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Can’t Banks just fund themselves?

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If Banks can create money out of thin air with their loan creation process why don’t they just fund themselves and their allies? I don’t understand the need to pay interest on loans that was technically created from nothing. Can’t they just print $100 trillion and go on a spending spree around the world?

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Posted by Incognito 7
Posted on 05/04/2017 11:27 AM
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Private answer

Depends on what you mean by “fund itself”. Banks fund their operations by meeting capital requirements. They meet capital requirements by earning a profit on their assets vs their liabilities. A bank can’t operate if it doesn’t meet capital requirements. So, banks are “self funding” in the sense that they earn the profits that make their business viable.

Make sense?

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Cullen Roche Posted by Cullen Roche
Answered on 05/04/2017 12:05 PM
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    The key to understanding this is acknowledging that banks do not create money out of thin air. They create money out of debt instruments, ie customer loan contracts. You can buy things with IOUs anyway and so the money is allready there before the bank gets involved.

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    Posted by Dinero
    Answered on 05/04/2017 12:26 PM
      Private answer

      Dinero, that is wrong. Banks do create new debt instruments out of thin air. Just like corporations create stock out of thin air. But banks are only allowed to extend credit when they meet capital requirements.

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      Cullen Roche Posted by Cullen Roche
      Answered on 05/04/2017 12:54 PM
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        As I said in the comment , Bank customer loan contracts.

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        Posted by Dinero
        Answered on 05/04/2017 1:15 PM
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          An IOU is not thin air. If Peter promises to pay Paul 1 car in a years time that obligation is not worth “thin air” it is worth 1 car , discounted by time and default risk of course.

          Lets not mis-communicate. Let’s ask the poster what exactly are they asking

          is the question

          A , what is the econimc nature of Bank deposits

          or

          B, How do individual commercial banks clear deposit transactions for transfers or withdrawals.

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          Posted by Dinero
          Answered on 05/04/2017 1:23 PM
            Private answer

            He’s not asking about Peter lending to Paul. He’s asking about banks lending to Paul.

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            Cullen Roche Posted by Cullen Roche
            Answered on 05/04/2017 2:01 PM
              Private answer

              Well Banks lend from Peter to Paul with the Banks capital as the buffer against loan default.

              “Can’t they just print $100 trillion and go on a spending spree around the world?”

              They cant do that because they would not have the reserves to clear the transaction with the Global banks in the “global spending spree.”

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              Posted by Dinero
              Answered on 05/04/2017 2:19 PM
                Private answer

                Central banks provide reserves where reserve requirements require them. Not vice versa.

                Keep saying wrong comments here and I’ll delete them.

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                Cullen Roche Posted by Cullen Roche
                Answered on 05/04/2017 2:52 PM
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                  Incognito – the important thing to remember is that the money that banks create is money for their customers. They can’t print $1trillion and go on a spending spree as the $1trillion is not theirs to spend.

                  In the majority of cases, when banks create money, there needs to be two willing participants in the transaction that the money is initially going to be used for. There needs to be a person who wishes to accept credit offered by a bank – this person wishes to obtain something now from someone, but doesn’t wish to provide something in return until some point in the future. Logically it follows that there needs to be another person who is willing to provide something now, but who doesn’t wish to receive something in return until some point in the future. The first person is the one who we might say takes out a loan and the second person is the one who ends up holding the money that is created by the loan being granted, (after the initial transaction has taken place). The money he ends up holding is in the form of a bank deposit, or an IOU from the bank. He is free to spend it as he sees fit, but only he can decide what to do with it, not the bank.

                  A bank COULD go on a spending spree and purchase assets from the non bank sector, by simply crediting the accounts of those they purchase the assets from. In effect the bank has taken possession of an asset and has written an IOU to that person. But that’s not something exclusive to banks. If you can find people happy to accept an IOU that you write, you too can go on a spending spree simply by writing those IOUs. In both cases, you or the bank would end up with an asset on the LHS of the balance sheet and a liability in the form of the newly created balances in customer accounts (or your IOU) on the RHS. Assuming you bought the asset at fair value, you (or the bank) would be no better or worse off than before buying the asset (providing you intend to honour the IOUs you have written).

                  A bank could also purchase services in the same fashion, simply by crediting the account of the person supplying those services. In this case, however, there will be no asset on the LHS of the balance sheet, but there will be a new liability on the RHS. Accordingly bank capital, or banks ‘own funds’ will reduce by the purchase price of the service. The bank shareholders effectively make the purchase.

                  If a bank was feeling exceedingly generous, it could just credit some random customer’s account with a $billion or so. That really is ‘creating money out of thin air’. However this is not money the bank could use – only the lucky customer could spend it. Because the newly created money is a new liability of the bank, with no corresponding asset to offset it, bank capital, or own funds, would again reduce by an amount equal to the lucky customer’s windfall. If the bank continued with its largesse, continuing to credit customer accounts until such point that its capital was zero, it would be balance sheet insolvent and would be placed into whatever resolution mechanism was applicable. The bank’s shareholders have effectively made the gift to the lucky customer.

                  Banks make money by charging a higher rate of interest on the loans they grant (or earning a higher return on assets they purchased) than any interest that the pay on customer deposits. Out of this the have to pay all their operating expenses, with whatever being left over being their profit. This profit can be paid out as a dividend, or retained in the bank, where it will add to bank capital. Either way, it is the return shareholders make for the risks they take.

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                  Posted by Robert Pearson
                  Answered on 05/04/2017 4:33 PM
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                    For me, when I try to explain this stuff, the confusion comes from expanding the “money supply” out of whole cloth. Some people worry that this “dilutes” the value of our fiat currency. Were our currency “backed” by something (gold), then this would be the case. But we have the value of our currency compared to others via FOREX. Cullen explained the amount of “money” is actually infinite when you consider that most everything is money with different “moneyness” properties. Our fiat currency (debt dollars) are merely a method of account between the people/companies/investments/loans/gifts/etc. and has no inherent value. This is very very hard to explain to people. The banks create loans and put the loan papers on their books and sell them to others sometimes. This expands the “money supply”, whatever that is, by adding “debt dollars” to the economy. [I’m typing to the choir here.] My question still is “who is going to pay the interest?” That you have dig out of the ground, build something, make something, or grow something of more value than the fiat currency needed to do those things. If you mess up the planet via Climate Change, then paying the interest becomes imposible. But since Republicans have proven that in their minds there is no such thing as CC then there will never be a problem, instead, we must worry about the mythical “national debt” and “unwinding” the Fed’s bond holdings and “raise interest rates”. Why? Because they DO NOT understand where “money” comes from nor where is goes.

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                    Posted by Dennis
                    Answered on 05/04/2017 4:37 PM
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                      Dennis, I get concerned about the use of the term ‘fiat money’, particularly when it is used to create the impression that money has no value. The narrative usually goes along the line that fiat money is only money because some government has decreed that it be, but that commodity money and representative money is actually (or is convertible into) a very real, tangible, physical thing and therefore commodity and representative money HAS to be somehow ‘better’.

                      As I’m sure you are aware, the vast majority of money that we use is bank money – that is created out of thin air and is therefore supposedly worthless. But the vast majority of bank money is actually backed by millions of real people and companies who have pledged to supply very real and tangible goods and services in return for that bank money. They need this bank money to repay the loans they have taken out, which created the bank money in the first place. Post QE, a large part of the backing of bank money is provided by the Government (Govt IOU in favour of the central bank and then a central bank IOU in favour of the commercial banks). Now a lot of people take some re-assurance from this given that a government with its own sovereign currency can never default, but I’m not so relaxed given that a government has not pledged to provide real goods and services in the future in exchange for bank money, which is what most holders of bank money will want to exchange their bank money for. All government can do is promise to take your bank money from you and call it taxation.

                      Even paper money issued by the central bank, in a convoluted way, is backed by the same promises of future goods and services from real people and companies (and the same promise from the government that they will take it from you as taxation). I have to apologise here for being British and talking about the situation in the UK, where paper money is a liability, or IOU, from the central bank, which in normal times is backed by IOUs from commercial banks, which are in turn backed by IOUs from all those millions of real people.

                      But this then brings me on to the third form of money that the general public use here in the UK – coins. Coins in the UK are not issued by or are a liability of the central bank, but are produced and distributed by the Royal Mint, which is a wholly owned subsidiary of the Treasury. Coins are not an IOU of the Treasury, though. They will never redeem them and therefore they have no need to be backed by anything. To me, in the UK, coins are the one true form of fiat money that is widely used. They literally are tokens, with little intrinsic value, that people are happy to use because the Treasury has told them that they are money. The Treasury doesn’t make it particularly easy for you to even pay your tax bill using coins – in fact, I don’t think they will accept them these days. Commercial banks don’t have to accept them or exchange them for paper currency or deposits. Your own bank probably will, but might raise a handling charge for doing so. The Bank of England certainly won’t accept them in exchange for paper currency that it issues.

                      When you look at the spectrum of ‘moneyness’ that Cullen has introduced, I would put coins lower down the scale than bank money and paper currency, really because they are not backed by anything and nobody has guaranteed to redeem them. I’m sure most people would put them higher than bank money, because they have the Queen’s head stamped on them and they are weighty and shiny and everyone knows that they are money. Maybe not many actually give it much thought, because coins are low denomination and there aren’t actually too many out there. But what if the Treasury instructed the Royal Mint to produce a £1million coin and the Treasury started using these to pay for big infrastructure projects. What then? Would recipients of government spending look at their £1m coins and truly think it was money and worth £1m? – even if it did have the Queen’s head stamped on it.

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                      Posted by Robert Pearson
                      Answered on 05/04/2017 5:49 PM
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                        Robert, Your “But what if” is exactly the same a deficit spending. Adding an actual monetary addition to the economy, not debt dollars. But, the congress in the USA under a law written by bankers makes every dollar used by Uncle Sam must be covered by taxes or the issuance of government bonds, thus the “National Debt”. This debt is born even for material things like Dams, Roads, National Parks, Government buildings that have a “moneyness” value. Even though these items make it possible for our private sector do what it needs to do, the cost is added to the “so-called National Debt”.

                        The value is still here in the USA in form of items that were traded for fiat currency. If all the “$tuff” were it added up and subtracted from the “so-called National Debt” that Republicans worry about every minute, there would be no debt, we would be in the black.

                        This is why we are really far and away the richest country in the world that does not want to spend the money on its people. We should be able to have a wonderful situation for most everyone. The only ones that are totally worried about the value of “diluted fiat currency” are those that have more “moneyness” $tuff than they can possibly add up.

                        If we understand “moneyness”, and we understand that the relative value of our fiat currency is measured by the strength of our economy and by FOREX (traders that are trying to figure this out the relative future value of the various fiat currencies they trade).

                        If our infrastructure is bad, the people are mad, if homes are underwater (physically or economically), the animals dead, and the plants are dead, then the value of our country’s economy would go away and our fiat currency would become valueless. There are plenty of examples of this on our planet today. The money goes to the richest of us and is spent on themselves and their beliefs. If Uncle Sam invests in our country then our fiat currency would be more valuable because our economy would be more efficient, growing and not be virtually stagnant like it has been since 2007.

                        Robert: “But what if the Treasury instructed the Royal Mint to produce a £1million coin and the Treasury started using these to pay for big infrastructure projects.” That would make England/America great again — all you have to do is think instead of pleading your beliefs. The fiat currency was traded for real $tuff if we did this, and was not wasted on bombs blown up on somebody else’s property.

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                        Posted by Dennis
                        Answered on 05/04/2017 8:24 PM
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                          Robert, Your “But what if” is exactly the same a deficit spending. Adding an actual monetary addition to the economy, not debt dollars. But, the congress in the USA under a law written by bankers makes every dollar used by Uncle Sam must be covered by taxes or the issuance of government bonds, thus the “National Debt”. This debt is born even for material things like Dams, Roads, National Parks, Government buildings that have a “moneyness” value. Even though these items make it possible for our private sector do what it needs to do, the cost is added to the “so-called National Debt”.

                          The value is still here in the USA in form of items that were traded for fiat currency. If all the “$tuff” were it added up and subtracted from the “so-called National Debt” that Republicans worry about every minute, there would be no debt, we would be in the black.

                          This is why we are really far and away the richest country in the world that does not want to spend the money on its people. We should be able to have a wonderful situation for most everyone. The only ones that are totally worried about the value of “diluted fiat currency” are those that have more “moneyness” $tuff than they can possibly add up.

                          If we understand “moneyness”, and we understand that the relative value of our fiat currency is measured by the strength of our economy and by FOREX (traders that are trying to figure this out the relative future value of the various fiat currencies they trade).

                          If our infrastructure is bad, the people are mad, if homes are underwater (physically or economically), the animals dead, and the plants are dead, then the value of our country’s economy would go away and our fiat currency would become valueless. There are plenty of examples of this on our planet today. The money goes to the richest of us and is spent on themselves and their beliefs. If Uncle Sam invests in our country then our fiat currency would be more valuable because our economy would be more efficient, growing and not be virtually stagnant like it has been since 2007.

                          Robert: “But what if the Treasury instructed the Royal Mint to produce a £1million coin and the Treasury started using these to pay for big infrastructure projects.” That would make England/America great again — all you have to do is think instead of pleading your beliefs. The fiat currency was traded for real $tuff if we did this, and was not wasted on bombs blown up on somebody else’s property.

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                          Posted by Dennis
                          Answered on 05/04/2017 8:24 PM
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                            Hi Incognito 7,

                            You must be a tad confused by the responses at this point. I think the early replies were a bit too hasty and were fired off the hip. Please go down to Robert’s 1st reply. I think that will answer your question better. I will try something more terse.

                            I am carving my teeth on a loan creation example (#3) with Pliu over here:
                            http://www.pragcap.com/ama/bank-loan-payments-explanation-for-dummies/

                            If you look at these sheets you will notice how a loan increases the bank’s sheet (in BOTH assets AND!! liabilities) but that the capital remains unchanged (capital is what banks call equity in the equation equity= assets-liabilities, they have their own argot, go figure).

                            Let’s remove any capital & reserve requirements for the bank to allow it to do what you want it to do. If we didn’t, the bank would be unable to do what you want it to do.

                            But 1st, let’s address the concept of “thin air” (which is renamed by highly erudite economists who possess an expanded lexicon as Ex Nihilo; I guess they know Latin). Even Cullen uses this term. It is a term that causes members of the Austrian economics school to plead for a rebellion, destroy the Federal Reserve system, or scream about hyperinflation (or all of the above).

                            The term “thin air” is actually a bit of a misnomer. Because if a bank could truly create money out of thin air, their would be no corresponding, EQUAL & OPPOSITE liability.

                            And that’s not what happens really. A bank creates a loan out of “thin air”. Great, that is an asset. But that asset has an EQUAL & OPPOSITE LIABILITY attached to it (this is BAD).

                            So that bank could go on a spending spree, BUT, at the end of the day, that bank still MUST pay off the loan (to itself).

                            There ain’t no free lunch, hoss. Let’s not hyperventilate about hyperinflation – take deep breaths and count to 10. It’s all good.

                            Now technically, banks actually do this, subject to some pretty harsh capital/reserve requirements. The VP that sits the board of a local community bank says that they make regular purchases of municipal bonds. Why not? It’s good paper, and they make good money on the margins when they pay off their loan (to themselves). By margin, I mean, the loan they took out has an interest that is way mongo less than the interest they are making on the paper. Banks make money on interest differences.

                            Oooops, I notice that I have violated the terseness requirement. Dang it.

                            But to summarize your concern, banks can’t go “fund themselves”. At the end of the day, the damn loan STILL has to be repaid. Has to.

                            Creating loans out of “thin air” should NEVER be construed as a FREE LUNCH. That ain’t happening.

                            PS: Pulse back to normal? Now that you have your breath back again, Robert also had a very good comment about fiat currency which was off-topic but still valuable. What backs a fiat currency is NOT the good faith of the (Federal) government, it is the total kick-butt GDP, investment, and productivity of the underlying economy. Cullen has mentioned this and so has Robert. They are correct.

                            Be well (deep breaths).

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                            Posted by Poseidons Bear
                            Answered on 05/04/2017 10:09 PM
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                              Thanks for all the detailed answers but I’m afraid I still don’t quite get it. Maybe I’m just being thick, but I don’t really understand why a Bank needs to have a corresponding Liability component in its balance sheet when it creates a loan “out of thin air”. Sorry I can’t visualize this properly because I was taught to understand that Liabilities are what “you owe” and Assets are what “you own”, and that Assets = Liabilities + Equity. So WHO exactly does the Bank “owe” this corresponding Liability recorded in its balance sheet when it creates a loan and credits a $1000 loan into a Customer’s bank account? If the customer can’t pay it back, why doesn’t that just mean that the $1000 loan is destroyed and thats the end of story? Why does it negatively affect the bank that the customer defaulted on a loan that it created ex nihilo in the first place?

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                              Posted by Incognito 7
                              Answered on 05/05/2017 6:58 AM
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                                Incognito – I would love to be able to creates assets out of nothing. So would banks. So would anyone.

                                Unfortunately, there aren’t too many people out there willing to owe me money and get nothing in return. From what you write, it seems to be that you do understand, but just haven’t realised it yet! When a bank ‘creates a loan’, it can only do this with the willing agreement of its customer. The customer has to agree to and sign the promissory note that represents the loan agreement. This promissory note will lay out how much the loan is for, what interest rate is payable, when repayments have to be made etc. They are pretty standard. If the customer simply signed that agreement, he would owe all the amounts listed, but would receive nothing else in return. Great for the bank since it gets this asset for free, not so great for the customer. So, what he actually gets in return is a form of promissory note from that bank for the same amount as the loan agreement. This special promissory note is otherwise called a bank deposit. It is a special form of promissory note in that it doesn’t have a maturity date, being referred to to as a ‘zero maturity’ instrument. The promise that the bank makes is that at any point, the holder of the promissory note from the bank (otherwise called the deposit) may demand:
                                a) to be able to assign the promissory note to anyone else holding a bank account at any bank in the banking system.
                                b) to have the issuer of the promissory note switched to any other bank in the system
                                c) to exchange the promissory note for a promissory note issued by the central bank (otherwise called banknotes).

                                The bank furthermore guarantees that it and all other banks in the system will accept the deposit in repayment of any debt to any bank in the system

                                The promissory note written by the bank, the deposit, is the liability of the bank that offsets the newly acquired asset – the promissory note written by the customer.

                                All that’s really happened is the bank has bought the promissory note written by the customer and has paid for it with a promissory note it has written itself. It has bought a debt instrument with another debt instrument. At this point, neither the bank nor the customer is any better or worse off. They both have an asset (the promissory note written by the other party) and they both have an offsetting liability (the promissory note they have written). You and me could do that all day long – I would write you an IOU if you wrote me an equal IOU. There is no limit to how much we could make those IOUs for. Wouldn’t make either of is better off though.

                                Once that bank customer has the bank deposit, he can exercise any of the rights that are granted with it – most likely he will assign it to someone else, otherwise called ‘spending his money’. That deposit can circulate around the banking system, as do other deposits, but at some point the customer has to convince a holder of a deposit too assign it to him (by providing some good or service in return) so that he can take the bank up on its final guarantee – that of accepting a deposit in repayment of his loan. When that happens, both promissory notes are effectively ripped up – the loan is extinguished and the money is destroyed.

                                If the customer couldn’t or wouldn’t repay the loan – that means he has been unable to persuade holders of deposits to assign them to him in sufficient quantity, there are two things that could happen. Firstly, if banks were run with no capital, such that assets = liabilities, the bank would have to write to all holders of deposits and inform them that because a customer had defaulted, their deposits would all have to be reduced by a little bit. Now, clearly thats unacceptable, so we make sure banks have capital and all that happens when somebody defaults is that assets go down by the defaulted amount, liabilities remain unchanged and thus capital goes down. That is the negative effect on the bank, or more precisely its shareholders.

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                                Posted by Robert Pearson
                                Answered on 05/05/2017 8:24 AM
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                                  Robert,

                                  Good explanation. One of the key points made there is that banks are constrained by their capital ratios. A bank cannot simply expand its balance sheet at will because it will run into a natural capital constraint at some point. Issuing $100 trillion overnight would certainly do this to any bank in the world. They’d get a knock on the door from the local regulators the next day and they’d be fined and told to get their balance sheet back in order.

                                  So, capital requirements are the short answer for what constrains bank lending.

                                  Make sense?

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                                  Cullen Roche Posted by Cullen Roche
                                  Answered on 05/05/2017 12:53 PM
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                                    Robert, I think we are in agreement here. [fiat currnecy] “commodity money and representative money is actually (or is convertible into) a very real, tangible, physical thing”.

                                    Maybe it’s because I’m a scientist, but this is what I mean by no inherent/intrinsic value; e.g. extrinsic. The currency has printed on it a value that in the USA you can trade that fiat currency for. The value of the currency itself is extrinsic to the piece of paper. It can by law be traded for very real tangible and valuable $tuff. It’s a unit of exchange and the “value” is extrinsic to the paper it printed on.

                                    These units of exchange can be created by banks in the form of loans, and the banks get assets (the promise to pay + interest), that can be sold or kept on their books. There is an increase in the “money supply”. When the loan is paid back that increase in the “money supply” is put back to where it was, and the loan is extinguished. When I ask: Where does “money” come from? This is 90% of it. This is the blood of our worldwide economic system and extremely important.

                                    I was horribly concerned in 2008 that something very very bad was happening. New loans were going away and others were being defaulted. Now, where was our money going to come from? Were businesses going to keep running? Were businesses going to fire millions of employees?Were customers going able to buy stuff? I prayed and prayed for Obama’s bailout of GM in order to put fiat currency to work again and end this worldwide “death spiral”. Republicans were furious and fearful. That was the day I started to invest again. I had sold EVERYTHING in 2008 putting the “fiat” currency in the money markets, only to find that these were under horrible stress. That was also when I started reading Mr. Roche and understood a bit how things work.

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                                    Posted by Dennis
                                    Answered on 05/05/2017 6:25 PM
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                                      Capital regulations do indeed act as a constraint on bank lending and money creation. However, they are not a strong constraint and neither were they ever designed to be. A bank can always (try to) increase its capital by retaining profits or by persuading holders of deposits to give up those deposits in return for shares in the bank. In addition, as capital regulations currently stand, there is nothing to stop a bank lending $100 trillion to a zero risk weighted government, which would in turn create $100 trillion of new money – assuming the government spent what it had been lent. The loan to the government would be accepted as collateral by the central bank for whatever quantity of reserves as might be required given the spending patterns of the government and the ensuing holders of this new money.

                                      Of course, in that previous example the bank could only lend $100 trillion to a government if the government wished to borrow it – which brings me onto another major constraint on bank lending – a supply of willing borrowers of a high enough quality who are willing to pay an interest rate that will make extending credit to them profitable for the bank. In most cases, borrowers desire credit because they wish to take delivery of some good. service or asset in the present, but not provide something tangible in return until some point in the future. This leads on to another constraint to lending – there has to be persons willing to provide some good, service or asset in the present but not receive something tangible in return until some point in the future. These persons will end up being the holders of money that will be created by extending credit to the willing borrowers. Without a willing borrower, a willing holder of money and a bank willing and able to extend credit, there will be no transaction, no loan and no increase in the money supply.

                                      Central banks claim that they wield the ultimate constraint to bank lending and money creation by the use of monetary policy. I remain to be convinced that their influence is as great as they believe, particularly if they also have to be mindful of whatever mandates they might have for monetary and financial stability and promoting the long term economic well being of the citizens within their system. If they push rates too low they will encourage potential borrowers, but discourage potential holders of money. Conversely, if they push rates too high, they will discourage potential borrowers but encourage holders of money to hold money. Central banks really have to try and find the sweet spot for rates that balances the wishes of both borrowers and holders of money. They can’t simply decide what that sweet spot will be. Indeed Prof. Richard Werner has postulated that there is no link between real interest rates set by central banks and economic growth. He claims that he has shown this empirically, but as he himself points out, because hardly any work has been done in this area, his work has not been corroborated.

                                      One thing I think we can all agree upon though is that banks are never, ever reserve constrained when it comes to lending decisions and money creation!

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                                      Posted by Robert Pearson
                                      Answered on 05/06/2017 6:32 AM
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                                        Dennis, I think we are more or less in agreement. I too am a scientist by training (many, many years ago), who had a 20 year diversion into the world of finance. I was incredibly grateful to my science based training, which encouraged me to continually question the accepted teachings from the (self admitted) dismal scientists – the economists. There were things taught and written in texts books that I could see were plainly wrong. They might have been assumptions made in order to simplify some complicated maths, which in most cases would hold true, but in extremis would cause the resultant models to completely break down.

                                        Or, as I have discovered since my retirement, most of the descriptions in text books regarding how money is created, how it is destroyed, what it is, how banking works (loanable funds models, FRB models, money multipliers) is just plain wrong.

                                        Your last paragraph reminds me of a protracted debate I had with someone recently, who claimed to understand the money creation/destruction process, who was adamant that defaults on bank loans led to the destruction of money, but loans being repaid made the money somehow available to be lent again. Of course the reality is that loans being repaid destroys money and loans defaulting destroys capital (in the first instance). Of course, reduced levels of capital does lead to a reversal of net money creation – which is one of the reasons we ended up with QE.

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                                        Posted by Robert Pearson
                                        Answered on 05/06/2017 12:46 PM
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                                          @Icognito7: I think you need to read about the Wildcat Banking era and the populism that prompted the creation of the Federal Reserve System to understand why we have all these legal and accounting constraints on private banks so that they can’t just create up money willy nilly for their own selfish purposes.

                                          But from a broader metaphysical perspective, I’m not sure if you’re fully grokking or not that credit (i.e. reputation) is the fundamental basis for all forms of money issuance. Money itself is just a token that converts a mismatch of needs of one party vs the desires of another party over spacetime. “Fiat” just means that the reference is now directly credit itself as opposed to a indirect tangible asset.

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                                          Posted by MachineGhost
                                          Answered on 05/09/2017 10:16 PM
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                                            @Dennis: GM should have been allowed to fail because it was (and still is) very destructive to shareholder capitalism, besides violating the rule of law and wiping out the bondholders. But GM was not the primary nexus of what went wrong during the subprime crisis, so bailing it out didn’t fix those primary issues. OTOH, since you’re a Democrat, you would be undoubtedly be concerned about the social effects of a “Too Big To Fail” failure and wouldn’t want the market to clear the problem via creative destruction. It’s not like we have very good social safety nets for such traumas… they’re all the typical and ineffective government-managed jokes. Just recognize that preventing short-term pain comes at a bigger ongoing cost… are we gonna bail GM out again when all their subprime auto loans implode? Is that another social goods program or just greedy capitalism run amok again?

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                                            Posted by MachineGhost
                                            Answered on 05/09/2017 10:27 PM
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                                              @Robert: I’m pretty sure all current monetary policy theories rest upon the faux money multiplier hypothesis. I haven’t exactly done an exhaustive study to be 100% sure, but central bankers are all schooled in the same dogma.

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                                              Posted by MachineGhost
                                              Answered on 05/09/2017 10:33 PM
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                                                MachineGhost – I think you are right to say that monetary policy theories and the models that central bankers use have been based on the ILF model. It’s a problem, but one that is at least recognised and is starting to be addressed by central bankers – particularly by the Bank of England.

                                                https://bankunderground.co.uk/2015/06/30/banks-are-not-intermediaries-of-loanable-funds-and-why-this-matters/

                                                It’s not going to be straightforward – we all know how difficult it is to persuade reasonably smart people that they have to rip up their textbooks and re-learn what they have taken for granted for so many years. I liken it to those enlightened souls who, many years ago, understood that the Earth orbited the Sun, rather than the other way around, but had to persuade all those that had been taught the reverse and who clung to the notion as an act of faith.

                                                At least they no longer burn heretics at the stake!

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                                                Posted by Robert Pearson
                                                Answered on 05/10/2017 6:13 AM
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                                                  This is the best paper I’ve read on the subject

                                                  Can banks individually create money out of nothing? — The theories and the empirical evidence

                                                  Richard A. Werner

                                                  http://www.sciencedirect.com/science/article/pii/S1057521914001070

                                                  Warts and all.

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                                                  Posted by Derek Henry
                                                  Answered on 05/10/2017 5:56 PM
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                                                    Posted by MachineGhost
                                                    Answered on 05/10/2017 7:48 PM
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                                                      The reason I still don’t get this is because I’m prone to thinking in Supply and Demand terms, and also the banking books are all about fractional reserve banking. So a bank creating loans out of thin air, while creating a corresponding deposit liability, violates my current way of thinking.

                                                      I honestly don’t see why a Bank’s daily Capital adequecy ratios cannot be funded by themselves if they create loans out of thin air as we speak?

                                                      So if I decide to start a Bank tomorrow with nothing, whats exactly stopping me from loaning Elon Musk $100 trillion for his Mars trip? I don’t need anything to back it up, right? I just credit $100 trillion to Elon’s account, and write a $100 trillion deposit on my end. If Elon defaults, then no worries because 100-100 = 0 and theres equilibrium as there was no net money gained or lost in the system.

                                                      This is how I’m thinking.

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                                                      Posted by Incognito 7
                                                      Answered on 05/11/2017 3:24 AM
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                                                        You can’t start a bank with nothing. You have to post some capital to fund your operations. Then you essentially leverage your capital. Banks are capital constrained. They’re not constrained by nothing….

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                                                        Cullen Roche Posted by Cullen Roche
                                                        Answered on 05/11/2017 3:27 AM
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                                                          @Cullen I understand that, but my question is, can’t they just fund those capital requirements themselves? Or perhaps you can correct my understanding of capital requirements – I’m assuming its funding a bank’s day to day operations and capex for its operations.

                                                          And also, I’d like to come back to the topic of bankruns. Why do banks prevent withdrawals if everyone tries to withdraw their deposit at once? Shouldn’t there be any problems when they can just credit deposits at will?

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                                                          Posted by Incognito 7
                                                          Answered on 05/11/2017 3:35 AM
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                                                            Banks can raise capital by issuing more equity but that’s expensive. It’s like me spending my own money to make the bank be able to operate. It’s not free money….

                                                            Bank runs eat into their capital ratios because banks will lose cheap sources of funding. When a bank loses deposits it loses a cheap source of funding for its balance sheet. Take away all it’s deposits and a bank has to borrow at punitive rates to fund its payments. This will eat into capital over time and threatens it’s ability to meet regulations….

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                                                            Cullen Roche Posted by Cullen Roche
                                                            Answered on 05/11/2017 3:48 AM
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                                                              But don’t loans create deposits?

                                                              See, This is where I am getting confused. The causality of loans and deposits… Your explanation makes more sense if I look at it with a “customer deposits creates loans” angle…

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                                                              Posted by Incognito 7
                                                              Answered on 05/11/2017 3:56 AM
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                                                                Yes, but if my bank creates a loan with a corresponding deposit and that deposit moves to bank B then I still have to fund my my payments. I’m short deposits which are cheap and might need to borrow at a punitive rate. If I need to borrow at a punitive rate then my margins get cut which could cut into my capital.

                                                                Think of banks as just operating a payment system. Deposits are the cheapest way to fund that payment system. So, when you pay for something at my bank and your custokmer receives that payment I can find those payments very inexpensively. If that customer banks somewhere else then it could be more expensive for me so I want to attract deposits because they make my payment system more profitable.

                                                                Make sense?

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                                                                Cullen Roche Posted by Cullen Roche
                                                                Answered on 05/11/2017 4:04 AM
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                                                                  Capital Adequacy Ratio is the ratio of the value of the assets above the value of liabilities divided by value of the rest of the assets.

                                                                  In short – Banks can print liabilities they can’t print assets.

                                                                  Does that help to define the operations.

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                                                                  Posted by Dinero
                                                                  Answered on 05/11/2017 4:06 AM
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                                                                    “but my question is, can’t they just fund those capital requirements themselves?”

                                                                    The simple answer to that question is no.

                                                                    As Dinero says, capital is simply assets less liabilities. Banks can create liabilities out of thin air, but that destroys capital. Banks cannot create assets out of thin air (without creating an offsetting liability), so they can’t use this route to create capital. The main way banks create capital is to persuade holders of bank liabilities (holders of bank deposits) to give up their claim – that is the holder of the liability has to agree to destroy what is his own asset (money) and receive a certificate that says he owns a certain percentage of the bank instead. If bank liabilities go down, the identity assets less liabilities = capital tells us that capital has gone up.

                                                                    But a bank can’t simply make that happen. It cannot force holders of its own liabilities to relinquish them, it can only persuade them to do so, in return for a partial shareholding in the bank.

                                                                    Does that make things clearer?

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                                                                    Posted by Robert Pearson
                                                                    Answered on 05/11/2017 5:23 AM
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                                                                      Great feed & great topic.

                                                                      Banks can create their own capital in theory, and Barclays did it in practice (they ended up getting fined, though I’m not sure regulators really understood what was happening). Richard Werner answered this question for me once and pointed me to an example where Barclays basically lent a group of gulf state billionaires the money to buy Barclays stock. Since the billionaires turned around and purchased Barclays stock with the newly-created, loaned money, the money never really left Barclay’s balance sheet.

                                                                      Presto: instant capital, out of nowhere.

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                                                                      Posted by Erestor
                                                                      Answered on 05/11/2017 1:31 PM
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                                                                        There’s a good summary of this incident right at the beginning this article:

                                                                        http://www.thisismoney.co.uk/money/news/article-4178086/Net-closes-Barclays-chiefs-7bn-deal.html

                                                                        Kind of hilarious that Barclays is being accused of fraud on the basis that they “used its own savers’ money…”

                                                                        So yes, the regulators do not really understand what happened, they just know that something “fishy” happened.

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                                                                        Posted by Erestor
                                                                        Answered on 05/11/2017 1:36 PM
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                                                                          Man, I love how you guys always overcomplicate things. 🙂

                                                                          Let’s make it simple. A bank doesn’t create money out of thin air. You deposit a Promissary Note and the bank monetizes it. It is constrained by willing Promissary Notes. And since Promissary Notes are non-secure (AFAIK), it is ultimately a person’s or business’s credit that determines the market demand for the bank’s alchemy.

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                                                                          Posted by MachineGhost
                                                                          Answered on 05/11/2017 1:44 PM
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                                                                            P.S. Werner overhypes the “money out thin air” fallacy… its not like that in the real world. And Werner is a bit of an ideological nutcase that I’m sure doesn’t engender him to respect anymore than Dangerfield did. (Not saying he isn’t correct, but he’s obviously very biased and has a chip on his shoulder in going against the prevailing dogma.)

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                                                                            Posted by MachineGhost
                                                                            Answered on 05/11/2017 1:47 PM
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                                                                              No one is saying that bank lending isn’t constrained by anything. Of course its constrained by regulatory constraints on the supply side and creditworthiness on the demand side.

                                                                              But banks that operate within regulatory requirements with creditworthy customers absolutely create money from thin air just as corporations who operate within regulations and have creditworthy borrowers can create their own bonds and stocks from thin air.

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                                                                              Cullen Roche Posted by Cullen Roche
                                                                              Answered on 05/11/2017 1:50 PM