[baobabKoodaa]

I think that's the most prudently argued response I've got on HN.

It sounds like we are mostly in agreement, but we disagree on:

1. When something should or shouldn't be called "money"

2. Will the bank - in practice - lose its money-printing ability if it behaves extremely bad

Regarding point 1, I guess we're going to just agree to disagree.

Regarding point 2, it's up to you to provide a single counter-example and prove me wrong. Theoretical arguments won't cut it here.

I'll answer some individual points below:

> I agree that money is a very ambiguous (and probably not very helpful) term, but insofar as we can consider the M1 money supply measure to be the quantity of money available in the economy at any given point in time (which is what the BoE paper is referring to when it says "money creation"), originating loans definitely creates money[0]. When you get a loan, the money lands in your demand deposit account, it's definitely "money" according to the definition of money being used in the BoE paper.

The BoE paper wasn't describing the case where a troubled bank with 0 capital makes up infinite amount of demand deposits. If such a case were to happen in practice, automated systems might initially report the amount of circulating money as infinite, but very soon someone would "correct the error".

> When a bank receives its license, it can immediately start both taking deposits and issuing loans.

This might be as it is written in Australian law, but in practice no bank is going to receive a license if it has 0 capital when starting up. Sure, it doesn't need deposits to start lending, but it still needs reserves.

> Banks lend money to each other all the time, and most loans from the central bank are against collateral such as government securities and other very liquid forms of capital[3] however the central bank will, under some circumstances, lend money to banks against the assets they have themselves created through loan origination[4]. So while my little thought experiment about "starting from $0" is not quite accurate, it's not that far off!

Well, I'd say it's far off. We're comparing "normal bank issuing loans more or less prudently" to "bank with 0 capital issuing infinite money to the chairman's wife". I would argue that your typical central bank is willing to bail out most cases in the former category, while refusing to bail out any case in the latter category.

> It may be the case that a bank that had no reserves at all would go bust because it wouldn't be able to compete with other banks, but it's certainly not the case that they all need to attract reserve deposits equal to the amount of loans they want to originate.

I'm obviously not claiming that banks need reserve deposits equal to the amount of loans they originate. I'm saying that banks need some deposits to issue loans, and I'm saying that any one individual loan is never going to be larger than the amount of reserves held by the bank. The sum of all loans might be larger than the amount of reserves held, but no single individual loan is going to be.

> They only need sufficient reserves to satisfy net flows of funds and, because they're banks, they have access to the types of credit facilities they need in order to satisfy short term liquidity shortfalls.

If a bank issues a huge loan that the customer intends to withdraw from the bank, that can cause a short term liquidity shortfall. So if you're saying the bank needs sufficient reserves to cover for potential short term liquidity shortfalls, then I suppose we are in agreement over the main question in this debate.

> loans are made independent of the banks’ reserve positions [...] Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank."

I'd be to happy to accept a single counter-example where a bank with 0 reserves issues >999999999 dollars to a family friend who then exchanges it to goods and services. Just a single example of this, and I will say I was wrong. Without a single documented case of this happening, you are essentially claiming "this could happen in theory". That's different from "this is how the world actually is today". Many things could theoretically happen in the world, but they don't, and that's not how to world is. In practice banks are constrained in their loan-making by their reserves, even if you have 9 research papers that claim otherwise "in theory".

[dools]

> Regarding point 1, I guess we're going to just agree to disagree.

I actually agree with you really, I think the term money is terrible and leads to all sorts of misunderstandings about how the world works. But in the sense of the word being used in that BoE paper, bank loans create "money" as in "money supply" as it is measured in official documents.

> 2. Will the bank - in practice - lose its money-printing ability if it behaves extremely bad

I absolutely agree that bad behaviour will (in an ideal world!) lead to the loss of a banking license (although recent events point to the contrary, "To Big To Fail" and all that -- I think that banks should have gone bankrupt and people should have gone to jail after 2008!)

But, with regulation as it stands currently, not having enough reserves to remain liquid prior to originating a loan isn't bad behaviour. In some cases banks can have a negative balance as long as it's not negative for a sustained period of time (regulations differ between jurisdictions). Capital adequacy is not the same as a reserve ratio!

> If a bank issues a huge loan that the customer intends to withdraw from the bank, that can cause a short term liquidity shortfall. So if you're saying the bank needs sufficient reserves to cover for potential short term liquidity shortfalls, then I suppose we are in agreement over the main question in this debate.

I think the key here is the sequence of events, which is subtle but crucial.

Banks don't first take deposits equal to the amount of loans they wish to originate, and then subsequently go looking for people to whom they will originate loans with those reserves as a guarantee of their ability to ensure liquidity to satisfy net flows of funds.

They originate the loans and then separately go looking for whatever funds they need to satisfy their liquidity.

Capital requirements are far more complicated than simply having a reserve ratio. They can be things like commitments of funds subordinated to demand deposit liabilities. In other words capital can be a potential source of liquidity, rather than actual reserves sitting in your account.

They also borrow from each other and from the central bank, including with self securitisation.

> I'd be to happy to accept a single counter-example where a bank with 0 reserves issues >999999999 dollars to a family friend who then exchanges it to goods and services

It doesn't have to be fraudulent in order to fit what the BoE is saying. It just needs to be the case that banks aren't constrained by their deposits, but rather their capital which can take many forms. Reserves make their operations more profitable, and if they're unprofitable enough for long enough, they'll go bust. But the statement "banks lend out reserves" is demonstrably wrong.

> In practice banks are constrained in their loan-making by their reserves, even if you have 9 research papers that claim otherwise "in theory".

I've provided reference documentation from the RBA (that's Australia's central bank) and APRA (Australia's financial regulator), and the original paper is a document produced by BoE which is the UKs central bank, so I think this is a little more than a purely theoretical argument!

I've also discussed this personally with Sean Carmody[0] who works for APRA and has a long history of working in banking with extensive experience particularly in liquidity risk management.

I'm not making it up!

EDIT: Also if you're interested, this whole lecture series is very good (gotta skip over the start with the host economist talking he rambles on a bit) but in particular lectures 6&7 address banking structure and regulation based on the work of Minksy https://www.youtube.com/playlist?list=PLnw-449iRxO-BbfN55FdO...

[0] https://www.apra.gov.au/apras-executive-and-governance

[baobabKoodaa]

> the statement "banks lend out reserves" is demonstrably wrong.

It is indeed wrong, but nobody here has made such a statement. Saying "banks lend out reserves" implies that when a bank issues a loan worth $X, their reserves are immediately reduced by $X. I've been pretty clear in my statements that their reserves are not reduced until the customer withdraws $X to another bank (which does not always happen, and even when it does happen, other customers from other banks transfer funds back into this bank, so the net flow is not always negative as multiple banks keep issuing loans and money is shuffled between banks).

> banks aren't constrained by their deposits, but rather their capital which can take many forms

Sure! I like this way of putting it.

Now, a bank which has a high amount of capital can in practice issue more loans than a bank which has a low amount of capital. And one way of increasing the bank's capital (and thus improving the bank's ability to issue loans) is increasing the bank's reserves. So there's some kind of positive correlation between a bank's reserves and its ability to issue loans, right? You mentioned yourself that a bank has to have sufficient capital to survive short term liquidity events, and issuing a large amount of loans increases the probability of such events.

> I've provided reference documentation from the RBA (that's Australia's central bank) and APRA (Australia's financial regulator), and the original paper is a document produced by BoE which is the UKs central bank, so I think this is a little more than a purely theoretical argument!

The sources you've provided describe the "general case" of banks making loans as part of normal business proceedings. The documents do not describe the extreme case of a bank issuing infinite money to the chairman's wife. I don't believe that the writers had this extreme case in mind at all when they were writing these papers. You're making the argument that the same mechanisms that enable the general case would equally apply to the extreme case. I don't believe that, and I don't believe all of the writers of those papers would agree with you either. Even if the writers are sometimes using inappropriately strong expressions like "there is no relationship between customer deposits and loan issuance", I don't believe they mean that literally (and if they do mean that literally, then I'm going to argue that the papers are wrong).

Let's go back to the concrete example: A bank is known to have lost ALL of its capital and is known to have billions in liabilities that it will never be able to pay off. The bank then issues a $10B loan to the chairman's wife. The chairman's wife then exchanges that $10B to physical yachts and aeroplanes. You believe that this can happen in practice, because you believe that the central bank would provide the reserves needed to settle the transfers, even though the central bank is aware that the bank is acting with malice and committing fraud. You believe that this behavior might "lead to the loss of a banking license", but you don't believe it might prevent yacht-buying and aeroplane-buying before the loss of banking license occurs? If I understood your position correctly, then we disagree here, and I'd be happy to change my position when a single counter-example is presented. If something like this has never happened in history, then I don't believe it can realistically happen in the future either.

The reason why I'm bringing up this extreme case is to demonstrate that clearly there is some connection between the bank's... I'm going to say capital... and its ability to issue loans. This connection also exists in less extreme cases, but it's easier for me to demonstrate with this extreme example.

[dools]

> It is indeed wrong, but nobody here has made such a statement

Really? The very first comment I replied to was:

"banks at least tell you they are loaning your deposits out"

My response:

"Side not but that’s not really how banking works. Banks create deposits when they originate loans and separately look for the assets they need in order to satisfy any regulatory requirements and net flows of funds for inter bank settlements."

Your initial response:

"No, when you take a loan out of a bank, the bank doesn't "create deposits" that it loans to you. The bank loans you existing deposits"

Are you saying there's a distinction between "banks loan you existing deposits" and "banks lend out reserves"? They seem to be the same statement to me ...

> Now, a bank which has a high amount of capital can in practice issue more loans than a bank which has a low amount of capital. And one way of increasing the bank's capital (and thus improving the bank's ability to issue loans) is increasing the bank's reserves

Yeah that's one way they can do it. Those reserves would then almost always be swapped for bonds unless there's more money to be made by loaning them to other banks (which is how the central bank sets and defends the interest rate).

> So there's some kind of positive correlation between a bank's reserves and its ability to issue loans, right? You mentioned yourself that a bank has to have sufficient capital to survive short term liquidity events, and issuing a large amount of loans increases the probability of such events.

You could, if you wanted to, have a bank that capitalised entirely with reserves, but it's way more profitable to attract reserves, lend them out to other banks who have attracted less reserves, and buy bonds with said reserves. You can use the loans you made yesterday to another bank as collateral to borrow at the discount window, for example, if you find yourself in your own liquidity crunch.

So I'd say a more accurate statement is that there is a positive correlation between a bank's ability to attract reserve deposits and its profitability, both due to additional loan origination capacity and due to low capital costs. But reserves are only one piece of the puzzle.

I would say that reserves within a bank's capital mix are similar to tyres and car safety. Having bald tyres is really unsafe, and having better tyres improves your car's safety, but there are tonnes of other ways to drive safely and there's a point at which you're over spending on tyres that won't make any difference to the overall safety of the car (don't you just love car analogies?)

> The sources you've provided describe the "general case" of banks making loans as part of normal business proceedings.

Yes agreed.

> You're making the argument that the same mechanisms that enable the general case would equally apply to the extreme case.

Not really, the part where I used "starting from scratch" as an example was to highlight that reserves increase profitability of a bank and that while, due to regulation, banks can't just start with "nothing" (they need some way to satisfy their liqudity requirements, aka capital), but the system we end up with a little while after "starting from scratch" is very similar to what we have now. The crux of the matter is that reserves increase profitability. It is almost certainly the case that a bank that always has to borrow to satisfy all liquidity requirements will go broke, so regulators don't let that happen, but also a bank which over capitlises reserves relative to loan origination (Xinja being the extreme example of that) will also fail.

The genesis of this thread was the notion that banks "lend out deposits", that's what I'm arguing against.

> but you don't believe it might prevent yacht-buying and aeroplane-buying before the loss of banking license occurs?

Well, actually probably not! Like, they couldn't do it twice, but banks are allowed to have negative reserve balances for a time. If they had been found to be fraudulent then they should go to jail (would they though?) but on the actual day that this happened, the yacht transaction would probably actually succeed. Of course, if the owner of the yacht could be traced back to the fraud committed as a willing participant then that yacht could well be siezed as part of the estate and so on, proceeds of crime and whatnot.

But if some dude really flipped and just typed in the numbers, they could do it, but it would wind up very quickly.

However there are not-too-dissimilar tactics used in banks such as appraisal fraud and liars loans. If you listen to Bill Black's recipe for control fraud it's more or less what you're describing[0], just a little slower and a little more "book cookey".

His book "The Best Way to Rob a Bank is to Own One" has many examples of control fraud. Sure it's a little more deceptive than just opening a spreadsheet and typing in the numbers, but they're totally faking capital levels in order to obtain liquidity to satisfy net flows of funds, resulting in tremendous short term profits and eventual collapse.

> The reason why I'm bringing up this extreme case is to demonstrate that clearly there is some connection between the bank's... I'm going to say capital... and its ability to issue loans. This connection also exists in less extreme cases, but it's easier for me to demonstrate with this extreme example.

Right so what you could say is there's definitely a "credit limit". If you typed in $9,999,999,999,999 into the spreadsheet and then tried to spend it all externally (meaning that none of the people you were buying from had accounts at the same bank, OR you tried to withdraw all that money as notes and coins) then that would set off some sort of warning: either you'd be trying to borrow too much too quickly from too many people, or your account would be so negative overnight that the Fed would give you a call and be like "ummmm ... no". This is pretty similar to what things might look like if you or I tried to spend too much too quickly on our AMEX card.

But "having reserve deposits" is not a pre-requisite for originating a loan. Banks can (and do!) get away with somewhat subtler forms of control fraud over a period of time that is not really that long (2 - 3 years, say) during which time executives can stash an enormous amount of cash and just leave the mess for the regulators to clean up.

There certainly are people who advocate for 100% reserve banking and an end to private credit such as Positive Money[1] but their policies are not very practical and (as per the lecture series I linked to earlier) some private credit creation is probably a good thing to have in an economy. The problem is how dominant the financial system itself (which is, ultimately, just a record keeping system) has become in terms of GDP. We need to make finance boring again!

[0] https://www.youtube.com/watch?v=ClfBxWPkBKU

[1] https://positivemoney.org it's worth noting that while I do, in general, not agree with much of what PM has to say my understanding is that they were actually quite instrumental in lobbying to get the BoE to produce the paper to which I originally linked. In their case they were motivated to "expose the reality" and shock everyone into demanding 100% reserve banking but I don't think anyone was actually all that shocked by it, except David Graeber who wrote about it https://www.theguardian.com/commentisfree/2014/mar/18/truth-... and, as luck would have it, was where I first learned about MMT in the comments section when someone linked to this youtube video https://www.youtube.com/watch?v=bTZGU9s0idM

[baobabKoodaa]

> > It is indeed wrong, but nobody here has [claimed that "banks lend out reserves"]

> Really? The very first comment I replied to was: "banks at least tell you they are loaning your deposits out"

Hmmh, you're right, that claim has been made. Also I acknowledge that I have phrased some sentences ambiguously. Specifically this one that you dug up:

> > "No, when you take a loan out of a bank, the bank doesn't "create deposits" that it loans to you. The bank loans you existing deposits"

> Are you saying there's a distinction between "banks loan you existing deposits" and "banks lend out reserves"? They seem to be the same statement to me ...

No, I wasn't trying to make that distinction in this context (in another context we were discussing a hypothetical of a newly-founded bank which might have a lot of reserves even before it has depositors, and in that context that distinction is meaningful).

I was making a distinction between the act of writing numbers on a computer, and the act of taking money out of a bank. Note that my sentence began with these words: "when you take a loan out of a bank". When I say "out", I'm referring to a cash withdrawal or bank transfer to another bank. When you withdraw your loan out of the bank, the bank needs to spend some reserves in order to settle the transfer.

You made a point that sometimes the bank acquires those reserves AFTER it issues the loan, and I take your point. You also made a point that the bank might fraudulently acquire those reserves, I accept that as well. My point wasn't really focused on when the reserves need to be available for the bank, or how the reserves were originated (deposits vs fraud vs selling off assets vs ...). My point was that when you take money out of a bank, the bank can't fake it. It needs to have some stuff that it can't make up out of thin air, and after you take that stuff, the bank no longer has that stuff.

> You could, if you wanted to, have a bank that capitalised entirely with reserves, but it's way more profitable to attract reserves, lend them out to other banks who have attracted less reserves, and buy bonds with said reserves. You can use the loans you made yesterday to another bank as collateral to borrow at the discount window, for example, if you find yourself in your own liquidity crunch.

I take your point that a bank's capital mix can consist of many different kinds of assets and reserves play only a small part. We can continue this by discussing the relationship between the bank's capital and its ability to issue loans, since that is a more accurate way of describing things.

> Right so what you could say is there's definitely a "credit limit" [...] Fed would give you a call and be like "ummmm ... no" [...] But "having reserve deposits" is not a pre-requisite for originating a loan. Banks can (and do!) get away with somewhat subtler forms of control fraud over a period of time that is not really that long (2 - 3 years, say) during which time executives can stash an enormous amount of cash and just leave the mess for the regulators to clean up.

Awesome. It sounds like we agree.

Listen, I've enjoyed this discussion so far, and I learned some things I didn't know beforehand, but it's time to call it a day. If you feel that we still disagree on some substantial points, I'd like to hear you hash it out in the form of "this is my opinion, and here is how that's different from your opinion" (articulate not only your own point of view, but also the opposing point of view, and how it is different from yours). I suspect that we're actually in agreement of all substantial points, while we might somewhat disagree on minor things like definitions for words or how easy it is to swap fake money to yachts.

[dools]

> When I say "out", I'm referring to a cash withdrawal or bank transfer to another bank. When you withdraw your loan out of the bank, the bank needs to spend some reserves in order to settle the transfer.

Agreed.

And yes, very enjoyable discussion. Peace out!