Yes Reserves Play a Part in Lending Power

Steve Keen has posted a new model is reponse to Mish Shedlock’s criticisms.

the “loans create deposits” and “loans and deposits precede lags” aspects of the empirically-based Post Keynesian analysis of money…means the model of Fractional Reserve Banking (FRB) is a false model of what currently happens. Instead of FRB explaining how banks are “lending out more money or gold than exists”, something else has to explain that phenomenon.

That something else is the capacity of private banks to create money… banks can’t lend from reserves, and that a system of pure private banking can result in banks creating money.

[One] way to involve reserves and try to make them part of the system is to argue that banks lend from liabilities rather than assets, and that one of its liabilities is a working capital reserve–the banking sector’s own liabilities to itself. Then you can derive a system which appears to show that banks lend from reserves {I think this is a comment on my own proposals here and Steve’s response incorporates some aspects of my proposals but he attempts to show that even then reserves play no part]…the bottom line here is that eliminating “Fractional Reserve Banking” does nothing to eliminate the capacity for banks to create money: that will exist in a purely free market system just as much as it does today.

I dont accept Steve Keen’s logic however that reserves pay no part at all in lending power. You could equally have said by the same logic that equity plays no part because his old model included no equity! Equally you could argue that collaterol and risk plays no part because it isnt modelled, or cost of funding doesn’t figure because it isnt modelled. (I hope to publish a revised model with collateral soon and am working with a former banker on the cost of funding/deposit drawdown issue). The truth is reserves play no part in the model because it isn’t modelled – circular reasoning and logical proof of nothing. This is not to argue that lending power cannot increase without reserves – it can – take the example of a bank starting out with equity but no reserves.

The issue is whether or not excess reserves increase. If they do then they are easily modelled in asset/liability terms (and I admit my first attempt was simplistic). It needs an intermediate column – required reserves – between bank reserves and working capital – if a bank (irrespective of reg requirements) sets its own reserve limit (say 10%) then their is an internal transfer from 10% of reserves to required reserves – and again an internal liability from working capital to required reserves. if then there is a increase in ‘excess reserves’ from either dropping reserve requirements or growth leading to more bank deposits there is an increase in working capital and an increase in lending power. Without this journal addition how else can economic growth cause an increase in lending – the monetary ciruit has not been closed. This also explains how bank runs reduce lending power, and how banks deleveraging reduce lending power in other banks through net deposit drawdowns. These were until now puzzles which were not explainable with the MCT pure bootsrap view of lending. We need to close the link, lending creating deposits which in turn through increasing working capital increases lending etc.

Assets Liabilities
Bk Reserves Excess  Reserves Working Capital
-Delta ER +Delta ER

(thanks to Steve for correcting me again on sign of liabilities)

From the point of view of the fundamental accounting equation the liabilities side has to be negative as lending power = anticipated assets minus liabilities +equity. The equation is always a good check if the sign is right should be.

Where ER is (1-bank reserves multiplied by the reserve ratio).

Its delta ER not ER as it’s a stock – like lending power and Equity that needs to be topped up to play any part at all. Of course the topping up comes from the reflux effect from the change in debt causing growth in the economy as a whole and creating new excess reserves which through spending boosts the lending power of the original loaning bank.

Note also there is not accounting mistake in assuming monetary growth comes from an asset not a liability, from the above all growth comes from liabilities not assets with the approach to what level of reserves to safely hold reflecting what level of money reserves to hold as liabilities to depositors and what level to hold as liabilities held against investment.

The quad accounting principles still hold as the +ER with interest is extra lending liability from the debtor to repay the loan.

Rather than in the crude ‘money multiplier’ approach saying reserves per se increase lending power it is better to say that profitability creates lending power if that profit is certain but lending power can be supplemented by excess reserves and equity and reduced by risk (which can be offset by collateral).

Rob Rawlings said in comments

‘reserves come into play when the borrower starts to spend the loaned money. People who receive this money will pay it into the bank and that bank will expect a transfer of reserves to match this. If the bank does not have them then it will have to either borrow the reserves or sell assets (such as the original loan) to acquire reserves.’

In the banking world this is called ‘deposit drawdown’ and the topping up of deposits to the reserve limit is called the ‘cost of funding’ of the loan.

However this approach was modelled mathematically over 80 years ago within an endogenous money framework – see my blog post above – and can easily be modelled within an extended/corrected version of Steves model. Though one bank loses deposits the banking system as a whole retains them. If every bank was an equal investment/deposit bank the cost of funding nets to zero – though it is prudent to account for the cost of funding (that is assuming no reflux back to deposits) as you cannot be certain of the extent to which your lending bank will directly benefit from increased deposits from other triggered by your loan.

Im sure the increased cost of funding from the rise of pure investment banking was one of the factors leading to our increased debt burden.