A simple explanation of how money moves around the banking system (2013)

I've been keenly interested in the subject of banks, debt, and money creation ever since I picked up a book on the subject of debt around 2006. I really appreciated having a (very faulty but nonetheless useful) mental model to apply when trying to make sense of subsequent events. I sometimes like to think that I saw the GFC coming, but was probably just primed to see how precarious our debt based financial system had become.

With my local (NZ) housing market once again appearing to be on the brink of big changes (many are suggesting a crash), my interest has been piqued again. Looking about at what is out there that can help me make sense of what's going on I rediscovered a nice little interview (from our friends at RT no doubt) that I'd recommend to anyone trying to create their own mental model to help them understand the fascinating, frustrating, and confusing reality of banking.

https://www.youtube.com/watch?v=EC0G7pY4wRE

One of the interviewees is Richard Werner - the man who introduced the concept of quantitative easing during the Japanese Financial crisis in the 90s.

Banks in a crunch don’t look for deposits. They approach the Fed’s discount window [1].

Capital requirements aim to ensure banks have enough high-quality collateral to borrow sufficient reserves in most catastrophes. (When the situation threatens to exceed that threshold, we call it a systemic event.)

[1] https://www.federalreserve.gov/regreform/discount-window.htm

This is financial Luddism. Just because something is unfamiliar doesn’t mean it’s bad.

Private money creation is necessary for a growing, dynamic economic condition. (The problem is simpler in a static or simply cyclic economy.) Growth is heterogenous. To preserve price and bank stability, you want money created where it’s needed and not in excess where it’s not. In times past, this was largely geographic: banks in the West created money faster than banks in the agrarian South. Today, the divisions are more complex: a bank serving tech companies probably creates more deposits than one serving aging manufacturers.

Centralising this function in a state apparatus has been proposed. But the central bank would have to run and then implement an economic model. Decide where and for whom to create money. This is central planning. It has a poor track record. (This is also the argument against bank concentration [1].)

[1] https://fred.stlouisfed.org/series/DDOI01USA156NWDB

This is true for the largest banks. For many smaller banks, interbank lending is cheaper than deposits. Particularly if those deposits must come from new customers.

Your model is roughly correct over long, strategic time periods. But in tactical timeframes, deposits are assumed fixed or lightly. (In fact, the post-97 role of money centre banks has been to attract deposits to then lend to smaller banks.)

The vast majority of people who benefit from bank loans are not value creators, they are rent-seekers. Value creation necessarily requires taking calculated risks and banks these days aren't willing to take any risk.... They need full collateral. It's all about existing collateral. In the short term, the safest investment you can make is to build a moat around your existing investment... But if everyone in the economy is busy building moats (because that's the only activity which is sufficiency safe for banks to fund), there will be nobody remaining to do useful stuff which moves the economy forward.