Canadian Banks Create Money, too

Apparently, a lot of people don’t seem to know how money is created, and some of these are arguably people who should know. As much as 85% of British MPs were unaware that most of the money in the British economy is created by private banks, each and every time a loan is made, according to an article published by the Guardian just over a month ago.

The article reminded me of a quote attributed to Keynes that I came across while reading Geoffrey Ingham’s The Nature of Money: “I know of only three people who really understand money. A professor at another university; one of my students; and a rather junior clerk at the Bank of England.” I guess things haven’t changed much.

Speaking of the Bank of England, I thought they cleared this one up back in 2014 in a paper titled, “Money creation in the modern economy,” in which the authors clearly state on the very first page, “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” But, I guess British MPs have better things to do with their time than worry about where money comes from, like gripe about how government budget deficits are going to heap unbearable burdens on future generations and important things like that.

All this got me wondering not only about whether Canadian MPs are similarly unaware, but also whether the Bank of Canada has released any documents as revealing as that issued by its British counterpart. Unfortunately, I did not come across anything as explicit. As for the status of Canadian MPs’ knowledge of our monetary system, who knows? What I did find, however, was a short briefing published in 2015 by Canada’s Library of Parliament titled, “How the Bank of Canada Creates Money for the Federal Government: Operational and Legal Aspects.”

Where Money Comes From In Canada

After discussing how the Bank of Canada can create money for the Federal Government by participating in the Government’s securities auctions and purchasing its debt, Penny Becklumb and Mathieu Frigon, the briefing’s authors, go on to explain how private banks can also create money by effectively doing the same thing — buying the Government’s debt at its auctions. But that’s not all.

Private banks also create money by extending loans to private households and businesses. Here’s what Becklumb and Frigon say: “it is important to note that money is also created within the private banking system every time the banks extend a new loan, such as a home mortgage or a business loan. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s account, thereby creating new money.”

Coincidentally, or not, the second sentence is almost word-for-word identical to the line in the Bank of England’s report. I imagine that upon reading that report, Becklumb and Frigon were like me, wondering how things work in Canada, and then decided that it was worth informing Parliament about. If after three years, 85% of British MPs still don’t get it, I don’t imagine Canadian MPs are any closer to the truth either. I could be wrong.

Anyways, contrary to what British and Canadian MPs may have floating around in their heads, it is bank loans that create bank deposits, not the other way around. This may or may not be news to the rest of the population. If you’ve taken an economics class in which some portion of the class was devoted to money and banking, this is probably old news and is just what the money multiplier implied by a fractional reserve banking system explains, or purports to explain.

I agree that this is actually old news, but I disagree that this news is precisely what the money multiplier, fractional reserve banking and reserve ratio, explains. In fact the fractional reserve model assumes the exact opposite — deposits create loans.

The Fractional Reserve Banking Model

Suppose someone deposits $100 cash into their bank account. According to the fractional reserve model, the bank can now lend out a certain fraction of that $100 and must keep the rest of it on reserve. The amount kept on reserve is determined by the reserve ratio, which for this example I’ll follow the standard macro textbook and say that it is 10%. That means the bank can lend out 90%, or $90, and must keep 10%, or $10, on reserve. What is important here is the assumption that the initial $100 deposit was first needed in order for the bank to make the loan — deposits create loans.

This $90 that the bank loans to someone else is now considered to be the new money created, because the first person who deposited $100 at the bank still has their $100 while the person who is borrowing the money now has $90. In total $190, which came from an initial $100. If this borrower takes the money and then deposits it into their bank account, the whole process can be repeated with a new borrower. This time $9 will be kept on reserve and only $81 can be loaned out.

As you can see, each time this process is repeated, the amount that can be loaned out becomes smaller and smaller. The total amount of new money that can be created from the initial $100 can be found using the inverse of the reserve ratio, (1/0.1), also known as the money multiplier. Multiplying the initial $100 by the multiplier and then subtracting that same initial amount will give you the total amount of new money created from that initial deposit.

That’s it, $900 of new money, no more, no less. If banks want to loan out more money they either need to attract new deposits or wait for the central bank to provide them with more reserves. Banks can create a limited amount of new money, but being constrained by the reserve ratio, it is ultimately the central bank that controls the money supply through its increase or decrease of bank reserves. That’s the fractional reserve banking model, which you can find in most standard macroeconomic textbooks. But that’s not how the banking system actually functions.

The Hierarchy of Money

To see why, let’s begin with a quote from Joseph Schumpeter’s History of Economic Analysis, posthumously published in 1954. He writes, “It is much more realistic to say that the banks ‘create credit,’ that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them.” While not word-for-word identical with the claims of our other two protagonists, the spirit is the same.

It is worth thinking about the differences. Notice that Schumpeter says that banks create “credit” rather than “money,” the word used by both the Bank of England and Library of Parliament. He does, however, immediately replace the word credit with the word “deposit,” bringing him closer to what we’re familiar with. But which is it then? Are deposits best thought of as credit or as money?

It all depends on perspective. From the bank’s perspective, that new deposit is a promise to pay something that we all would agree is unambiguously money — cash. Yet, because the deposit represents a promise to pay money, a kind of IOU, it seems like it would be best to refer to that deposit as credit rather than money.

That’s the bank’s perspective. From the depositor’s perspective, because that deposit can be used to settle debts as well as purchase goods and services without having to convert to cash, it may as well be money. While the general public may not refer to the deposit itself as money (thinking of it more as some kind of container where their money is kept safe), this general public definitely refers to the balance of their deposit accounts as representative of their money. Again, it can be used to pay for things and settle debts. From the general public’s perspective, it is money.

This dichotomy in perspectives lends credence to the idea that monetary systems are hierarchical. Within a country like Canada, the money issued by the Bank of Canada (i.e. cash and reserves) is at the top of that hierarchy. Bank deposits, which are issued by private banks, are lower on the hierarchy. IOUs that I issue to my friends and family are much much lower on the hierarchy. One could think of all money as a form of credit, although not all credit is considered money. It all depends on what level of the hierarchy you’re situated.

This hierarchy of money is often masked by the fact that we use the word money to refer to both the stuff issued by the central bank as well as the stuff issued by private banks. Here’s the Bank of England: “Broad money is made up of bank deposits — which are essentially IOUs from commercial banks to households and companies — and currency — mostly IOUs from the central bank.” By referring to both currency (i.e. cash notes and coins) and bank deposits as money, the Bank is recognizing the fact that for the general public, bank deposits purchase goods and services just as well as physical cash can. One could argue that deposits actually do these things better, since cash gets awkward (physically and socially) for large purchases.

Since deposits are better for making larger purchases, it would be reasonable to assume that most of the money in the economy comes in that form. That assumption would be correct, as the briefing from the Library of Parliament reads, “Most of the money in the economy is, in fact, created within the private banking system.” The Bank of England is even more specific: “Of the two types of broad money, bank deposits make up the vast majority — 97% of the amount currently in circulation.”

Banking in the Real World

As we turn to examining how private banks actually do create the majority of money in the economy, it’s worth going through one more example of what banks do not do.

Suppose I lend $20 to a friend. I do this by giving my friend $20 in cash with the expectation that at some future date my friend will give me back $20. This is similar to what banks in the fractional reserve model do; although, if I were truly a bank and the $20 was all I had, then I could only lend out $18 and would have to keep the other $2 in reserve. But this is precisely what banks do not do. Banks do not lend out reserves or cash to their clients.

Rather, when a bank extends a loan, it simultaneously creates both an asset and a liability on its balance sheet. Here’s an example of a simplified bank balance sheet to illustrate what I’m talking about.

There are a couple of important things to take note of here. First of all, notice that both sides of the balance sheet are equal: $110 on the liabilities side is matched by $110 on the asset side. Secondly, notice that reserves are exactly 10% of deposits, meaning that the regulatory reserve requirement is being met prior to the loan being made (even though I’m showing that the fractional reserve model is incorrect, banks still have to follow regulatory requirements).

Supposing the bank makes a loan for $20. That process is shown in the balance sheet below.

As you can see, the top portion of the balance sheet remains as before, but now, we see that the bank is adding $20 to both the asset side and liability side of its balance sheet to represent the process of extending a new loan. Notice that on the asset side we are recording a new loan, while on the liability side we are creating a new deposit, which of course is new money. Now we take a look at the balance sheet after the loan is made.

Notice that the balance sheet is still balanced. Also, notice that in extending the loan, the amount of reserves did not change. There was no draw down of reserves in order to make the loan. In other words, no reserves were lent out, as the fractional reserve model assumes. The bank simply created an asset and an offsetting liability, and that liability is a deposit, which is money, brand new money. That is what the Bank of England and Canada’s Library of Parliament mean when they say that private banks create new money.

If I want to lend $20 to my friend following the logic of this banking model, I would have to write my friend an IOU worth $20. This IOU would be a promise to pay $20 in cash on demand. As you can see, this is where the hierarchy of money forcefully asserts itself. Unless my friend can use that $20 to buy goods and services and to settle debts, it will be little good to her. Bank IOUs (i.e. deposits) don’t have that problem. That’s the privilege that comes with being a bank.

Bank Lending is Not Reserve Constrained

There is one problem, however, with the above “Simplified Balance Sheet After the Loan is Made.” Notice that reserves are now less than 10% of total deposits: 10/120 = 0.833 or 8.3%. Our bank is now in violation of a regulatory requirement, or at least it will be at the end of the day if it doesn’t remedy the situation.

It’s worth mentioning here that the above bank would not be in violation of any reserve requirement in Canada as well as several other countries. That’s because the reserve requirement in these countries is 0%. That’s right, there is no reserve requirement. The only limit to bank lending, if the fractional reserve model were correct, would be the total amount of reserves. Once a bank loaned out all the reserves, that’s it, no more loans. But, as I have been arguing, that is not correct. Banks are not reserve constrained, regardless of whether there is or is not a reserve requirement.

The reason is simple: in monetary systems where central banks target the level of interest rates, they will supply whatever reserves are necessary to the banking system in order to maintain their interest rate target. We’ll come back to this.

It may appear that our above example just couldn’t happen in the real world because as soon as the bank makes that $20 loan, it is violating the reserve requirement. The bank would have to turn the customer away in order to avoid such a violation. However, banks never turn a customer away for this reason. They may turn them away for other reasons, but not because their reserves will fall below the legal minimum.

Banks make whatever loans they think are profitable and then look for the necessary reserves later. Here’s Alan Holmes, a former senior vice president of the New York Federal Reserve Bank, stating in 1969, “in the real world banks extend credit, creating deposits in the process, and look for the reserves later.” Then there’s Vítor Constâncio, Vice-President of the European Central Bank, in a speech made in 2011, “In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.”

The above example of bank lending is actually quite accurate then. Banks make their loans first and then they search for the reserves, which they can find in the overnight interbank lending market. Banks with reserve deficiencies will borrow from banks with excess reserves. If a bank with a reserve deficiency cannot find a counterparty in the interbank market to lend them the reserves, they can always turn to the central bank’s discount window.

If the banking system as a whole is running short on reserves due to increased lending activity, this will have upward pressure on the interbank interest rate, which is the central bank’s key rate that it targets in conducting monetary policy. Because the central bank wants to maintain a specific level for that key rate, it will supply the necessary reserves demanded by the banking system in order to relieve the upward pressure (I told you we’d come back to this point). The central bank is reactive in its supply of reserves rather than proactive.

Confirming the fact that the reserve requirement does not constrain bank lending, as the fractional reserve model assumes, Claudio Borio and P. Disyatat from the Bank for International Settlements write in a 2009 paper, “the level of reserves hardly figures in banks’ lending decisions,” and that the central bank will supply whatever reserves are needed by banks: “in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system” (emphasis theirs). If reserves are supplied on demand, then banks cannot be reserve constrained.

Final Remarks

Loans create deposits, which for banks, is a form of credit, and for the rest of the public, it’s money. Banks create this money by simultaneously creating an asset and liability on their balance sheet, not by handing out cash or drawing down reserves. They create the loans first, then look for the necessary reserves later. The central bank supplies whatever reserves are necessary to the banking system in order to maintain its interest rate target.

Of course, the question of what does constrain bank lending and the total supply of money — if not the reserve requirement — is still open. That will have to wait for another post. In the meantime, hopefully parliamentarians will have a chance to catch up on their monetary education, if they haven’t already.