Nope, Ritchie still doesn’t understand banking

Here’s he’s saying that Stiglitz is just all wrong:

As the Bank of England conceded in April 2014, the idea that banks act as intermediaries between savers and investors is just wrong. The fact that economics textbooks and economists still say they do does not, they argue, make that true: it just means that the textbooks and economists in question are wrong, they say. Which makes it all the more surprising and even shocking that here is one of the world’s leading economists making what should now be seen as an elementary error.

The reality is that banks technically do not need any deposits to make a loan: all money is created out of thin air through the process of money creation that occurs in the lending process. And money is cancelled by the repayment process. In that case banks do not allocate savers money to investment when they make loans: they create new money to provide to investors, and they have not been willing to do that.

The relationship between deposits and investment is much more remote and complex in that case. Effectively deposit taking is a service utterly distinct from lending although historically undertaken by the same institutions. What the deposit taking does provide is capital to underpin risk at very low cost. That is because money deposited in banks ceases to be the property of the depositor: it becomes the property of the bank. What the depositor is left with is a loan to a bank that may, or may not be repaid (hence the bank deposit protection schemes that would not, otherwise, be needed). So the cash deposited then becomes the bank’s risk capital in the event that they make poor lending decisions (as was seen in the case of Northern Rock). But that capital is a buffer to the bank, and not a source of funds for lending.

It is vital that these distinctions are understood now because if not serious policy errors and blame result, and we cannot afford to do that again.

He just still isn’t understanding that credit creation process, is he? By 4.30 pm on the afternoon of making a loan a bank has to have funded that loan from somewhere. That is, it must attract deposits to cover the advance it has made. It is indeed possible that the bank simply attracts back the deposit of the loan that it made, and that can be direct or through many levels of intermediaries. But it still must attract back some matching deposit. Thus there still is the matching of all deposits against all loans.

He’s got himself fixated on the very short term, what happens before the daily balancing of the books, and not grasped that there is even a longer term.

44 thoughts on “Nope, Ritchie still doesn’t understand banking”

  1. what does he think the word intermediary means?

    I do put my savings in a bank, and that bank does lend money to other people. I think that qualifies the bank as an intermediary even if strictly speaking it can make new loans without first having to round up a new depositor.

    “By 4.30 pm on the afternoon of making a loan a bank has to have funded that loan from somewhere. ”

    er, not quite right? If Barclays lend me £100 then can open a deposit account for me with £100 in it, and they don’t have to fund anything until I try to withdraw or spend that £100 in a way that does not constitute a transfer to another Barclays account holder. Which may not be at 4.30pm. (and even then, they really only have to fund net movements in and out of the bank, and they might already have the reserves needed to do so without having to attract any new deposits – not sure about this last bit)

    I agree that’s a minor detail and suspect that by “making a loan” you probably had in mind somebody drawing down that loan.

    Also you are right these people are fixating on the short term of loan creation and not thinking about what happens over time as banks expand or contract their balance sheets and manage their liabilities, and not thinking about differences between individual banks and banking system.

  2. Hi Luis

    Covered in the next sentence:

    “That is, it must attract deposits to cover the advance it has made. It is indeed possible that the bank simply attracts back the deposit of the loan that it made”

  3. @Rob

    I agree. Bank A could create huge amounts of money out of thin air and lend to Bank B (and vice versa). Bank A could then buy Europe and Bank B could buy the Americas and they could have a giant game of Risk.

  4. I’ve read a couple of end-to-end explanations of the way banks work in this area and they would both support what Murphy has written here, maybe reflecting a common political starting point for the authors. I’ve no personal attachment to this particular explanation but have no personal knowledge nor have I seen any other comprehensive explanation to set against it.

    It would be really helpful if someone here could provide a brief end-to-end explanation of this aspect of banking operations so that I, and any similarly ignorant folks, could understand the process and see wherein lie the errors of Murphy and his ilk. A reference to an existing explanation elsewhere would do just as well, if that saves reinventing this particular wheel.

    Thanks, in hope, for your help.

  5. Basically, what the guys above have said.

    Northern Crock was in no danger, because instead of returning savers their money, it could have created loans out of thin air and lent the money to them, then written off the loans.

  6. Banks don’t ” match all deposits against all loans”.This is why its called Fractional Reserve Banking (clue is in the name) Matching would produce 100% Banking .Suggest you read Murray Rothbard on Fractional Reserve Banking and stop making a fool of yourself.
    Encyclopaedia Britannica Vol 12 p359 “In the course of issuing money the commercial banks actually create it by expanding their deposits, but they are not at liberty to create all they may wish whenever they wish for the total is limited by the volume of bank reserves and by the prevailing ratio between these reserves and bank deposits- a ratio that is set by laws, regulation or custom”

  7. Tim – your post is wrong – Surely you need to either take banking out of the title completely or replace it with ‘anything’?

    Any sign of Lawrence from Guernsey this calendar year by the way?

  8. Tim,

    He just still isn’t understanding that credit creation process, is he? By 4.30 pm on the afternoon of making a loan a bank has to have funded that loan from somewhere.

    Actually, I think Richard understands the balance sheet positions of banks perfectly well.

    Reading carefully what he has just written, isn’t he just playing his usual politics?

    Para 2 is perfectly accurate – if in this context we take “money” = M4. Because it ignores all the rest of what’s going on such as offsetting loans to the individual, drawdown, banks settling with each other, circularity, etc. ie, wind up your readers: “banks are my target today”.

    Pare 3 then goes off on a tangent, which is the politics. Ie, he admits first off that it’s much more “complex” etc. That’s his “I understand this really” escape clause, if someone knowledgeable challenges him.

    He then carries out the attack – deposits not the “property” of the depositor (shocking!), savers deposits being quasi-equity (risk capital) thanks to bank deposit protection (evil banks), etc.

    I have to remind myself that he’s an FCA, not a layman.

    I think he understands the financial detail perfectly well – ie, he’s quite happy to let some of his readers draw their own (unsurprisingly erroneous!) conclusions as long as he gets his politics across…

    My two pennies worth.

  9. While it’s good to see that DBCR no longer believes in the “thin air” theory, it would be nice if he were a little less rude about it. “Constraints” is the key word.

    What I learned in Economics A-Level, so no doubt slightly out-of-date, was the following. Anyone care to confirm or otherwise?

    – Banks must cover demands for cash
    – So can create loans up to a set multiple of cash held in deposits (the multiple set was 7, which was regarded as very “safe”)
    – So, if a bank grants a mortgage, for example, of 100k, then (taking the whole system into account), demands for cash will increase by 7k
    – So the bank needs to cover the 7k through cash

    Therefore, banks can and do create money, but within hefty constraints (including the ability of the debtor to pay the loan).

    Bear in mind that the gap between interest paid and interest charged by banks would not be enough to allow bank profits.

  10. @ken

    Thanks. I now feel somewhat better informed… may need to read it a couple of times more, though. 8^)

    The BOE explanation is somewhat similar to what I have read before but, as PF suggests above, differences in emphasis may reflect a political motive.


  11. Here’s my “understanding”.

    Ritchie is right in that the bank creates the money out of thin air.

    Tim is right in that they must balance the books at the end of the day.

    Ritchie is wrong in that they cannot create as much as they like – they have a capital reserve requirement to meet.

    Tim is wrong in that the inability to exceed this ratio AT COB means they cannot exceed it.

    It just means that if they create too much and find themselves in breach of the statutory ratio at CoB, they must go out and borrow the money (see Libor) which eats into their profits.

    So banks would rather have the headache of depositors, because the depositor is unable to charge as much for the loan of their money (see banking oligopoly) as are other banks.

    In summary, Ritchie is right about the mechanics but wrong about the implications.

    Tim is right about the implications, but not because he understands the mechanics.

    Or it might be Option 3 – this is all wrong and I should get my coat.

  12. Isn’t this historically why banks used to close to customers at 3:30pm? So they could reconcile the day’s inputs and outputs, not so bankers could go home at 3:30pm.

  13. Ivor,
    It’s not quite “out of thin air” though, due to the constraints.

    Each loan requires reserves, a credible bank, a credible debtor and a credible reason for the loan. The money created has backing and a foundation.

    Anyway, where exactly is the problem? Banks do not make excessive profits in % terms. Mortgages are very cheap. Mine like many or most has a piffling rate of interest, and one that couldn’t be possible if there wasn’t some “magic” involved.

    We all know the risks of too-easy credit, but that’s a separate subject.

    Aside from “yuk-banks”, what exactly is the problem with this rather neat financial trick? And it’s not like it’s a new thing, even if many have only just found out.

  14. Having read it again, I’m not sure Tim understands the implications.

    Having to balance the books merely means that the shortfall at Bank A can be borrowed from Bank B (who may of course have created money for this purpose if they have made insufficient loans to other borrowers)

    So when Tom deposits £10, the bank is then empowered to end the day with £100 of loans on their books (assuming a capital reserve ratio of 10/1)

    They assume another £10 in deposits will arrive throughout the day and lend £200 to Dick.

    They have created £190 out of thin air.

    They are hoping to have the £20 needed (Tom’s £10 deposit and the £10 they expect will arrive that day), to underpin the £200 loan by CoB.

    But what’s this?

    Tom goes to the bank next door and deposits his £100, who is then empowered to lend Harry £1000!

    If the first bank gets to the end of the day without attracting another £10 in deposits, they have to borrow the money (see Libor)

    Likewise, if the second bank gets to the end of the day without attracting another £100 in deposits, they have to borrow the money.

    And so on – a spiral of ever-increasing collateral used to fund more and more loans until we reach peak debt and no-one can afford to service the loans anymore.

    Or as we call it…………..2016.

  15. JonD>

    It’s really pretty easy to explain the whole system, once you forget about the magic money tree bollocks. It’s much like electric light. The BoE is the generator, the National Grid, the wiring, the light-bulbs, and so-on. The banks (or ‘jooz’, to Ritchie’s lot) are the light switches. Light is created by generating electricity, transmitting it, and so-on, not by flicking a switch in your home.

    Ritchie, being a neo-Nazi, professes to believe that the banks are creating light, but it’s just antisemitic ranting with a thin disguise.

  16. @Jack C

    Agreed, except “credible” has been left to the banks to decide (admittedly under pressure to lend to the poor by politicians who wanted their votes)

    Which is where we got “sub-prime” from.

    In any case, the banks quickly realised that magicking money into existence and lending it to shmoes who wanted mortgages at 5% was a fool’s game (especially when the inevitable repossessions meant a asset disposal arseache) when compared to magicking it into existence and then “investing” it.

    Giving us a massive equity/bond bubble – lots of new cash chasing assets.

    Huge amounts of money around, with no-one left to borrow it (the consumer is at peak debt)

    So we get the velocity of money crashing (if no-one borrows it, then no-one spends it), a failure of aggregate demand and a huge bubble in various asset classes as the new money fails to soak into economic ground baked hard by debt and runs off into financial engineering instead.

    At least that’s my understanding of it, but then I am not an economist.

  17. Ivor,
    Agreed that many banks were less than sensible, but they can’t just magically create money. Otherwise they wouldn’t have run out of it.

    So, yes, the crisis was one of confidence and a lack of credibility. Banks stopped trusting each other and the works jammed up.

    The money creation process itself wasn’t at fault.

    There was a similar situation in the early 1990’s, leading to huge losses for the banks. The difference was that they still knew what they were on the hook for, what bad loan exposure they might have and so on.

    Result: write-offs and big losses announced, balance sheet corrected, red faces, then back to normal. Sadly, with some lessons unlearned (most particularly that retail banking is about being boring but safe, not red braces and coke).

  18. What *everyone* forgets is the effect of adding service charges into the mix. It allows a non regulated cash flow. With a bank with a large retail operation it could represent their total profits for the year. It also gives the bank more incentive to overleverage themselves to become the BMOC at the banker’s table by ignoring reasonable returns from lending and allowing the S.C. to carry the load.

    Unwise and foolhardy.

  19. Ivor

    Tim’s point about an individual bank hold. In the wider banking system we know they can create money which is the point of figure 1 in the BoE piece I linked to above. But within the banking system as a whole there is a limit to how much they can create based on capital requirements and profitability. Murphy is just wrong.

  20. Banks do indeed create money “out of thin air” when they make a loan. They enter a debit in the borrower’s loan account, and an offsetting credit in the borrower’s current account, the bank’s books are balanced, it’s just electronic money. There’s no need for any sort of funding at this point (there’s no minimum ‘fractional reserve’ requirement in the UK).

    However, customers who borrow money may well spend it, usually by transferring it to an account at another bank. This can happen at any time during the banking day, via the BoE’s Real-Time Gross Settlement system. When such a transfer is made, the BoE takes the money out of the bank’s settlement account with it. And the settlement account has to be kept in credit, not just at 4:30 but all the time. The BoE provides interest-free intraday lending to facilitate this, but only against high-quality collateral. Intraday funding ends at the end of the banking day: if the bank then has insufficient reserves to keep its settlement account in credit it has to borrow overnight at interest, either from the BoE or from a market counterparty.

    So a lending bank does in reality have to come up with the funds to back loans it makes to customers who choose actually to spend the money.

    However, other banks lend money too. Perhaps some of that money will be used to make payments into accounts at the bank we first thought of. So there’s no limit to the amount of money the system as a whole might be able to create.

  21. theoldgreenfascist

    The BoE appears to agree with RM. Read “Money Creation in the Modern Economy” issued by the BoE.

  22. DBC Reed is correct, so far as he goes, on this occasion. Except that he misunderstands what “match” means – fractional reserve banking *used* to require that the banks held cash (i.e. M0) equal to 8% of all loans. So if it wanted to issue a new loan for £100, it first had to get hold of an extra £8 in cash – all loans had to be matched by cash in a ratio of 100:8. Now it means that the bank’s own capital is equal to c.10% of risk-weighted assets and at least 3% (shortly to be 4%) of all loans.

  23. @ SJW
    Thanks – more lucid than the explanation I was about to proffer. However there IS a limit to the amount of money the system as a whole might be able to create due to the capital requirements imposed by governments and Basel II.

  24. theoldgreenNazi>

    No, that’s just antisemitic nonsense. As explained above, it’s like saying light switches are what make the electric lights in your house come on: it’s technically true that when you flip the switch the light comes on, but that’s ignoring the context of the electricity generation, the grid, and so-on. In fact, the switch is only the trigger, just as banks lending money is the trigger for the central bank to create more money.

    The BoE document is very clear on this, if you don’t cherry-pick a single sentence and take it entirely out of context.

  25. SJW>

    “So there’s no limit to the amount of money the system as a whole might be able to create.”

    Absolutely true, but the key point here is that all creation is done by the central bank. Banks do not create money, they can only create debts.

  26. @theoldgreenfascist

    No, the point made by the BoE is that the banking system as a whole creates money – limited by capital requirements and the need to maintain profitability to sustain capital – but that individual banks do not in that they need to find funding for any of the loan that is spent and does not become a deposit at the bank.

    Banks continue to act as intermediaries between savers and investors in the BoE piece I linked to above. Murphy is a moron.

  27. No, they don’t create money “from thin air”. They create money using existing money, and a big, purpose-built system.

    Did the banks create money when they ran out of it? No.
    Would they have done if they could? Yes.

    Simple as that.

    I know we’re all supposed to be shocked by this (actually rather old) concept, but until someone can explain why this is a Bad rather than a Good thing, I can’t see what the issue is.

  28. I agree with “Social Justice Warrior”, ken and john77.

    There are two key points:
    * Borrowed money is spent quickly.
    * Banks settle debts between each other using base-money, i.e. reserves.

    Let’s suppose I borrow £100K, most likely I will spend it soon afterwards since most large loans are to buy things, like hoses. So, it will be transferred to the bank of the person I’m buying from. At that point the gross settlement system that SJW mentions is employed. Then there’s the day of free intraday lending SJW mentions (I didn’t know about that). After that though, the bank must have base money. It can borrow that base money, but not at an attractive interest rate. So, in actual practice it needs depositors. The process is not at all far from the old idea that a bank needs deposits before it can make loans. Opposing views come from concentrating on the very short term in an unrealistic way.

    The other things mentioned come afterwards. That’s when we get into required reserves and capital requirements and the actions of the banking system as a whole. Those are separate issues.

    I don’t like the BoE’s report on money creation. It takes the “Modern Monetary Theory” approach, which is complex but provides little in the way of extra enlightenment over the conventional approach. Textbooks that don’t use MMT are a better way to learn.

  29. @ ken
    NO. They did not create money. They *pretended* that they had some real money. Iceland has jailed people.

  30. SJW

    As john77 says, an excellent and lucid explanation.

    I did once have an exchange with Ritchie on this. He got the first paragraph of yur explanation just fine, showed me the Db loana/c; Cr current a/c and everything. When I asked him, however, if that was all he asked me why else was there. Cretin

  31. @john77

    Yes, they pretended. And people do go to jail for this. But technically the money was there (it was spent on shares in AIB and it appeared as deposits).

  32. Why does the bank have to fund the loan at the end of the day? Are we assuming the loan is spent and the money goes to another bank? That’s not necessarily the case. And even if it is, what if the banks settle net? Central bank money is only a fraction of commercial bank money, and so a much smaller pile is needed to ‘fund’ loans, if by funding we mean make good on payments using that loan. Of course, if every bank is maxed out and can’t create anymore without having more central bank money then yes, it will have to fund the loan, but what happened up to that point?

  33. Seems to me a key part is his assertion that the text books are wrong, most likely he’s lining up his excuses for teaching stuff he’s made up instead of syllabus stuff for his practicing professorship

  34. James g,

    Why would someone borrow if they don’t intend to spend what they have borrowed? If a person wants some money now and some later then they will not borrow the whole amount at the start. They will borrow it incrementally, a line of credit.

    Let’s suppose that after the loan is spent the person who receives the money uses the same bank. This doesn’t change much either. That’s because this second person is most probably going to spend the money again. For example, suppose I borrow to buy shares. The person selling the shares to me will probably reinvest his proceeds.

    Of course, a small percentage of loans made don’t leave the originating bank. But, it is very small.

    The banks do settle net, but if you think about it, that doesn’t change anything.

    I don’t really understand the rest of what you’re saying. Remember, we’re not denying that banking creates money.

  35. Robert Thorpe, but this is the issue with fractional reserve banking, is it not? If everyone wanted to spend their ‘money’ at the same time it would not be possible. There has to be enough people sitting on their balances or payments cannot be cleared with actual reserves. I guess the way it is held in check overall is that a lot of this borrowed money is paid to someone who then pays off their borrowed money.

    Why doesn’t settling net change anything? It seems obvious to me that the more net settlement the less reserves banks need allowing them to increase lending without having as much reserves (as long as they all increase at roughly the same rate).

  36. All this is pretty dire. Quite a big collection of fairly well educated people and utter confusion about how money is created, not helped by the leading expert on the subject Clueless Tim Worstall.
    “No banks don’t create money” Tim Worstall 14 July 2012
    “The short explanation is that banks do just create money out of thin air” Tim Worstall 19 March 2014 (both on this blog.)
    Don’t worry children ,you go off and play.Leave all this nasty money stuff to the grown-ups ,who will screw up your lives forever .

  37. James g,

    “If everyone wanted to spend their ‘money’ at the same time it would not be possible.”

    Yes, that’s right, but that’s not the issue we’re addressing here.

    ” I guess the way it is held in check overall is that a lot of this borrowed money is paid to someone who then pays off their borrowed money.”

    Not really. What’s more important is that the banks hold assets, most of those are loans. If you’re a bank, then a mortgage is the right to a steady stream of payments.

    If a bank is doing good business then there’s no reason why all the depositors would take out all their money at once. On the other hand, if the loans the bank made aren’t being paid back, then the depositors will want their money back. Bank runs usually happen in this situation. Mostly the central bank will try to stop, it and sometimes that will fail. This is the cost of fractional reserve banking. The benefit is that it saves the cost of commodity money. Or, it saves the cost and instability of a purely fiat money system where all money is government fiat money.

    Yes, banks settling in net does reduce the amount of reserves needed by banks overall. I suppose you’re thinking that if a bank must carry more reserves then it must be safer. It doesn’t really work that way with the reserve fractions we have now. A bank may have 20% reserves and a very poor loan book. Another bank may have 10% reserves and a good loan book. The latter bank is the one I’d put my money with.

    The reserve requirement is more about enabling the central bank to target the interest rate or the amount of money. That’s through the money multiplier. The asset quality requirements are more important for preventing banks going bust. I don’t believe that asset quality regulations will ever be refined to prevent bank collapses. Banks are businesses and subject to the same problems as any other business.

  38. Robert, if a bank can create a loan on the basis that someone will give them money in the future and their house if they default, then I’d call that creating a loan without funding.

  39. @ James g
    We have ALREADY pointed out that the bank cannot create a loan unless (i) it has sufficient surplus capital (shareholders’ equity plus subordinated loans) to cover a set fraction of the loan and (ii) net deposits plus borrowings from other banks so that it’s end-of-the-day balance with BoE is positive.
    So “if” it can wave a magic wand and say “abracadabra” then … (fill in to suit your latesat fantasy).

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