A critique of Werner’s view on banking

I have already published a quick critique of one of Prof Richard Werner’s previous papers on banking theory and money endogeneity some time ago, but, following the publication of a new, follow-up, paper on the same topic I thought I should deconstruct his arguments a little more comprehensively.

Werner published last September a follow up paper to his previous one Can banks individually create money out of nothing?, titled A lost century in economics: Three theories of banking and the conclusive evidence. Werner adheres to a form of endogenous money theory that differs from the MMT version. And, as I have repeatedly wrote on this blog, I strongly disagree with those theories. Werner’s view is pretty specific though, and, unlike MMT doesn’t seem to be an ‘endogenous outside money theory’. It is wrong nevertheless.

Overall, my criticisms are similar to those I had about his previous papers. I think that the main (big) issue with Werner’s papers is that he distinguishes three main banking theories that are in reality mostly undistinguishable, and proceeds to draw misleading conclusions from those effectively virtual definitions. He classifies banking theories as follows:

  • Financial intermediation theory: supposedly dominant in the economics field, with proponents such as Keynes, Mises, Gorton, Diamond and Dybvig, Tobin, Bernanke, Krugman, Admati and so forth, and which says that banks aren’t different from other non-bank financial institutions. Werner describes this theory as “banks borrow from depositors with short maturities and lend to borrowers at longer maturities” and are “unable to create money.” According to Werner, this theory implies that deposits are held in segregated accounts and hence not shown on banks’ balance sheet.
  • Fractional reserve theory: supposedly mostly agrees with the previous theory but disagrees with it in that the banking system creates money (read, deposits) through the ‘money multiplier’ process, with Phillips and his Bank Credit, as well as Samuelson, Hayek but also Keynes (who apparently supports two opposite theories… though I wouldn’t be surprised knowing him) as main proponents.
  • Credit creation theory: supposedly at odds with the two previous theories, as banks are considered to be able to create money out of thin air by the simple act of lending or buying assets, and without securing deposits/reserves first. Apparent supporters were Macleod, Schumpeter, Wicksell, and even…Keynes (yes, him again…)… Werner sums up the theory as “according to the credit creation theory then, banks create credit in the form of what bankers call ‘deposits’, and this credit is money.” An ‘important’ difference with the fractional reserve theory is that a single bank can create deposits. This is the theory Werner subscribes to.

I believe there is a big misunderstanding here. In reality, those three ‘theories’ all massively overlap, if not represent the exact same thing. I am still absolutely baffled by Prof Werner’s claim that believing that banks are financial intermediaries imply that deposits are held in segregated accounts… He then attempts to disprove this theory by simply…opening banks’ annual reports. But everybody already knows that deposits appear on banks’ balance sheet. I have never ever seen any claim to the contrary, in any textbook or banking theory article. Depositors have been legally considered bank creditors since the 19th century and, as all credit/funding instruments, deposits have to appear on the liability side of the balance sheet. There really is no news here, and none of the economists who supposedly believe in the intermediation theory believe that deposits are off-balance sheet.

Second, the financial intermediation and fractional reserve theories are one and the same. As we have just explained, the financial intermediation theory never implied that deposits were segregated, like at other non-bank financial institutions. This theory is a fractional reserve theory. It mostly emanates from Tobin’s very famous article Commercial Banks as Creators of ‘Money’, in which he exposes his ‘New View’. Tobin’s article is about the limit to deposit expansion (see my take on the Tobin-Yeager debate here). He espouses the fractional reserve model. He certainly doesn’t believe in the exposition of the theory attributed to him by Werner.

Third, as the title of the Tobin’s article suggest, the two previous theories also state that banks create money by the act of lending. So they largely overlap with Werner’s definition of the Credit creation theory. However, where they disagree is in the origins of this ‘money’. For the first two theories, deposits are a source of funding that are consequently lent out to borrowers (roughly, see below). For Werner’s last theory, money is created out of thin air.

Let’s reconcile it all. It is by intermediating between savers/depositors and borrowers that fractional reserve banks create money. Maturity transformation implies that banks borrow short-term (from depositors) and lend long-term (to borrowers). Liquidity risk arises from this process, because depositors are still supposed to have access to their money, which has in fact been lent out to other customers of the bank. So banks, at the same time, are intermediaries and create money through credit extension, resulting in many different claims on the same unit of base money (i.e. reserves, or high-powered money). This is the money multiplier model.

So the ‘money’ that banks create out of thin air is in fact a claim on base money. And there are limits to this extension, which I have highlighted in my many posts on endogenous money theory.

One of those limits is the adverse clearing that occurs during interbank settlement, which is barely discussed in Werner’s papers. Werner wrongly claims in his article that “for this fractional reserve model to work, Samuelson is assuming that the new deposit is a cash deposit, and the extension of the loan takes the form of paying out cash.” He further adds:

Thus a further inconsistency is that it is a priori not clear why customer deposits or reserves should be any constraint on bank lending as claimed by the fractional reserve theory: since deposits are a record of the bank’s debt to customers, the bank is not restricted to lending only as much as its excess reserves or prior customer deposits allow. It can extend a loan and record further debts to customers, shown as newly created deposits (as the credit creation theory states).

There is no need for cash to be paid out to be a drain on the reserve/liquidity position of the bank. And banks (individually, or as a whole) cannot expand indefinitely either. Interbank settlements, through the adverse clearing process, operate as a very good limiting constraint, unless there is an exact offsetting amount that the counterparty bank owes (in which case no reserve transfer occurs and limits to expansion are defined by other criteria).

Werner does eventually mention this point however, albeit too briefly given how crucial it is:

As long as banks create credit at the same rate as other banks, and as long as customers are similarly distributed, the mutual claims of banks on each other will be netted out and may well, on balance, cancel each other out. Then banks can increase credit creation without limit and without ‘losing any money’.

While this is theoretically true, this is highly unrealistic, as I have explained in this post:

[The BoE economists] seem to believe that all banks could expand simultaneously, resulting in each bank avoiding adverse clearing and loss of reserves. This situation cannot realistically occur. Each bank wishes to have a different risk/return profile. As a result, banks with different risk profile would not be expanding at the exact same time, resulting in the more aggressive ones losing reserves at the expense of the more conservative ones in the medium term, stopping their expansion. At this point, we get back to the case I (and they) made of what happens to over-expanding single banks.

Please note that banks do not need to secure reserves before lending in the fractional reserve model, unlike what Werner claims. What they do need to do is to secure reserves before they are transferred to another bank or withdrawn as cash by the customer*. If one of those two events occurs and our bank hasn’t got the required reserves to settle, it causes an event of default. And bank managers don’t like events of default much. Which is why banks have dedicated treasury and asset/liability management teams that attempt to secure funding sources (i.e. reserves), as cheaply as possible.

All of those issues make Werner believe that modulating reserve requirements cannot work to control banking expansion. Yet all empirical evidences seem to be against him. Many central banks across the world use RR to tame or boost lending (China, Turkey, Brasil…) and evidences seem to show that it works (see here for a recent paper on Brazil for instance).

Finally, his empirical test is flawed, as was his previous one (see here). His credit creation theory of money (which is quite similar to this very rough one published by some BoE staff earlier this year) cannot be demonstrated by making a single small loan to a virtual customer of a given bank.

There is one thing that Werner got very right though, and it is that BoE publications have been overly confusing, if not completely contradictory, over the past few years. But it’s not a reason to add to the confusion.

 

*In an ideal world, that is, when the borrower utilises his newly acquired fund to pay another customer of the same bank, an individual bank does not have to secure reserves. But if the second customer does in turn transfer his cash to another bank, well, you know what happens.

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11 responses to “A critique of Werner’s view on banking”

  1. Himmi says :

    Can you recommend some books / resources which would provide a comprehensive view of modern banking?

    • Julien Noizet says :

      Himmi,
      Unfortunately not. I am not aware of any book or article that comprehensively sums up the various factors influencing banks’ balance sheet and P&L management combined with money creation/expansion and monetary economics.
      It’s a huge task.
      A friend of mine, top M&A investment banker, once asked me to write such book so he could teach junior member of his team. He had no knowledge of any such resource either.

      Bits and pieces can be found there and there, and I believe that the economists of the so-called ‘free banking’ school are the best at understanding how banks work and their link with monetary economics. I let you seach for George Selgin (who wrote The Theory of Free Banking), Larry White (who wrote The Theory of Monetary Institutions), as well as Kevin Dowd. They all wrote numerous articles and also regularly write on the alt-m.org blog.

    • Marco Saba says :

      The “truth bomb” awaiting explosion: cash flaw accounting

      One has to understand that money loaned out is not coming from “speculators” clients of the banks, but out from nothing. I.e. In their lending, banks create credit ‘ex nihilo’, and new money ‘ab initio’ with cash made ‘out of thin air’, because the loan amount is added onto the borrower’s account immediately after signing a loan contract. The loan is ADDED onto the borrower’s account, not TRANSFERRED from any existing cash account ! And this is the point: when the bank creates this new money, she don’t write it in existence directly to her cash flow account as a newly created asset, but on the borrower account ! So, the banks have always what appears as a NEGATIVE CASH FLOW ACCOUNT, but is not a real loss ! It’s all a make-believe game of mirrors…

      Further reading: Cash Flow Accounting in Banks— A study of practice, Ásgeir B. Torfason, 2014 https://www.scribd.com/doc/294880212/Cash-Flow-Accounting-in-Banks-A-study-of-practice

      And: Werner, R.A., A lost century in economics: Three theories of banking and the conclusive evidence, International Review of Financial Analysis (2015) http://www.sciencedirect.com/science/article/pii/S1057521915001477

      • Justin Merrill says :

        But borrowers from banks don’t often keep their borrowed money on deposit at a bank for long. It is usually withdrawn (uh-oh, reserves gone) or transferred to a third party (car dealer, real estate broker, etc.). Chances are, this party is not banking at the same institution, but even if they are, they are unlikely to keep the whole amount on deposit.

  2. Ken G says :

    Summarizing, you have not shown that Werner is mistaken that banks create new credit from thin air. You merely show that adverse clearing is the practical limitation on this practice. With over 500 banks failed in the USA since 2005, it would appear true that more aggressive banks are prone to failure. This has always been known to be the case since the wildcat banking days of the 18th and 19th centuries.

    Werner is correct that as long as all the banks maintain the same reserve ratio the clearing will tend to net out. Therefore the effective average reserve in the system determines the dividing line between banks that will run into liquidity problems and banks that will accumulate more liquidity.

    • Julien Noizet says :

      Ken, everyone is able to ‘create money out of thin air’. But this is irrelevant. Everyone already knows that fractional reserve banking implies creating ‘money of out thin air’.
      What is relevant and important though is that this process is not infinite.

      Regarding the claim that Werner is correct about the very specific and unlikely case in which banks maintain the same reserve ratio, it is also irrelevant as it is totally unrealistic.

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