Bundesbank joins Bank of England in saying banks are not financial intermediaries but creators of money…

We usually understand banks as financial intermediaries which first collect deposits from surplus units and then pass them as loans  towards deficit units.

In 2014, Bank of England turned this wisdom upside down with their research. They said banks first give loans and then put deposits as liabilities to balance the balance sheet. This had massive implications on the way we thought about banking, monetary transmission and so on. The most important being we need to pay more attention on quality of loans than just mobilising deposits. More on this here.

Now it seems other central banks are catching up to this view.

Bundesbank in its monthly report reviews this literature:

The accommodative non-standard monetary policy measures taken by the Eurosystem in response to the financial and sovereign debt crisis caused the reserves of (commercial) banks in the euro area to increase sharply. In spite of this, the annual growth rate of the monetary aggregate M3 has remained at a moderate level over the past two years, reigniting interest in the connection between the creation of reserves and growth in the broader monetary aggregate.

It suffices to look at the creation of (book) money as a set of straightforward accounting entries to grasp that money and credit are created as the result of complex interactions between banks, non-banks and the central bank. And a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves or deposits at its disposal. Instead, various economic and regulatory factors constrain the process of money creation. From the perspective of banks, the creation of money is limited by the need for individual banks to lend profitably and also by micro and macroprudential regulations.

Non-banks’ demand for credit and portfolio behaviour likewise act to curtail the creation of money. The central bank influences the money and credit creation process in normal times through its interest rate policy, which affects the financing and portfolio decisions of banks and non-banks through various transmission channels. Non-standard monetary policy measures, too, have effects on the creation of money and credit. One such unconventional measure, the Eurosystem’s asset purchase programme, differs from interest rate policy in that it directly boosts the supply of reserves. Moreover, purchase programmes structured in this manner have an immediate expansionary impact (originating directly from the asset purchase) on the stock of money held by non-banks, though this effect is dampened in the euro area by the fact that the Eurosystem does not only purchase the assets from domestic non-banks.

There are also indirect effects resulting from the transmission of the purchase programme and its impact on lending and portfolio allocation. Critics point to the banking system’s capacity to create money as one of the main culprits behind destabilising financial cycles and financial crises, hence the long-standing debate about proposals to fully back deposits with central bank money, a move intended to restrict the extent to which the banking sector can create credit. It is not evident, however, that these constraints do indeed make for a financial system that is more stable overall than might in any case be achieved through targeted regulatory action. At the same time, that kind of transition to a new system would risk impairing important functions which the banking system performs for the economy and are crucial for keeping real economic growth on a steady path.

Lots of other details in the publication..

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3 Responses to “Bundesbank joins Bank of England in saying banks are not financial intermediaries but creators of money…”

  1. vikramml Says:

    There’s a Fed paper from 2010 which was similar.
    http://www.pragcap.com/your-textbooks-lied-to-you-the-money-multiplier-is-a-myth/

    The blog Pragmatic Capitalism discussed this and other monetary issues in great detail in 2010-11. The author seems to be a proponent of Monetary Realism, what is also called MMR (which is related to MMT).
    http://www.pragcap.com/monetary-realism/

    I’m not so sure of the author’s ideas but there was a great deal of discussion on monetary issues on his blog in 2010-11 which were interesting and good mental exercise, although I couldn’t digest all of it.

    • Amol Agrawal Says:

      Thanks vikramml. Please leave something for us to analyse 🙂

      • vikramml Says:

        Well, I don’t know much, if any, economics or monetary theory, but at that time, when QE was being introduced, some of these ideas were being discussed, in order to understand the effect of QE. It is interesting to see the key takeaway (which is all that I remember) from that old post being reiterated in this post. Absent my own understanding, I’ll take it as credible if the concept is gaining traction. 🙂

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