It certainly creates a new deposit, which is a type of money, but I've made the mistake before of thinking that this is an increase in the total money stock ("money supply"). It turns out it isn't.
If you look at the definition of M1 (see https://en.wikipedia.org/wiki/Money_supply#M0 and scroll up to the table), you'll see it doesn't include cash and reserves held by banks. So M1 is actually unchanged by someone depositing cash at the bank. Deposits go up, but cash in circulation outside the banking system goes down.
Thanks. I wasn't talking about the money stock or any particular measure of it. Maybe I should have made that clear.
My point is that the deposit claim is a newly created money instrument that didn't exist before. And this is true whether you deposited physical cash from under your mattress or just deposited money as it was being lent to you.
Another way to understand banking is that they borrow interest free credit and use it to buy assets like bonds and loan contracts. This credit creation amount is leverage based on their investor bank capital, not customer deposits. So when they find an asset to purchase they merely record the credit creation as a loan they must pay back and this is why the majority of their purchases are as secure as possible, usually backed by an asset itself, like a house, the car, biz assets, or the faith of the government. They are limited to these secure assets otherwise they would take too many risks and suffer insolvency more often due to leverage of up to 30x (BIS 3% capital adequacy ratios)
Thanks for your comment, Remzi. I think that’s exactly right. Banks borrow at a lower interest rate (not always zero) than they lend. In other words, they pay less interest on their liabilities (e.g., deposits) than they receive on their assets (e.g., loans, bonds, etc.). The interest rate spread is what makes it possible for the banking business to be profitable. That interest rate spread incorporates the price that banks are being paid to supply liquidity to the market. They’re being paid to take liquidity risk (and other risks) onto their own balance sheets.
We need to be careful with concepts like leverage and solvency, though. Both of these concepts require adding up the total value of your assets and the total value of your liabilities and summing them into single numbers. This causes us to lose information about the time patterns of cash flows and cash commitments, which is super critical for understanding the health of your balance sheet. If regulations only pay attention to leverage and solvency, they’re going to fail to address important liquidity risks.
It’s true that if you have no debt, then you have no leverage, and you are solvent by construction. Furthermore, you have no liquidity problems because you have no cash commitments that you need to meet. But once you have any debt on your balance sheet, the timing of your cash flows and cash commitments really starts to matter. For assets whose price is marked to market, the amount of cash you can get for those assets depends entirely on market conditions at the exact moment you want to sell.
Perry Mehrling sometimes says that “solvency is accounting fiction, but liquidity is market fact.” And I think that’s exactly right. What matters is whether you can meet your obligations. That’s about liquidity. You can be solvent or not, depending on how you measure the value of your assets. Are you marking to market? Are you discounting the value of future cash flows? Some combination of the two? If you can’t make a payment, does it even really matter that you’re “fundamentally solvent” according to some measure? And as long as you can make your payments, does it matter that according to someone’s accounting, you’re actually insolvent?
Not really.
I talked a little bit about how the money view thinks about assets and liabilities in one of my previous posts.
Obviously, there are certain assets (e.g. stocks) that are entirely marked-to-market. They don’t have a pre-defined timing of cash flows. The timing of the cash flow is “whenever you sell the asset,” and the size of the cash flow is “whatever the price happens to be at the moment of sale.” In that case, your ability to liquidate the asset at a reasonable price is entirely a story of market liquidity.
"Depositing money in a bank creates new money."
It certainly creates a new deposit, which is a type of money, but I've made the mistake before of thinking that this is an increase in the total money stock ("money supply"). It turns out it isn't.
If you look at the definition of M1 (see https://en.wikipedia.org/wiki/Money_supply#M0 and scroll up to the table), you'll see it doesn't include cash and reserves held by banks. So M1 is actually unchanged by someone depositing cash at the bank. Deposits go up, but cash in circulation outside the banking system goes down.
Thanks. I wasn't talking about the money stock or any particular measure of it. Maybe I should have made that clear.
My point is that the deposit claim is a newly created money instrument that didn't exist before. And this is true whether you deposited physical cash from under your mattress or just deposited money as it was being lent to you.
Another way to understand banking is that they borrow interest free credit and use it to buy assets like bonds and loan contracts. This credit creation amount is leverage based on their investor bank capital, not customer deposits. So when they find an asset to purchase they merely record the credit creation as a loan they must pay back and this is why the majority of their purchases are as secure as possible, usually backed by an asset itself, like a house, the car, biz assets, or the faith of the government. They are limited to these secure assets otherwise they would take too many risks and suffer insolvency more often due to leverage of up to 30x (BIS 3% capital adequacy ratios)
Thanks for your comment, Remzi. I think that’s exactly right. Banks borrow at a lower interest rate (not always zero) than they lend. In other words, they pay less interest on their liabilities (e.g., deposits) than they receive on their assets (e.g., loans, bonds, etc.). The interest rate spread is what makes it possible for the banking business to be profitable. That interest rate spread incorporates the price that banks are being paid to supply liquidity to the market. They’re being paid to take liquidity risk (and other risks) onto their own balance sheets.
We need to be careful with concepts like leverage and solvency, though. Both of these concepts require adding up the total value of your assets and the total value of your liabilities and summing them into single numbers. This causes us to lose information about the time patterns of cash flows and cash commitments, which is super critical for understanding the health of your balance sheet. If regulations only pay attention to leverage and solvency, they’re going to fail to address important liquidity risks.
It’s true that if you have no debt, then you have no leverage, and you are solvent by construction. Furthermore, you have no liquidity problems because you have no cash commitments that you need to meet. But once you have any debt on your balance sheet, the timing of your cash flows and cash commitments really starts to matter. For assets whose price is marked to market, the amount of cash you can get for those assets depends entirely on market conditions at the exact moment you want to sell.
Perry Mehrling sometimes says that “solvency is accounting fiction, but liquidity is market fact.” And I think that’s exactly right. What matters is whether you can meet your obligations. That’s about liquidity. You can be solvent or not, depending on how you measure the value of your assets. Are you marking to market? Are you discounting the value of future cash flows? Some combination of the two? If you can’t make a payment, does it even really matter that you’re “fundamentally solvent” according to some measure? And as long as you can make your payments, does it matter that according to someone’s accounting, you’re actually insolvent?
Not really.
I talked a little bit about how the money view thinks about assets and liabilities in one of my previous posts.
https://survivalconstraint.substack.com/p/balancing-act
Obviously, there are certain assets (e.g. stocks) that are entirely marked-to-market. They don’t have a pre-defined timing of cash flows. The timing of the cash flow is “whenever you sell the asset,” and the size of the cash flow is “whatever the price happens to be at the moment of sale.” In that case, your ability to liquidate the asset at a reasonable price is entirely a story of market liquidity.