? Let’s just create money to cover it.

      Can you give a simplified example of how the banks create spot money ex-nihilio?

      There’s a way you could claim bank “create money”, which is by extending a loan of 100 for a year at 2% interest they explicitly assume that there will be 102 of currency units in a years time. This is probably a more relevant way of creating money. That said, it is not instrisnic act of making the loan that creates the money, or even interest – credit events could cause the money not to be there for example. In theory it could work even in a closed system.

      1. winterspeak


        It’s the reserve accounts at the Fed that enable banks to do this.

        Here are the mechanics:

        Bank A makes a loan. It credits its receivable account (asset) and debits its reserve account at the Fed (asset).

        The borrower then takes that loan and deposits it in Bank B. Bank B credits its deposit account (liability) and its reserve account at the Fed (asset).

        Bank A is now short reserves to meet its reserve requirement, but Bank B is long. So, overnight, Bank B lends its excess reserves to Bank A. Everyone hits their target. When the sun comes up, Bank A gives the reserves back to Bank B. The Treasury is active in this overnight market so it can make the rate close to the target set by the Fed.

        If the system as a whole is net short reserves, then it borrows from the Fed directly at the discount window.

        As you can see, the loan comes first, which then creates the deposit to “fund” the loan.

  3. MyLessThanPrimeBeef

    Not that I am for it, does every state, except Vermont, have balanced budged requirements?

    If so, why?

    1. winterspeak

      States are not the Federal Government, and therefore cannot create money. They are currency users, like us poor schlubs.

      Banks have reserve accounts at the Fed that let them inflate their balance sheets by credit extension in a way that we cannot. Best to think of them as public/private partnerships, if recent events haven’t made that crystal clear already.

    2. ScottB

      From what I understand, the State of Washington does not have that requirement– the law is merely that the governor must propose a balanced budget.

      States go into debt for capital projects by selling bonds all the time, and in the past (not sure about 20th century, know it happened in the 19th century) have defaulted on those bonds. I don’t see any theoretical reason for not allowing deficits in the operating budget. Of course California presents a pretty good practical reason.

      Too bad Congress didn’t require an airtight rainy day fund for states before they could tap into stimulus funds…

  4. RueTheDay

    “Remember, Milton Friedman – the monetary economist worshipped as the guy with all of the answers in the latter part of the 20th century – advocated for 100% reserves.

    Forget 100 to 1 or even 10 to 1. Friedman said the capital ratio should be 1 to 1, where banks only lend out the amount they actually have as deposits on hand.”

    LOLWUT? Under a 100% reserve system, banks do not “lend only the amount of deposits on hand” (whatever that is supposed to mean, for it is literal nonsense). Banks do not lend ANY depositor funds AT ALL under a 100% reserve system. A reserve ratio denotes the percentage of deposited funds that are held either in the vault or on deposit at the Fed. If you have a 100% reserve ratio requirement, there are NO depositor funds available for lending. Under a 100% reserve system, banks are essentially warehouses for storing money.

    This is Econ 101 stuff. Yves needs to tighten up the requirements for who gets to write for her blog.

    1. George Washington Post author

      Please take another look. I revised to:

      “Remember, Milton Friedman – the monetary economist worshipped as the guy with all of the answers in the latter part of the 20th century – advocated for 100% reserves.

      Friedman has been deified as the economist to follow. But his views on reserve requirements have been completely ignored.”

      1. RueTheDay

        Again, just to be clear – a bank under a 100% reserve system is no longer a bank. It cannot take deposits and make loans with them. It simply takes deposits and STORES them, like a warehouse. It would make money by charging depositors fees for storing their money, and for transfering it to other storage facilities. It would no longer be a financial intermediary.

        I’m not arguing in favor or against a 100% reserve system, just pointing out that many people who advocate for it have no idea what it actually means.

        1. LHB

          It’s not true that a bank operating under a 100% reserve requirement would cease to be a bank. It could only make loans up to the amount of its capital. $500 billion in deposits + $100 billion in capital under 100% reserve banking still leaves the bank with $100 billion of funds to lend. In this case, the “bank” would simply be a financial intermediary, loaning the funds of it’s owners to borrowers.

          1. mannfm11

            I concur. 100% fractional reserve banking means the bank is lending out your funds and you no longer can get them. Regular banking kind of works that way with CD’s.

          2. RueTheDay

            “It could only make loans up to the amount of its capital. ”

            You might want to re-read what I wrote. I specifically said, “It cannot take deposits and make loans with them”

            Under a 100% reserve requirement, a bank CANNOT loan out depositor funds. Thus it is not a bank. Period. Sure it can make loans from its owners’ capital rather than from deposits, but ANYONE can do that today – I can loan people money from my saved “capital”, but that does not make me a bank.

    2. Peter T

      > LOLWUT? Under a 100% reserve system, banks do not “lend only the amount of deposits on hand” (whatever that is supposed to mean, for it is literal nonsense). Banks do not lend ANY depositor funds AT ALL under a 100% reserve system.

      Banks would not lend any money from checking accounts, true, but what would prevent them to lend out money for a year that was deposited in a CD with 1-year maturity. Banks would become more like brokers, linking depositors and borrowers, checking the borrower, guaranteeing the loan, and earning a fee for their services.

      1. RueTheDay

        “Banks would not lend any money from checking accounts, true, but what would prevent them to lend out money for a year that was deposited in a CD with 1-year maturity. Banks would become more like brokers, linking depositors and borrowers, checking the borrower, guaranteeing the loan, and earning a fee for their services.”

        You are describing an attempt at a maturity matched system, not a 100% reserve system.

  5. fresno dan

    I have been reading this stuff from Keen and find it quite interesting.
    But I would ask a question about how the Fed sets rate and money supply. What objective criteria is used to determine these rates? Isn’t it true that it is merely based on “wants” (get the economy moving, prevent deflation) versus analysis of actual saving?

  6. sgt_doom

    And why can Goldman Sachs switch to become a “finance holding company” (FHC)? Because of the passage of the Financial Services Modernization Act (Gramm-Leach-Bliley Act of 1999). And who has the responsibility — under the Federal Reserve Act, Title 12, Part 208 — to set, oversee and monitor the capital and reserve requirements for those banks and banksters? Why, none other than the Federal Reserve.

  7. Charles

    100% Banking is an unfortunate expression that serves as a straw-man to dismiss sound banking practice. A banking system that is forced to place 100% of its deposit to the Central Bank is of course useless, because neither money nor credit is created. Actually, with today’s technology, it would be quite straightforward for the Central Bank to open a deposit account to every citizen. In a sense, this is what is doing.

    Maturity matching is in fact the realistic goal that we should strive to achieve. Because it removes the existence of bank runs, private banks cannot take the whole country as hostage to force conversion of their privately issued money into Central Bank money (this is exactly what happened last year). In this set-up, private banks can create credit, but cannot create money. (To be more precise, they create a money that is NOT legal tender, I.e. that a counter-party is NOT FORCED to accept).

    In such a system, Money is exclusively created by the Central Bank, and the seignorage revenues accrue to the state. Private Bank curves could be steep of course, by that would reflect the real price of liquidity (much higher than the paltry sums paid to the FDIC and the interest lost on reserves). If unreasonable risk aversion make these curve too steep, thus stymying the development of the economy, the Central Bank can buy same maturity government bond or even long bonds of well managed financial institutions.

    1. vlade

      Maturity matching doesn’t work, because a single credit event has a potential to destroy the whole system (by breaking the maturity matching chains of debt).
      With maturity matching, you would need a buffer of spot money to be maintained at any given time, with the size of the assumed credit event being the determinant of the buffer size. Of course, the larger the buffer, the smaller the utility of the system.

      The only maturity matching that would work all the time is that all money would be spot money, in which case you don’t need commercial banks in the first place (you need instant money transport mechanism, which is not the same as bank).

    2. Ingolf

      “In this set-up, private banks can create credit, but cannot create money. (To be more precise, they create a money that is NOT legal tender, I.e. that a counter-party is NOT FORCED to accept).”

      Charles, would you be good enough to clarify what you mean by the above?

    3. RueTheDay

      Maturity matched banking looks great at first glance, but it doesn’t hold up to even the simplest scrutiny. The canonical example of someone depositing money into a 5 year CD and the bank making a 5 year loan with that money only results in a maturity matched initial transaction. The bank cannot control what the borrower does with the loan. What happens if he loans it out to someone else for 6 years? Are we going to make rolling over a loan (and hence the entire concept of a line of credit) illegal? Are banks going to have to forbid borrowers from making loans (how does that work when the borrower is a financial corporation)? An even more subtle problem is that the asset purchased with a loan is not always a financial asset. The borrower may be an industrial company that purchases a machine with an expected life of greater than 5 years. Minsky himself once used the latter example to demonstrate that maturity mismatch will occur even without banks.

    4. HomeEconomics

      All of those ideas work until a bank enters leveraged speculative investments. At that point, the bank has risked more than they have and are therefore on a fast road to insolvency as soon as any of their investments turn sour.

  8. David

    The article starts out noting that the money center banks and especially investment banks play a different game from commercial banks, and that “conservative” commercial bankers would blame the crisis on the NY money center and investment banks.

    But then it goes on to discuss essentially commercial banking, which involves loans created “out of thin air” and expands on how much concern that might cause us. But again this is not the game of investment banks, or even money center banks (which borrow from the Fed and the Treasury), but of commercial banks.

    Indeed commercial banks have a big slice of blame in this debacle, having made subprime and alt-A loans, and also commercial real estate loans. But most of the blame belongs on the NY players, with their CDO’s and Credit Default Swaps. Without those, I think the house of cards that was real estate lending would still be standing, and we wouldn’t even be calling it a house of cards.

  9. Jesse

    Thank you Charles. You have brought some clarity to a rather muddy issue.

    Vlade made the original sound point. Banks do their business, but at the end of the day, they will obtain the reserve requirements, one way or the other. The chicken or egg issue is rather meaningless.

    Banks do not need to lend these days, they can park their excess reserves with the Fed, can’t they? LOL. Its not much though, but its safe.

    But then we have the beta monsters chasing the big profits in derivatives and other exotics, and now even the big GS which is now more or less a hedge fund, at least respect to the bulk of its profit origins.

    Funny stuff, banks.

  10. john bougearel

    Milton Friedman was about the worst thing that happened in the second half of the twentieth century.

    Think twice about advocating anything he has to say or painting him in a favorable light.


    Yes, he was worshiped by all the wrong people and for all the wrong reasons. Please get that much.

  11. farrar

    The notion that banks must have cash available to pay out their loan proceeds is about the most ridiculous and naive I have ever read on any blog. Think about it for more than 30 seconds. If you buy a car, are you going to take $20, 000 in cash over to the dealers? Obviously not. You are going to get a cashier’s check or write your own check in favor of the dealer. Even if you are borrowing to take a vacation, you are not going to carry all the necessary cash around with you. You are going to pay by credit or debit card, or a la rigueur travelers’ checks. Can anyone cite any legitimate loan purpose which would require loan proceeds to be paid in cash. It is even less likely that loan proceeds would be paid out in cash in the case of business loans.

    Farrar, ex banker

    1. BS

      It is a waste of time arguing about trivial points in this blog. Sure no one is going to carry cash around to buy a $20K car but when a check is tendered from Bank A to a car dealer and the dealer presents the check for payment to bank B then Bank A better have the liquidity to transfer the digital money to bank B or there is a problem. Digital money is no different from cash in this respect. A loan made to the borrower from Bank A must have either physical cash or digital money available to be transfered to bank B or the deal does not happen. In one message it was suggested that since there is so much digital money floating around there is no real need to account for the money that appears to be created out of thin air. Well, that suggestion just doesn’t comport with reality. It is fractional banking that makes it all work; but the solvency of banks, i.e., whether they are over-lending in the face of reserves that have been diminished by bad debts means that insolvency is being disguised by a lack of regulatory enforcement. Imagine If bank A has lent out 10 times what it has taken in from deposits and FRB loans but is unable to collect 50% of its loans it is not only insolvent its fractional reserves are now greater than 10 to 1.

  12. The Fist

    Right on, BS. It is fractional-reserve banking that our entire currency depends upon for valuation, and nothing else.

    When you base your currency on “thin air”, it seems to always come home to roost. Houdini-based economics from the Chicago and Keynesian schools can never work unless they are backed by Treasuries – regular taxpayers.

    This is a freaking joke. Seriously, stop believing in Houdini, in the form of Friedman, Knight, Bernanke, Greenspan, and the other monetary illusionists and start believing in one thing – REAL currencies like gold!

    We are bartering our way through a fractured currency. The Fed sucks, and so does anything that states keeping them around.

  13. flow5

    Basil wasn’t the first. Dr. Leland James Pritchard, Ph.D, Economics, Chicago 1933, MS Statistics, Syracuse (self-described flow of funds, rates of change, economist: explained the process, before Basil, in his 1958 money & banking text. I’ll condense it:

    “Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements – Testimony of Treasury

    “These measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businesses” Testimony of Treasury

    A member commercial bank (depository institutions) only becomes a financial intermediary when there is a 100% reserve ratio applied to all its deposit liabilities. The weighed arithmetic average of reserve ratios applicable to deposit liabilities stood at 84%, and for demand deposits the ratio was 91, in 1942.

    Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

    From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, State, and other Governmental Jurisdictions) & (every person), (except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (transaction deposits) — somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

    The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free/gratis legal (excess) reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (10% on transaction accounts in excess of the low-reserve tranche), as fixed by the Board of Governors of the Federal Reserve System.

    Since 1942, Bank credit creation is a “system” process. No bank, or minority group of banks (from an asset standpoint), can expand credit (and the money stock), significantly faster than the majority group are expanding. If the member commercial banks hold 80 percent of total bank assets, an expansion of credit by the non-member banks, and no expansion by member commercial banks will result, on the average, of a loss in clearing balances equal to, 80 percent of the amount being checked out of the non-member banks. I.e., the FED, through controlling the reserves of the member banks, can control the expansion of total bank credit, member and non-member.

    From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its free/gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a (1) decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), (2) unless the inflow results from a return flow of currency held by the non-bank public, or (3) is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative. Note: the trend of the nonbank public’s holdings of currency has been up since 1930, i.e., return flows are purely seasonal.

    That is, CB time/savings deposits, unlike savings-investment accounts in the “thrifts”, bear a direct, virtually one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink, pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

    Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

    Consequently, the effect of allowing member CBs to “compete” with financial intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase long-term interest rates, increase the proportion, and the total costs of CB TDs.

    Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals.

    The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its “open market power”, to prevent any outflow of currency from the banking system.

    However, disintermediation for financial intermediaries- (non-banks), is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets (e.g., mortgages), with historically lower fixed rate and longer term structures.

    In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the “thrifts” with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

    Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries.

    Shifts from TDs to TRs within the CBs and the transfer of the ownership of these deposits to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets. I.e., the non-banks are customers of the member money creating depository banks.

    In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

    The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.

    Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process.

    Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

    Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

    E.g., the expansion of bank credit and new money-TRs (transaction deposits) by the CBs can be demonstrated by examining the differences in the consolidated condition statements for the banks and the monetary system at two points in time.

    Increases in CB loans and investments/earning assets/bank credit, are approximately the same as increases in TRs & time deposits/savings deposits (TDs)/bank liabilities/bank credit proxy (excluding IBDDs).

    That the net absolute increase in these two figures is so nearly identical is no happenstance, for TRs largely come into being through the credit creating process, and TDs owe their origin almost exclusively to TRs – either directly through transfer from TRs or indirectly via the currency route.

    There are many factors, which can, and do, alter the volume of bank deposits, including: (1) changes in currency held by the non-bank public, (2) in bank capital accounts, (3) in reverse repurchase agreements, (4) in the volume of Treasury currency issued and outstanding, and (5) in Reserve Bank credit. Although these principle items are largest in aggregate, they nevertheless have been peripheral in altering the aggregate total of bank deposits.

    For the Monetary System:

    Thus the vast expansion of deposits occurred despite:
    (1) an increase in the non-bank public’s holdings of currency $801.2b
    (2) an increase in other liabilities & bank capital $39b
    (3) an increase in matched-sale purchase agreements $32.2b
    (4) an increase in required-clearing balances $6.7b
    (5) the diminution of our monetary gold & silver stocks; etc.(-)$6.6
    (6) an increase in the Treasury’s general fund account $4.9b

    Factors offset by:
    (1) the expansion of Reserve Bank credit $847.5b
    (2) the issuance of Treasury currency; $35.9b

    These “outside” factors made a negligible contribution in bank deposit growth the last 67 years of $4.4b (deposits declined by $877.4b and were offset by the expansion of $883.4b).

    For the incredulous reader I make this assignment: Please explain how the volume of TRs and TDs could grow since 1939 from $48 billion, to $ 8,490 (NSA) billion, even while the banks were paying out to the non-bank public a net amount of (-)$801.2 billion (NSA) in currency.

    Federal Reserve Bank credit since 1939 (2.6b), has expanded by billion 847.5 (NSA), (-$801.2 of which was required to offset the currency drain from the commercial banks. The difference in the above figures outlined above was sufficient to supply the member banks with $46b of legal reserves.

    And it is on the basis of these legal reserves that the banking system has been able to expand its outstanding credit (loans and investments) by over (+) $8,462 trillion (SA) since 1939. (40.7)

    From a System standpoint, time deposits represent savings that have a velocity of zero. As long as savings are impounded within the commercial banking system, they are lost to investment or to any type of expenditure. The savings held in the commercial banks, in whatever deposit classification, can only be spent by their owners; they are not, and cannot, be spent by the banks.

    From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

    Lending by the intermediaries is not accompanied by an increase in the volume of money, but is associated with an increase in the velocity, or turnover of existing money. Here investment equals savings (and CB velocity is evidence of the investment process), whereas in the case of the CB credit, investment does not equal savings, but is associated with an enlargement and turnover of new money (bank credit & the money stock).

    The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy. Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

    It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

    In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, Financial Services Regulatory Relief Act of 2006, etc.

    The CBs can force a contraction in the size of the S&L system, and create liquidity problems in the process, by outbidding the S&Ls for the public’s savings. This process is called “disintermediation” (an economists word for going broke). The reverse of this operation, as implied in the analysis above, cannot exist. Transferring saved TR or TD deposits through the S&Ls cannot reduce the size of the commercial banking system. Deposits are simply transferred from the saver to the S&L to the borrower, etc.

    The drive by the commercial bankers to expand their savings accounts has a totally irrational motivation, since it has meant, from a system standpoint, competing for the opportunity to pay higher & higher interest rates on deposits that already exist in the commercial banking system. But it does profit a particular bank, Citibank for example, to pioneer the introduction of a new financial instrument such as the negotiable CD until their competitors catch up; and then all are losers. The question is not whether net earnings on CD assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the banking system. This is not a zero sum game. One bank’s gain is less than the losses sustained by other banks.

    How does the FED follow a “tight” money policy and still advance economic growth.? What should be done? The money creating depository banks should get out of the savings business — gradually (REG Q in reverse-but leave the non-banks unrestricted). What would this do? The commercial banks would be more profitable – if that is desirable. Why? Because the source of all time/savings deposits within the commercial banking system, are demand/transaction deposits – directly or indirectly through currency or the CBs undivided profits accounts. Money flowing “to” the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits

  14. HomeEconomics

    “Congresswoman Kaptur said last week:

    We used to have capital ratios. We need to get back to them. Ten to one. For every dollar in your bank, you can lend ten.”

    You know we’re in bad shape when we have to beg for 10% reserve ratios from depository institutions.

    I’m not going Friedman-style and saying 100% reserves are required, but clearly we need to be well above 50% reserves. The only reason banks need a sub-100% reserve ratio is to generate revenues. They clearly don’t need 10:1 to generate revenue. I’m willing to bet that most banks could turn a profit at 90% reserve ratios if they went back to actual banking instead of running TBTF trading shops.

  15. tts

    When we are granted banks’loans we are asked from what source will these be repaid.And we reply from salaried income(in the case of individuals) or profits(in the case of
    corporates)implying the future.In other words banks INSTANTLY create credit in the present or money/cash (by accounting entries) that was non-existent only a few minutes ago.So it is not out of thin air but from the future
    semantically speaking.This special privilege/prerogative
    afforded to banks is a subject of considerable concern to
    all citizens after the financial debacle attributed to them
    and therefore reforms are crucial in this respect….

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