By Frances Coppola

This post by Sober Look caught my eye. It has a lovely chart which shows the considerable shortfall of lending relative to deposits in American banks:

Sober Look 1

This doesn’t look too good, does it? Why on earth aren’t banks lending? After all, it seems they have the money to do so. So what is stopping them?

Firstly, here’s a short explanation of bank lending. Under normal circumstances, deposits and loans are more-or-less equal across the banking system as a whole. This is because when a bank creates a new loan, it also creates a new balancing deposit. It creates this “from thin air”, not from existing money: banks do not “lend out” existing deposits, as is commonly thought. You can see this clearly on the chart. Until 2009, deposits and loans were roughly equal.

But since 2009 there has been a very evident change.  There is a large and growing gap between loans and deposits. So what is causing this?

Firstly, banks, households and businesses have been deleveraging. That means they are paying off (or writing off) loans and not taking on any more. Damaged banks don’t want to lend, damaged households don’t want to borrow and fearful businesses don’t want to invest. The combination of these three factors means that both the supply and the demand for loans are considerably below the levels prior to the financial crisis. This explains the evident fall in loan creation (red line) in 2009. Though the line is now rising. Seems banks are lending, actually, though not at the rate they were before the crisis.

 Secondly, the Fed has been doing QE. QE involves buying assets held by the private sector, both banks and investors. When the Fed buys from banks, the bank simply exchanges one asset (UST or MBS) for another (new reserves), and there is no change in deposits. But when the Fed buys assets from private sector investors, the purchases are intermediated through banks, and the newly-created dollars that investors receive in return for their assets are credited to their bank deposit accounts. Consequently bank deposits rise. This is the reason why the blue and red lines have diverged. Without QE, the two would have remained in sync: we would have seen a fall in both loans and deposits, since money is destroyed when loans are paid off or written off.

But, what about all those reserves on which the Fed is paying interest? Surely this is a major reason why bank lending is so far below deposit creation? After all, if banks can be paid interest on risk-free deposits at the Fed, they won’t want to lend, will they?

This chart appears to support that argument. Sober Look has “added back” to the loan line the excess reserves held by banks at the Fed:

Sober Look 2

Well, that’s amazing. Loans + excess reserves = deposits. Therefore placing excess reserves at the Fed must be crowding out lending, mustn’t it? So what we need to do is cut the interest rate on excess reserves, preferably into negative territory. Then banks will be forced to lend out the money.

No, just no. Double entry accounting is sufficient to explain this effect. It tells us absolutely nothing about the lending behavior of banks.

When the Fed buys private sector assets from investors, it not only creates new deposits, it creates new reserves. This is because a new deposit (liability) in a bank must be balanced by an equivalent asset. When banks create deposits by lending, the equivalent asset is a loan. When the Fed creates deposits by buying assets, the equivalent asset is an increase in reserves, also newly created. So it does not matter how much lending banks do, if the Fed is creating new deposit/reserve pairs by buying assets from private sector investors then deposits will ALWAYS exceed loans by the amount of those new reserves.

Of course, banks do make a few pennies in interest by paying less on deposits than they receive on reserves. So cutting interest rates on excess reserves might encourage some banks to lend more to the private sector in order to compensate for loss of earnings on the reserve/deposit spread. But they might choose to increase credit spreads instead. They could do this by cutting deposit rates, but they don’t have much room to do this, since if deposit rates are much below zero people will hoard physical cash instead. So they might raise interest rates on loans instead – which is not exactly an encouragement to households and businesses to borrow. Or they might simply absorb the cost, squeezing their profits and limiting their ability to grow their capital base by retaining earnings. I thought we wanted them to increase their capital? Hitting their profits with negative interest rates on reserves certainly isn’t going to help with this.

The volume of excess reserves in the system is what it is, and banks cannot reduce it by lending. They could reduce excess reserves by converting them to physical cash, but that would simply exchange one safe asset (reserves) for another (cash). It would make no difference whatsoever to their ability to lend. Only the Fed can reduce the amount of base money (cash + reserves) in circulation. While it continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.

Banks cannot and do not “lend out” reserves – or deposits, for that matter. And excess reserves cannot and do not “crowd out” lending. We are not “paying banks not to lend”. Positive interest on excess reserves exists because the banking system is forced to hold those reserves and pay the insurance fee for the associated deposits. It seems only reasonable that it should be paid to do so.