POINT 1: THE BANK IS NOT LENDING ANYTHING IT HAS: WHEN PROVIDING CREDIT SERVICES, THE BANK SWAPS PROMISSORY NOTES
ΔAssets ΔLiabilities and Net Worth
30‐year 5% mortgage note of #1: +$100 Reserves: ‐$100
Household#1 is borrowing cash from the bank. But what happened is this:
Bank A
ΔAssets ΔLiabilities and Net Worth
30‐year 5% mortgage note of #1: +$100 Bank account of #1: +$100
One may ask: Is there not an indirect lending of reserves though? After #1 gets its account credited, it could withdraw reserves and make a cash payment to #2. #1 would then have to get reserves back to A. The answer is no for two reasons:
‐ We have just seen that in practice the bank makes the payment for #1. That payment does not need to result into any reserve drainage (it did not above).
‐ As shown below, #1 does not have to give back reserves to A to repay its debt, and #1 rarely, if ever, does so in practice.
POINT 2: THE BANK DOES NOT NEED ANY RESERVES TO PROVIDE CREDIT SERVICES
While it may need reserves to provide payment services (that is to transfer funds to #2), A does not need any reserves to provide credit services to #1. All it does with household #1 is to exchange promissory notes:
‐ The household makes the following promise: pay 5% interest on the outstanding mortgage value for 30 years and repay some of the principal every month.
‐ The bank makes the following two promises:
o To convert bank accounts into Federal Reserve notes at the will of the account holders
o To accept its own promissory note when #1 services the mortgage.
All these are promises and none of the issuers has to have what is needed to fulfill the promise right away when he issues his promissory notes. That is the point of finance; it is about banking on the future (see Chapter 8).
Think of a pizza shop that issues coupons for a free pizza. The shop does not have to make pizzas first before it issues the coupons; it will make pizzas only if people show up with coupons.
Converting the coupons into pizzas is costly for the shop and so affects its profitability, but the issuance of coupons is not constrained by the current availability to pizzas. The shop is just making a promise and anybody can make any kind of promise. The hard parts are, first, to convince someone of the genuineness of this promise and, second, to fulfill the promise once it has been relatively stable but the Volcker experiment shows that a central bank may make reserves prohibitively expensive.
POINT 3: THE BANK IS NOT USING “OTHER PEOPLE’S MONEY”: IT IS NOT A FINANCIAL INTERMEDIARY BETWEEN SAVERS AND INVESTORS
This is a development of the first and second point. A view of banking, from which the word
“lending” probably comes from, is that banks are intermediaries between savers and investors.
Some people come to deposit cash and then banks lend the cash. It is quite clear that a bank is not lending any funds that some deposited (nobody deposited anything in our example). And, worse offender, a bank is certainly not using others’ bank accounts to grant credit. Assume that household
#3 comes to bank A to get a $100 credit, A never does this:
Bank A
ΔAssets ΔLiabilities and Net Worth
Bank account of #2: ‐$100
Bank account of #3: +$100
That is, it does not take the funds of #2 and give them to #3. This t‐account would be a payment from #2 to #3, not a credit by bank A. To provide a credit is exactly what credit means, it is about crediting accounts. The crediting is done by typing a number on the computer. Once this number is
Banks do not wait for depositors before they engage in the provision of credit services. Say household #3 comes to open an account by depositing $50 worth of Federal Reserve notes. The following occurs:
Bank A
ΔAssets ΔLiabilities and Net Worth
Reserves: +$50 Bank account of #3: +$50
This deposit does not enhance the ability to provide credit services because A is not in the business
‐ If a bank participates in an auction of Treasuries, the Treasury only accepts federal funds in payment. In the past, the Treasury sometimes allowed banks to pay for the Treasuries by crediting the TT&Ls (another cash management method used for monetary‐policy purpose beyond the ones presented in Chapter 6), but it no longer does since 1989.
‐ if it buys promissory notes from another bank
In the first case, the balance sheet changes as follows (says the bank buys $10 worth of Treasuries from the Treasury)
Bank A
ΔAssets ΔLiabilities and Net Worth
Reserves: ‐$10 Treasuries: +$10
And on the balance sheet of the Fed the following occurs
Fed
ΔAssets ΔLiabilities and Net Worth
Reserve: ‐$10
TGA: +$10 And the Treasury:
Treasury
ΔAssets ΔLiabilities and Net Worth
TGA: +$10 Treasuries: +$10
Chapter 6 showed that the Fed always ensures that banks have enough reserves to make the auction successful. The supply of Federal Reserve notes by savers is irrelevant for the success of auctions of Treasuries.
POINT 4: THE BANK’S PROMISSORY NOTE IS IN HIGH DEMAND
Why did #1 enter in an agreement with A? Because nobody else would accept #1’s promissory note and a large number of economic units accepts A’s promissory note (if someone does not, A offers
conversion into cash that most accept in payments). Chapter 15 explains why bank monetary instruments are widely accepted.
If #2 had been willing to accept #1’s promissory note then none of the previous agreement would have been needed. The problems with #1’s promissory note are two fold:
‐ There is a credit risk: #2 is not sure that it will get paid the interest due and that it will be able to make payments to #1 by giving back to #1 its promissory note. If #2 knew that it would become heavily indebted ($100 is a lot in our example) to #1 in the future, then assuming that #1 is creditworthy, #2 may be willing to accept #1’s promissory note for the payment of the house. Later #2 could use #1’s promissory note to pay debts owed to #1.
‐ There is a liquidity risk: the promissory note only comes due in 30 years so household #1 does not have to take it back before that time (though it could because mortgage notes usually allow accelerated repayment of principal). In the meantime, #2 is stuck with this promissory note that nobody else will accept.
Bank A’s promissory note is due at any time the bearer wants (it converts into cash on demand and it can be used to pay the bank at any time) and the creditworthiness of a bank is strong. This is all the more so given that the government guarantees that A’s promissory note can always be converted into Federal Reserve notes at par, and that the (nominal) value of A’s promissory note will not fall even if A goes bankrupt. All this makes the A’s promissory note free of credit risk and perfectly liquid.