How bank lending and QE actually works

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.


What are the Treasury and the Bank of England up to?

There was an interesting announcement yesterday by the Chancellor saying that excess cash held by the Bank of England’s Asset Purchase Facility will be transferred to the Exchequer.

It’s widely known that the BoE has been purchasing UK government bonds on the secondary markets via QE. To date it has bought £375bn worth. What is less known is that the Government has been paying the Bank of England interest on these bonds – around £35bn so far. Blogger Neil Wilson has written about this previously here, which Think Left drew attention to here.

These interest payments will now be returned to the Treasury on a quarterly basis, so in effect, the bonds held by the Bank of England will now be interest-free. Previously, we have been issuing more debt than we needed to in order to pay interest to the Bank of England, which was actually money the Treasury was entitled to. If it sounds crazy, it is.

George Osborne argues this change just brings the UK into line with the practice in Japan and the US. This is true in that the US Treasury regularly ‘sweeps’ the accounts of the Federal Reserve to return any profits it makes to the Treasury, but it represents something of a volte face and the timing is interesting. A while ago, I put a question to the Treasury about this via my MP and was told that profits from QE would not be returned to the Treasury until QE was ‘wound-up’. They were not able to say when they expected this to be. I had suspected Osborne was saving this up for some pre-election tax cuts, but desperation seems to have set in.

So what does this mean in practical terms? The timing is interesting, coming as it does just a couple of weeks before the Autumn statement, when the OBR was expected to announce that Osborne would miss his debt and deficit targets. As Duncan Weldon argues, this change could mean that Osborne could now remain on course. The payments from the BoE will mean the deficit will be lower than it otherwise would, and it looks like Osborne will not use this money to increase spending, but instead to reduce the amount he borrows externally. This appears to be a purely political move though, as good economics would say this money would be better spent on capital projects, direct job creation, or tax cuts for low earners.

There is a complicating factor here however, in that the Treasury ‘indemnifies’ the Asset Purchase Facility, meaning that if the BoE makes any losses when unwinding QE (if it sells bonds back to the markets for less than it paid for them), then the Treasury would have to cover the losses. So while this may be a short term (political) benefit to Osborne, in the longer term, it may actually end up costing the Treasury more. In reality though, I think it unlikely that QE will be unwound any time soon (in the next five years at least).

If all this sounds confusing, don’t worry, it is. Making the Bank of England a separate entity from the government means that it looks like the debt is a lot higher than it actually is. Officially, the national debt is over £1 trillion, but if the Bank of England consolidated its balance sheet with HM Treasury under the rules in IFRS-10 (h/t Neil Wilson again), the debt goes down to around £700m.

A lot of commentators reacted to the news quite hysterically by announcing that the Government had finally lost the plot and resorted to ‘printing money’ again. Jeremy Warner in the Telegraph was one of the first here (although he later rowed back somewhat). This is not what is happening though, and we are just bringing ourselves into line with the US and Japan, although as I said, the timing is interesting.

I’ve argued before that a lot of the hysteria about government debt is irrational. As the government issues sterling, it can never run out of money, neither does it need to tax or borrow in order to finance it’s spending. This latest announcement is just another reminder that much of ‘the debt’ is not really debt at all and certainly isn’t a burden on future generations.