Just to be clear, what makes a bank is not really lending, anyone can lend money (you might not necessarily be able to write a mortgage depending on the jurisdiction though). And there are lots of non-banks that lend money routinely, starting with car makers credit arms.
What makes a bank is taking deposits (that's what requires a banking license). And banks are competitive at lending because they can fund cheaply with deposits.
> banks are competitive at lending because they can fund cheaply with deposits.
This was my understanding until I read this article[1] which essentially asserts that banks’ primary function is to create money to be lent out. True, banks did start out as deposit taking entities which they still continue. However, banks don't make much profit from deposits. In fact deposits, being liabilities, cost them money to keep them safe. They keep those deposits in short term fixed investment funds, most of the long term loans made by a bank are from money created by itself.
That article is from none other than the Bank of England.
This is a pretty bad explanation. In almost all cases the deposit created is taken, sent elsewhere and reduces a loan somewhere. The document does explain this a little way down.
The original statement about cheaply funding loans with deposits is spot on. Look at any of the big four banks - they all have over a trillion dollars of deposits at 10-15 bps which they then lend at a few %.
Similar assertion (i.e., money is created by commercial banks) is made in this book too [1]. It is in the context of working of The Federal Reserve. The author worked is a former fed trader.
> the deposit created is taken, sent elsewhere and reduces a loan somewhere.
Sure, but that doesn't imply the converse (i.e., a loan is made from deposit), does it?
> they all have over a trillion dollars of deposits at 10-15 bps which they then lend at a few %.
It is not clear (to me at least) if the money they lent out is indeed from the deposits they took.
"money is created" doesn't mean what you think it means. The definition of "money' used by central bankers isn't the same definition which is used by regular folks in a common sense manner.
Take a look at the balance sheet of any of the big public banks. The assets on their books (mostly loans) has to add up to the equity on their books + liabilities (mostly deposits). If they didn't have all those deposits, what would they use to plug the hole? They could borrow money from elsewhere, but it would be more expensive and less sticky.
Yes they do need them, because they are cheap and long term (technically they are overnight but in practice, banks and regulators assume limited retail run-on-the-bank, so they are effectively long term liabilities).
If you don't have deposits, the only three ways a bank can fund are
a) issuing term wholesale funding (i.e. issuing bonds, no liquidity risk but expensive, if not uneconomical),
b) short term wholesale funding (money markets, cheap but dangerous, what happens if the wholesale funding market dries up like in 2008?). Banks are now prevented from taking too much of that risk by the introduction of the LCR ratio (which requires them to keep in liquid asset the equivalent of a 30 days bank run) and the NSFR ratio (which forces banks to maintain as much long term (>1y) liabilities than long term assets),
c) and the "originate and distribute" model, i.e. make some loans and resell almost immediately them through securitisation. Though banks are now required to retain much of the credit risk and are therefore limited in how much they can do that by their capital requirements.
And yes, your deposit has been lent out, at least 70-80% of it. That's because everyone assumes not all retail customers will request their money back the same day (and if they do the bank is dead).
The continued threat of bank-runs is the central absurdity of our monetary system. "Everybody keep your money in the bank because if you don't, bad things will happen!"
Personally, I think the only significant disruption would be that enterprises, instead of only having to get buy-in from bankers, would have to sell the public on direct investment.
Though I've been known to be an economic stick in the mud.
Why is it absurd? If all the creditors of any company decided they wouldn't roll their credit, and no new creditors would come along to replace them (ie, in effect a bank run), any company would default. It's not some unique thing to banking. It just tends to rear it's head more often in banking because banks are more levered than most other companies, and the nature of the agreement with creditors (you can call in your loan any time) means it can happen fast.
But that's the thing with deposits, people treat it as cash and don't even think of the credit risk. Companies are free to offer investments to the general public right now, but it is also heavily regulated to make sure that investors understand the risk they are taking. Banks do not have to at the expense of tens of thousands of pages of regulation in every jurisdiction (and that's probably low estimate).
No, they don't do that because "they have been lent out" makes no sense. You give them money and then you are a creditor of the bank. There is no special place for "your" money, ie "they" isn't a thing. It's just a giant bucket of money they now have.
Of course they need the money to fund loans. The money lent by banks doesn't come out of thin air. The bank has some equity (A) contributed by the shareholders and they borrow money (B). They can lend out A+B. That's it. They borrow it from several places, and the cheapest, stickiest way to borrow it is deposits.
There is no magic in banking. No money comes from the sky. The second you think "money is being created" you are going down the wrong path from an understanding perspective. When people who actually know what they are talking about say "money is created" they have a different definition of "money" than you do.
You misunderstand. Lending is what makes a bank. When a bank (in the US) lends, it is creating new money that didn’t exist before due to fractional reserve requirements.
If you made a loan you’d effectively have a 100% reserve requirement to do so, while a bank currently needs 0% backing in deposits. You cannot make new money.
I don't misunderstand and given my profession I should know. Loans are not a regulated activity. You can make loans. Any corporation can make loans. Taking deposits is what requires a banking license.
What makes a bank is taking deposits (that's what requires a banking license). And banks are competitive at lending because they can fund cheaply with deposits.