When it comes to banking, mainstream textbooks usually forget the fact that it is not only banks that can create bank deposits. Sure enough, banks create additional bank deposits when they extend a loan. The balancing entry is the loan itself, nothing else but a promise to pay deposits when the loan is due. Theoretically, there is no limit to this process. As the Swedish economist Knut Wicksell realized in his book “Interest and Prices” (1898), there is a practical problem for the individual bank. As it extends more and more loans, clients will transfer more and more money to other banks. Thus, the bank either has to rely on interbank market loans or on central bank loans to stay in business. If it runs out of collateral or good will, the bank might find itself in a position of having to repay its loans quickly. Illiquidity or insolvency might become an issue.
This is why prudent banks expand their loan book in lockstep. Any problems regarding liquidity or insolvency would then affect all the banks. Blame can then be laid on the regulator or central bank as the problem is obviously “systemic”. Thus, banks are able to hide their “systemic” mistakes – the ones they all made simultaneously – by letting it appear that something happened that nobody could foresee, while in reality something happened that they either did not foresee or that was ignored because of, say, profits arising from this ignorance. This probably was the case in the build-up of the US sub-prime crisis that started in 2007.
Normally, banks that extend a lot of real estate loans and mortgages become exposed. If, however, they are able to sell their loans through securitization, then they would not be exposed – their asset side would look just like every other bank’s asset side. Except for the fees the bank makes when extending loans and then selling their securitized version. In this way, banks can and did use their theoretically unlimited power to create deposits through loans. The results were devastating. American households defaulted on billions worth of real estate loans and mortgages, many losing their home along the way. The same happened in Europe, where real estate bubbles turned bad in both Spain and Ireland.
Banks therefore are able to drive the economy, to create both booms and busts. The money that they create provides additional purchasing power to clients, who are thus able to purchase resources or financial assets. This is not neutral. House prices are driven by people paying higher house prices, financed with debt. Household debt soared in the US, in Ireland and Spain. In Spain, household debt is never erased, not even after declaring personal bankruptcy. This creates social hardship and a fertile ground for anger and hate.
What can be done? Banks have, through their consistent mistakes, channelled billions of euros and dollars respectively into the real estate sector. The resources appropriated with that money are not available for other uses. This has created a loss for society. How can we limit the banks’ role in the economy?
The usual answer is to raise their equity requirements. The idea is to have banks issue more shares and other liabilities that count as equity when the bank increases its lending activity and the risk associated with it. Thus, the bank has to hand over part of its profits to those holding the equity. The problem is that this does not stop banks to lend more when times are good.
Banks are vital for the functioning of capitalism. They create additional purchasing power, thus enabling borrowers to create new products and processes. However, borrowers might also aim for profits through purchasing real and financial assets in the expectation of rising prices. It is this type of banking that has brought us problems. The solution is not to close banks or promise not to bail them out anymore. Lending for profit as a business model has failed us badly. The solution is to re-regulate the banks in order to make sure that their lending furthers the public purpose. To find out how banks can serve the public purpose, we need a public debate about what it is that we want banks to do. This is why it is critical for the public to understand what banks really do and how they work.
Technical University of Chemnitz
This is a guest post written for the Rethinking the Role of Banks in Economics Education campaign.