Reserves Don’t Constrain Lending – But cash flow, cost of capital and credit risk does – John Carney

John Carney offers important insights as a former banker on the issue of whether reserves constrain lending – worth reading in full. The argument being one made over a century ago – even with endogenous money there will be a cash flow constraint on further lending and this is influenced by the setting of interest rates – but this is a weak means of controlling the money supply.

The idea that banks are not constrained by reserve levels—because they can always borrow required reserves should they fall short—shouldn’t leave anyone with the impression that banks do not face serious constraints on their lending.

The biggest constraint on lending is the basic business model of banking.

When I was a banking lawyer, we usually referred to this as “cost plus lending.” The idea was that the bank’s source of profit was charging more for loans than it cost the bank to make the loan.

This sounds pretty simple until you start thinking about the source of the costs to make a loan. The first cost, of course, is what’s known as “the cost of funding”—the amount the bank must pay to borrow the reserves required to make loans.

But there are a host of non-funding costs as well. The bank must also somehow acquire the regulatory capital to back the loan, and capital can be expensive. The bank faces administrative costs in making the loan. Bankers must be paid. There may also be various taxes and government fees that apply.

Banks also face interest rate risk that they attempt to hedge by either borrowing funds at durations that match the term of the loan they are making—which raises the bank’s cost of funding—or making floating rate loans. But with very large loans, banks will often require floating rate borrowers to hedge against interest rate risk themselves—since you don’t want your borrower defaulting just because rates have increased. The price of interest rate hedging also has to be figured into the borrowers ability to pay the loan.

These aren’t trivial costs. The best estimate is that these add up to almost 300 basis points—the spread between the Fed Funds rate and the Prime Rate.

This means that even if banks can make loans out of thin air, there are plenty of loans that a bank cannot make. Or, to put it differently, if a bank makes too many of these loans it will lose money and eventually fail. A person or business whose free cash flow is too light to support the costs of the loan, for example, is not credit worthy—that is, not eligible to receive a loan under most circumstances.

This is one way that monetary policy works to encourage more lending. When monetary policy brings down the price of banks borrowing reserves—that is, reduces the Feds Funds rate—it brings down the cost of making loans. This means some borrowers will be credit worthy at lower rates that wouldn’t make the cut at higher rates.

The flip side of this is that potential borrowers must also see opportunities to put bank loans to work. If they view potential for future profit as weak, the demand for new loans shrinks. Of course, monetary policy plays a role here too. Low rates can make otherwise uneconomic projects work and, as the Austrians put it, may send a signal that there is more saving in the economy available for future spending. (Although, I would add, that under our current system of Fed manipulated interest rates and endogenous money creation by banks, this is almost certain to be a false signal.)

Banks also must price in the “credit risk” of making a loan—the risk that the borrowers may default, either because the collateral for the loan becomes so undervalued that the borrower “walks away” or because cash flow fall short of what is needed to make the loan.

Credit risk depends both on the individual character of each borrower and the general economic prospects. Rising unemployment, fall in consumer demand, the plausibility of management’s business plans all feed into credit risk.

Evidence indicates that credit risk, interest rate risk and other costs of lending exercise very strong influences over lending. The stuff the Fed tends to influence most directly—the cost of funding—can be overwhelmed by the credit risk and cost of capital.

As Christina and David Romer showed in this 1994 paper, banks have shown that they can maintain high lending levels even when policy is tightening. And, as we’ve seen recently, banks can maintain low lending levels (relative to reserves) even when policy is loosening.

To put it differently, banks are not free to create money willy-nilly. They are subject to restraints imposed by both the markets and regulators. But under current procedures, these restraints do not arise from a hard limit on the amount of reserves in the system. They arise from the costs of lending, which is conditioned by (a) the interest rate targeted by the Fed, (b) regulatory and market capital requirements and the market price for bank capital, (c) by back-office administrative and hedging costs of lending, and (d) the credit-worthiness and credit-hungriness of borrowers.

Is this banking mysticism then – imagining as Krugman asserts that different rules apply to banks than the rest of the economy. No Carneys ‘Cost plus lending’ model is exactly the same ‘cost plus’ balance sheet model of profits that Post-Keynesians have always asserted.  Banks are firms whose product is money – they follow the same rules as any other firm – firms produce physical goods, banks and other financial intermediaries produce money.



What is more you will spot we have a missing piece to the jigsaw – a theory of interest rates, cost plus=risk adjusted NPV of loan over period (very similar to Fisher).

5 thoughts on “Reserves Don’t Constrain Lending – But cash flow, cost of capital and credit risk does – John Carney

  1. One of the great things that’s come out of the past few days of argument is a clear explanation of how banks work. And not just conventional banks. Everyone should now have a handle on loan sharks, credit unions, building societies, investment banks, you-name-it. The basic cost-plus business model applies to them all. And it’s a “loans-create-deposits” model.

  2. Granted. But I would emphasise the word “slightly”. When you come down to it they still need to take in more from their borrowers than they pay to their savers, so it’s still a cost-plus model.

    The difference as I see it would be that Credit Unions or Building Societies have to loan at a higher interest rate than they pay out to their savers to make a profit whereas a fractional reserve bank can also make a profit by loaning $10 at 5% while only borrowing $1 at 5% as reserve support.

    The full reserve condition also means that they can legally create no more new money than their savers have deposited with them at the time of the loan. But some of those savers could be the recipients of funds from some of their borrowers, so it is still possible for them to legally create an indefinitely large amount of new money over time, albeit it would take them more loan/deposit cycles to create the same amount of new money as a fractional reserve bank.

  3. “The difference as I see it would be that Credit Unions or Building Societies have to loan at a higher interest rate than they pay out to their savers to make a profit whereas a fractional reserve bank can also make a profit by loaning $10 at 5% while only borrowing $1 at 5% as reserve support.”

    The difference is much more subtle than that.

    Commercial banks are limited by capital, and capital is somebody’s savings. Therefore banks do have a ‘capital multiplier’. The difference with Building Societies is that a bank’s ‘capital multiplier’ is instant, whereas the ‘deposit multiplier’ of the Building Societies takes some work. And that may generate a small time difference between the banks and the Building Societies as to how fast they can get their loans into the system.

    Having said that modern financial innovation has narrowed that gap. It’s near unheard of these days to go into a Building Society for a loan and be told to come back next month. Yet that was very common thirty or forty years ago.

    Both banks and building societies create new credit money in a similar fashion. The backing mechanism is slightly different but the end result is the same. Possibly building societies might be slightly slower at generating the loans because they have a couple more hoops to jump through, but I suspect those are masked by the time required for the administrative overhead of credit checking anyway.

  4. Thanks, Neil. I was trying to say some of that in my final paragraph. But did not manage to do so as fully or clearly as you did.

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