This is a hard hitting piece by Prof Steve Keen which questions the basic ideas on banking. It is hard hitting as he takes on Prof. Joseph Stiglitz of all people. I am ignoring the hard hitting bit and getting directly to the banking bit.
Traditionally, we are taught that banks intermediate between depositors (surplus units) and loan seekers (deficit units). So they take deposits from someone and pass them on to others as loans. It charges higher interest rates on loans than interest it pays on deposits. This spread in turn should ideally help recover operational costs and also result in profits.
Lately. this model is being questioned as too simplistic. Bank of England econs make a great case of this.
The critiques like Prof Keen say banks do nothing of this kind. They are actually originators of loans and not really intermediaries. So, they first figure who to give a loan to and deposits just become a liability entry later as money eventually gets deposited in banks. In earlier models, the flow was from deposits to loans. Now, it is the reverse from loans to deposits. It just turns things upside down.
Come to think of it, the second model actually makes sense and you wonder why it was ignored. While studying history of banking you often come to this issue- where do deposits come from? And then you are told that banks actually shaped to finance industrialisation and absolve poverty etc.. Do people have that much money that they could park money with banks?
Let’s turn the model upside down now. If banks create loans upfront and deposits follow, then things start to make more sense. The banks first gavce loans to large industrial projects which then eventually began to show as deposits in banks.
So, the problem is more of figuring who to give loans and not really from whom to get deposits. It changes the way you think about banking, monetary transmission etc.
Coming to Prof Keen’s piece. He argues how loans in recent years have led to a high private debt. In the older view, private debt does not matter but it maters greatly in the new view. We want banks to give more loans to tide the recent crisis. But with already a very high private debt, things will become more complex going ahead.
This could be the crux of India’s credit market problems too. Large NPAs kind of indicate that private debt is already high and cannot be paid. These NPAs are obviously a result of loan growth being highly aggressive in earlier times. But we seem to be obsessed pushing credit higher.