In the last couple of weeks we’ve seen that banks create money when they make loans, and that the only limitation on their ability to do this (if they have customers wanting loans) is that they cannot allow payments being made by their customers to significantly exceed payments received by their customers, or else they will run-out of central bank reserves to make the underlying payments to other banks (and go bankrupt).
But the transactions between bank customers are never going to balance out exactly, so what does a bank do if it’s down at the end of the day and running low on bank reserves? The answer is very simple. If one bank is down, it means another bank must be up, so the first bank borrows reserves off the second.
This is one of those simple statements that is actually really important to understand, so let’s not gloss over it. I described 2 weeks ago how all banks have a reserve account with the Central Bank. For all the thousands of transactions in a day between bank customers, with money transferring between bank accounts, there is a corresponding transfer of reserves between the respective banks. But the net transfer between banks is going to be much smaller than the total value of all transactions (this is why I had a whole post dedicated to “clearing” several weeks ago). Some banks will finish the day with more reserves, and some with less, but these differences must balance out in total, because the amount of reserves in the system as a whole hasn’t changed. And what this means is that if one bank is down on its reserves, there will be other banks out there with excess reserves that are willing to lend them at the right rate of interest.
This is an interbank overnight loan. At the end of the next day, maybe the situation will be reversed, and the loan will run the other way. The banks charge interest on these loans, so this is one way they make a profit.
Obviously, if a bank is down by large amounts day after day for a long period, they won’t be able to keep taking out these overnight loans. Once other banks become worried that a bank is not going to be able to repay they will stop lending to it, and the bank could go bankrupt. This is essentially what happened to Northern Rock in 2008.
But when business is ticking over normally, banks can make up any shortfalls in reserves at the end of the day by borrowing off each other. This interbank lending is a vital element keeping our entire financial system, and therefore our entire economy, stable.
In fact, we’re now getting to the heart of the business of banking. There’s a saying that banks “borrow short and lend long”. When this term is explained, usually the short-term borrowing is presented as being the deposits of banks customers (technically, your bank account is a statement of what your bank owes you – you are “lending” the bank your deposits). But of far more significance is the wholesale money market – this is large-value lending between financial institutions, through which they will then finance their lending to the rest of the economy. Banks and other financial institutions borrow short (for example in the overnight market) and lend long, and that’s how they make their money. I’m not saying deposits are irrelevant as a form of short-term borrowing, but I am saying that if you only talk about this (which most textbooks would, if they talk about it at all) then you don’t study and understand by the far the biggest and most significant part of the system (which, of course, is what economists and central bankers missed in the run-up to the financial crash).
So banks lend central bank reserves to each other overnight to make up daily shortfalls in reserves. They then lend to non-bank financial institutions (NBFIs) using overnight loans secured against government bonds (known as “repo” for reasons we won’t go into now). The significance of this is that non-banks do not have reserve accounts with the Central Bank, so cannot participate in the interbank overnight lending market – they just have accounts with banks using the same bank-created money as the rest of us. So a bank might borrow reserves on the overnight interbank market to fund overnight lending to NBFIs at a higher rate of interest; and the NBFI is using this overnight loan to finance a longer term loan at an even higher rate, and is banking (no pun intended) on being able to keep rolling that loan over day after day.
Our entire financial system is built on short-term loans funding long-terms loans. At the base of this is the interbank overnight lending rate, and this is the interest rate that Central Banks set targets for – all other interest rates in the economy flow from this one. (When interest rates are reported on the news, this is actually why it matters – the central bank is not “setting” your mortgage rate, it is seeking to influence the interbank overnight rate, and then everything else unfolds from there.)
And it all works fine* so long as the institutions making the short-term loans have funds to keep making them, and stay confident that those receiving the loans will be able to pay them back the next day. Most lending is secured (interbank overnight being the exception), so a fall in the price of assets that are being used as collateral will also affect the system.
When institutions can no longer roll-over their short-term loans, either because of a fall in the value of their collateral or because lenders have lost confidence in them (or, indeed, because the lenders themselves are in trouble), the system freezes, and then collapses if the Central Banks don’t intervene. This, in a nutshell, is a perfect description of the last financial crisis.
If you’re reading this, you’re probably interested enough to know already that the last crash started with subprime mortgages in America. The problem was not, as people sometimes assume, that defaults on these mortgages meant that the banks weren’t receiving their payments. The problem was that the widespread realisation that some of these mortgages were likely to default in the future led to a fall in value of the securities based on these mortgages (collateral debt obligations – CDOs) and thus they were not worth as much as collateral in the lending market.
There’s been a lot of meat in this post, because we’ve penetrated to the very core of the financial system, so let’s draw out 3 key points:
- For the purpose of understanding the process of money creation, all you need to understand is the process of interbank overnight lending – if banks are down on reserves at the end of the day, it means another bank must be up, and they can borrow off them to make up their short-fall – simple as that.
- But this simple point gives you an insight into the very essence of banking – borrowing short to lend long.
- The rest of the post just gives you a flavour of how the financial system is built on this – we will look at this all in more detail in when we look at monetary policy and at financial markets (including “shadow banking”). Hopefully, you now see why it is so important that in the future we spend time understanding these areas.
And finally, I want to remind you that one of my earliest posts was on credit. I claimed that it was ubiquitous to business – that without it there could be no business and therefore no economy. I claimed that decisions about who to allocate credit to, and how much credit to allocate, are absolutely fundamental to the path the economy takes in the future.
What you have seen today is that our entire economic system is built on overnight lending between financial institutions – on credit.