The Bank of England published a paper on Friday 29 May repeating a simple but important truth about money: Private banks print it.
The paper points to consequences of this argument in economic modelling, bank leverage, and economic theory. But the effect it has on European policymaking should be at least as important.
Economics textbooks typically present the whole financial system as matching savers with investors.
It might suck a lot of the goodness out in the process, pay itself lavish bonuses, and build tall glass and steel edifices, but basically it channels existent money from place to place according to risk appetite and productiveness of investment. Depositers put money in banks (or mutual funds, or pension funds, or life insurers), these institutions look for borrowers, the money filters out, sorted by the price mechanism.
But that doesn’t match the bookkeeping. When a bank lends money, it simultaneously gains an asset — a loan — and a liability, in the form of the money on deposit which the borrower now has. It can do this as much as it likes, limited only by the demand for borrowing, its own judgements about borrower credit quality, and the capital requirements of the loan.
The loan is funded, up front, by a short term liability, the cash deposit. But the bank cannot prudently fund its whole balance sheet in this way. Instead, it must mix in long term funding and permanent loss-bearing capital so that it can cover the losses on its overall loan book.
“This is not a theory that needs to be proved, it is a simple fact, it is part of the elementary design of any modern economy’s financial system,” notes the paper. Some people are outraged that banks get this power, but really, it is pretty much the defining quality of a bank.
The paper then goes on to discuss whether this matters for “dynamic stochastic general equilibrium” models of the economy, to the point where GlobalCapital’s head started to spin (spoiler alert: it does matter).
But it also matters for Capital Markets Union, and the initiatives to restart securitization, and encourage market based funding.
European officials (and optimistic capital markets bankers) are fond of trotting out statistics pointing out that while US corporates get 70%-80% of funding from the market, European corporates get the same proportion from their banks.
This assumes, once you unblock the right channels, clear up regulation, and shake out the various cultural objections to capital markets investment, Europe might reach similar levels of market based funding because markets and banks are just different forms of intermediation.
But if banks are institutions which create money, and markets are not, this substitution can only go so far.
Regulation of various kinds — the leverage ratio, CRD IV, bank structural reform, TLAC, the Fundamental Review of the Trading Book, Pillar 2 requirements under Banking Union — has reduced the appetite of banks to create money.
Tweaking the rules to make it easier for existing money to flow to productive investments will help Europe’s economy — surely it can’t hurt — but it will do much less, and be much slower, than harnessing banks’ power and desire to create money.
Of course, this doesn’t have to be done by lending to corporates and households. The same money creation process applies to margin loans, prime brokerage, securities financing, or even purchases of securities by banks.
But the money needs to be created in the first place, and that means letting banks provide this leverage. For all the good intentions of Capital Markets Union, without this mainspring, it will struggle to make a difference.