Let’s start with a basic bank and its customer and do T-accounts for both. The bank creates a loan and a deposit “out of thin air,” and the customer has now a new liability (the loan) and an asset (the deposit) as shown in Figure 1.
As is well known, and by the logic of double-entry accounting, the bank does make a loan out of thin air—no prior deposits or reserves necessary. (...)
Krugman:
“Yes, a loan normally gets deposited in another bank”
Actually, a loan doesn’t get deposited in another bank—a
deposit gets deposited in another bank. The loan is a bank’s asset, and a deposit is a bank’s liability. Here we see the very beginnings of the importance of remaining clear on accounting if one wants to truly understand what “loans create deposits” means. If we assume, as per Krugman’s example, that Customer 1 takes the proceeds of the loan and
deposits them in, say, Bank B, then we have Figure 2 below:
This is a bit more complicated than Krugman made it sound, isn’t it? Let’s walk through this slowly.
Customer 1 withdraws the deposit from Bank A, which is the “-Deposit” on Bank A’s liability/equity side, and the “-Deposit @ Bank A” on Customer 1’s asset side. Customer 1 then makes a deposit in Bank B, which is the “+Deposit @ Bank B” on Customer 1’s asset side and the “+Deposit” on Bank B’s liability.
But how does the deposit get from Bank A to Bank B? Let’s assume it’s done by electronic transfer here (that is, Customer 1 instructs Bank A to transfer the funds from the account at Bank A to the account at Bank B) since Krugman wants to discuss currency withdrawals below. Note that as far as the banks are concerned, this is the equivalent to Customer 1 spending the proceeds of the loan and the recipient of the spending being another customer that banks at Bank B—that is, in either case the deposit simply moves from Bank A to Bank B.
Now, let’s also assume that Bank A had no reserve balances on hand when it made the loan. How does it transfer reserve balances to Bank B? As it turns out, the Fed provides an overdraft for any payment sent in which a bank’s account goes below zero—that is, the payment is never rejected when it occurs on the Fed’s books. The Fed does this as part of its legal obligation to promote stability in the payments system (more on this in a minute). The rub is that the Fed requires Bank A to clear this overdraft by the end of the day, which Bank A will most likely do in the money markets (such as the federal funds market, often via pre-established lines of credit). So, on the liability/equity side for Bank A, we end with “+Borrowings” in the money market to clear the overdraft.
Note underneath Bank A’s balance sheet I’ve shown the totals or net changes to its balance sheet overall, which is simply
a loan created offset by borrowings in the money markets on the liability/equity side. So, the loan was made without Bank A ever needing to meet reserve requirements, without needing reserve balances before making the loan, and without needing any deposits. Can Bank A just continue to make loans forever this way without ever needing any of these?
The key here is to understand the business model of banking—which is to earn more on assets than is paid on liabilities, and to hold as little capital (equity) as possible (since that’s generally more expensive than assets). The most profitable way to do this is to make loans (that are paid back, obviously, so credit analysis is an important part of this) that are offset by deposits, since deposits are the cheapest liability; borrowings in money markets would be more expensive, generally. So, Bank A, if it is not able to acquire deposits is not operationally constrained in making the loan, but it will find that this loan is less profitable than if it could acquire deposits to replace the borrowings.
If Bank A wants a more profitable loan but is not able to acquire deposits, it can raise the rate charged to Customer 1 and thereby preserve its spread, which can result in Customer 1 taking his/her business elsewhere. But it can still make the loan. In other words, it is not deposits or reserve balances that constrain lending, but rather a bank’s own choice to lend given the perceived profitability of a loan—
which can be affected by the ability to obtain deposits after the loan is made—and also given a perceived creditworthy borrower (someone has to want to borrow, after all, if a loan is going to be made) and sufficient capital (since regulators will want the bank to hold equity against the loan).
