What follows is basically a re-post of the first half of this, except I’ve reworked and extended some parts for a UK audience.
How bank lending works
1. Banks do not take in deposits from savers and then lend them out. Loans create deposits. When a bank creates a loan, it simultaneously creates a deposit. This is how credit grows, by banks expanding their balance sheets.
For example. You walk into a bank and want a loan to buy a car. The loan officer approves you. He does not go and get some depositors funds and transfer them to your account. He credits your account with a deposit, and creates an asset, the loan. The bank has a new asset, the loan, and a new liability, the deposit. They created the deposit by making the loan. Two new entries have been added to the ledger, and the bank has created the money you get in your account.
2. It is often said that banks take in deposits and then lend out a proportion of it, keeping some back as reserves, but bank lending is not constrained by bank reserves. The process described above is never interrupted by the bank manager worrying about reserve requirements. The bank will get its required reserves later by borrowing them in the interbank market, or trying to attract depositors. System wide, if banks are short of required reserves, ultimately the Bank of England will have to provide them by buying bonds on the secondary market (like it has done with QE). Reserves are provided to the banking system, with a lag, following bank credit expansion.
3. The money multiplier (where it is said that if the reserve requirement is 10% for example, a bank can take a deposit of £100, then lend out £90, take that £90 as a deposit, then lend out £81 and so on) is an exploded myth. Banks never make lending decisions on the basis of their reserves. As described above, if a bank needs to meet its reserve requirement, it borrows them at the Bank of England base rate. The Bank of England will always supply reserves at the target rate (now 0.5%), and so banks don’t worry about this. If a bank is in trouble with solvency and other banks refuse to lend to them, the bank will make use of the discount window and borrow at a penalty rate. But in normal conditions when a bank’s solvency isn’t questioned, banks will acquire reserves through the overnight loan market from other banks, and the Bank of England will provision whatever reserves are required by the system-wide demand to meet their target rate.
Banks create loans, and worry about reserves later. Reserves follow private bank credit expansion, they do not lead it.
Quantitative Easing (QE)
4. When the Bank of England does QE, it purchases UK Government debt on the secondary market. This has the effect of pumping new reserves into the banking system. It’s often said that QE is inflationary, or even hyperinflationary, but this stems from a misunderstanding of the bank lending process described above. There is a belief for example that if a central bank were to inject £100bn say into the banking system, then the banks will create multiples of this amount in loans. But because, as above, the money multiplier story is a myth (at least in the way it’s presented) and because banks don’t lend out reserves, QE cannot be inflationary. This is what we have seen following QE. The government has injected £375bn of new reserves into the banking system, but the wider measure of the money supply has been growing much slower than before the crash.
The inflationary impact of QE is not clear cut, and there are those who argue it might even be slightly deflationary, as it reduces interest income to holders of government debt (gilts) because through QE the Bank of England are buying gilts on the secondary market in exchange for new reserves (which pay a lower rate of interest), which in turn reduces income and spending in the economy. This is manifested in the £35bn in gilt interest the BoE has returned to the Treasury recently, which George Osborne has decided to use to reduce the deficit rather than recycling it back into the economy.
The description of the system outlined above is not commonly understood, including by politicians, and in misunderstanding it, a lot of the policy-making that follows is often misguided and sometimes counter-productive. I think the impact that additional monetary policy can have for example is wildly overblown, and the constant references to how the banks are not lending at the moment seems to misdiagnose the reasons why this is so. Maybe a topic for another day.