Bank Lending and Non-bank Lending

Daniel Nevins, in Economics for Independent Thinkers, a book I mentioned the other day, thinks of non-bank lending as coming from savings and bank lending as created by fiat. I do not think in those terms.

Think of an economy that includes fruit tree growers, households, and banks. The fruit trees represent risky, long-term investments.

The fruit tree growers finance their investment with a combination of debt and fruit-tree equity. Households may purchase some of the fruit tree debt directly. This would be called non-bank lending. Banks purchase the rest of the fruit-tree debt and fund it with a combination of bank equity and liquid deposits. The fruit tree debt that the banks fund is owned indirectly by households.

In the aggregate, households hold everything. Not every household is identical, but in the aggregate they hold the fruit tree equity, the direct fruit tree debt, and the indirect fruit tree debt that comes to the household in the form of bank equity and liquid deposits.

Now, fruit tree growers are households, just like anyone else. So you can think of an increase in bank lending as a bank creating a deposit at the household of a fruit tree grower in exchange for more debt issued by that fruit tree grower. That may be the way that Nevins wants to think of it,, and he thinks that this makes it much different from non-bank lending, because the bank can create a deposit seemingly out of thin air. He would say that it does so without prior saving, although he adheres to the identity between current saving and current investment.

In contrast, I think of bank lending and non-bank lending as doing the same thing, namely funding the debt issued by fruit tree growers. The only difference is that with non-bank lending, households have a direct ownership of the debt, while with bank lending their ownership is indirect.

Households may have a limited appetite for direct holding of fruit tree debt. And they may have a less limited appetite for holding that debt indirectly. In that case, if fruit tree growers and bank managers become more risk tolerant, you may get an expansion of fruit tree investment along with an increase in bank lending. Conversely, if fruit tree growers and bank managers become more risk averse, you may get a contraction.

The bottom line is that I think that bank credit matters, just as Nevins does. But I am not comfortable with his semantics.

7 thoughts on “Bank Lending and Non-bank Lending

  1. Arnold, I think I can relate the relevant parts of my book to your example with these observations:

    1) Fruit farm debt funded by a non-bank lender (say, a pension fund) requires the lender to forego the investment it would have otherwise made if it hadn’t seen your fruit farm presentation. Imagine the pension fund canceling its loan to an inferior fruit farm located just down the road from your farm, thus freeing up funds for you. When it comes to financing, your farm crowded out the inferior farm.

    2) Fruit farm debt funded by a bank, by comparison, is much less likely to crowd out other businesses. The bank only needs to allocate a small portion of equity capital to the loan and possibly tweak its reserves—relatively minor adjustments. It finances the loan primarily by creating money, normally deposit money, from “thin air,” which it’s able to do thanks to its bank charter. Therefore, the inferior fruit farm down the road continues to operate and with ample funding. In other words, bank lending differs from non-bank lending in the effects on your neighbor, not on your own business (at least in your example), which I agree can be financed either way.

    3) Such money creation through bank lending is ignored or bungled in mainstream models (even today—don’t believe the claims that this is all fixed), as described in works such as the Bank of England’s 2014 report listing the fallacies in “textbook” monetary theory.

    That’s the crux of my discussion of bank versus non-bank lending. Non-bank lending implies crowding out, and bank lending not so much, with the implication that bank lending is unconstrained by prior saving and macroeconomically “riskier” (as noted by Hume, Thornton, Wicksell, the Austrian school, Schumpeter, Minsky, etc.). On the other hand, bank lending makes the economy more vibrant. I conclude that certain bank lending metrics can help identify excesses that can lead to recessions and crises.

    I can see that you disagree with the notion of bank lending being created “by fiat,” but that’s your phrase, not mine, and I’m not sure exactly how you mean it. I’m also curious as to which of my three observations doesn’t fit your thinking, as I believe we agree on the conclusion. In any case, thank you for the post, and I hope this comment makes my argument clearer.

    • One more clarification after rereading – your use of the term “fiat” struck me as vague only in a bank lending context, since you also write that “you can think of an increase in bank lending as a bank creating a deposit at the household of a fruit tree grower in exchange for more debt issued by that fruit tree grower.” Some might say that the second statement implies “fiat,” but I would normally reserve the term for sovereigns.

      The second statement is exactly how a banker would describe a loan transaction and I totally agree with it, whereas textbooks normally imply that the bank needs to have a deposit on hand from elsewhere before it can make the loan. That’s the crux of a schism between mainstream economists on one side and, on the other side, a variety of old-time and heterodox economists, bankers (by my own surveys – I worked for a bank for 12 years), and, more recently, the Bank of England as noted in my first comment and the BIS (issued a short report on this before the Bank of England’s report).

  2. MMT lives.

    Regrettably.

    The one question that never seems to get answered is that if banks can create money, why did they need $6 Trillion from the FED to keep the payment system working in Sept of 2008?

    Why bother to pay interest on deposits? Why have deposits at all?

    • Wow.

      MMT is pretty insignificant in this discussion.

      You didn’t find MMTers among the classical economists, Austrians, Schumpeterians, or original post-Keynesians who studied bank lending. And I doubt you would find them among the BIS and Bank of England officials who felt compelled to inform the economics community that its textbooks are incorrect and commercial banks do, in fact, create money.

      I don’t know about you, but I think I’ll side with the central bankers’ bank and the world’s second oldest central bank on a topic that involves, well, banking.

      • The MMTers have been over this BOE paper for a long time.

        I notice no answer to my questions. I only have 30 years experience in banking, and certainly not at the CB level. Just a little bank that created loans and sold them to bigger banks. Strange, but when the banks paid me for my paper, I actually had to pay the vendor.

        • I wasn’t convinced that you wanted to hear the answer, but I’ll answer your first question.

          Commercial bank-created money is a liability to the bank. It doesn’t strengthen the bank’s balance sheet at all and, all else equal, is likely to weaken it. Had commercial banks granted even more loans during the crisis, it would have likely worsened the seizures in the banking system.

          Central bank-created money, on the other hand, creates an asset for the commercial bank (reserves at the central bank). That asset can help to strengthen the commercial bank’s balance sheet.

          I understand the MMTers latched onto the BofE report; my point was that they came late to the discussion and aren’t especially big. The BofE didn’t act on their behalf; they acted because they wanted to clear up fallacies found in textbooks, papers, and blogs.

          I can’t speak to your lending experience without knowing more about your business model, but as long as your activities contributed to an expansion in commercial bank balance sheets, the additional commercial bank assets (loans) were likely to have been matched by additional (newly created) deposits or money on the liability side. And I agree that everyone gets paid.

          • I am at the end(perhaps past) of my competence level on this discussion, so excuse me if my thoughts are not what they should be.

            But I do not understand how CB created money strengthens a banks balance sheet unless that money is given to a certain banks and or through the purchase of bank holdings with the proceeds going to that bank’s reserves.

            The same exact way I do not understand how commercial banks created money with a loan. They moved it, they did not create it.

            Meanwhile, the vast majority of lending during the crisis was done via securitization, once again the bank moved the money from investor to vendor(or seller), they did not create any money.

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