Why Do Banks Want Our Deposits? Hint: It’s Not to Make Loans.
A loyal customer is a handy tool for big banks.
Janet Yellen, set to be
appointed on Wednesday as the first women head of the US Federal
Reserve, is expected to go easy on winding down the easy-money policy
which is oiling the US and other economies
October 28, 2014
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Many authorities have said it: banks do not lend their deposits. They create the money they lend on their books.
Robert B. Anderson, Treasury Secretary under Eisenhower, said it in 1959:
When
a bank makes a loan, it simply adds to the borrower’s deposit account
in the bank by the amount of the loan. The money is not taken from
anyone else’s deposits; it was not previously paid in to the bank by
anyone. It’s new money, created by the bank for the use of the borrower.
The Bank of England said it in the spring of 2014, writing in its
quarterly bulletin:
The
reality of how money is created today differs from the description
found in some economics textbooks: Rather than banks receiving deposits
when households save and then lending them out, bank lending creates
deposits.
. . . Whenever a bank makes a loan, it simultaneously
creates a matching deposit in the borrower’s bank account, thereby
creating new money.
All of which leaves us to wonder:
If banks do not lend their depositors’ money, why are they always
scrambling to get it? Banks advertise to attract depositors, and they
pay interest on the funds. What good are our deposits to the bank?
The
answer is that while banks do not need the deposits to create loans,
they do need to balance their books; and attracting customer deposits is
usually the cheapest way to do it.
Reckoning with the Fed
Ever
since the Federal Reserve Act was passed in 1913, banks have been
required to clear their outgoing checks through the Fed or another
clearinghouse. Banks keep reserves in reserve accounts at the Fed for
this purpose, and they usually hold the minimum required reserve. When
the loan of Bank A becomes a check that goes into Bank B, the Federal
Reserve debits Bank A’s reserve account and credits Bank B’s. If Bank
A’s account goes in the red at the end of the day, the Fed
automatically treats this as an overdraft and lends the bank the money. Bank A then must clear the overdraft.
Attracting
customer deposits, called “retail deposits,” is a cheap way to do it.
But if the bank lacks retail deposits, it can borrow in the money
markets, typically the Fed funds market where banks sell their “excess
reserves” to other banks. These purchased deposits are called “wholesale
deposits.”
Note that excess reserves will always be available
somewhere, since the reserves that just left Bank A will have gone into
some other bank. The exception is when customers withdraw cash, but that
happens only rarely as compared to all the electronic money flying back
and forth every day in the banking system.
Borrowing from the Fed
funds market is pretty inexpensive – a mere 0.25% interest yearly for
overnight loans. But it’s still more expensive than borrowing from the
bank’s own depositors.
Squeezing Smaller Banks: Controversy Over Wholesale Deposits
That
is one reason banks try to attract depositors, but there is another,
more controversial reason. In response to the 2008 credit crisis, the
Bank for International Settlements (Basel III), the Dodd-Frank Act, and
the Federal Reserve have limited the amount of wholesale deposits banks
can borrow.
The theory is that retail deposits are less likely to flee the bank, since they come from the bank’s own loyal customers. But
as observed by Warren Mosler
(founder of Modern Monetary Theory and the owner of a bank himself),
the premise is not only unfounded but is quite harmful as applied to
smaller community banks. A ten-year CD (certificate of deposit) bought
through a broker (a wholesale deposit) is far more “stable” than money
market deposits from local depositors that can leave the next day. The
rule not only imposes unnecessary hardship on the smaller banks but has
seriously limited their lending. And it is these banks that make most of
the loans to small and medium-sized businesses, which create most of
the nation’s new jobs. Mosler writes:
The current
problem with small banks is that their cost of funds is too high.
Currently the true marginal cost of funds for small banks is probably at
least 2% over the fed funds rate that large ‘too big to fail’ banks are
paying for their funding. This is keeping the minimum lending rates of
small banks at least that much higher, which also works to exclude
borrowers because of the cost.
The primary reason for the high
cost of funds is the requirement for funding to be a percentage of the
‘retail deposits’. This causes all the banks to compete for these types
of deposits. While, operationally, loans create deposits and there are
always exactly enough deposits to fund all loans, there are some
leakages. These leakages include cash in circulation, the fact that some
banks, particularly large money center banks, have excess retail
deposits, and a few other ‘operating factors.’ This causes small banks
to bid up the price of retail deposits in the broker CD markets and
raise the cost of funds for all of them, with any bank considered even
remotely ‘weak’ paying even higher rates, even though its deposits are
fully FDIC insured.
Additionally, small banks are driven to open
expensive branches that can add over 1% to a bank’s true marginal cost
of funds, to attempt to attract retail deposits. So by driving small
banks to compete for a relatively difficult to access source of funding,
the regulators have effectively raised their cost of funds.
Mosler’s
solution is for the Fed to lend unsecured and in unlimited quantities
to all member banks at its target interest rate, and for regulators to
drop all requirements that a percentage of bank funding be retail
deposits.
The Public Bank Solution
If the
Fed won’t act, however, there is another possible solution – one that
state and local governments can embark upon themselves. They can open
their own publicly-owned banks, on the model of the Bank of North Dakota
(BND). These banks would have no shortage of retail deposits, since
they would be the depository for the local government’s own revenues. In
North Dakota, all of the state’s revenues are deposited in the BND by
law. The BND then partners with local community banks, sharing in loans,
providing liquidity and capitalization, and buying down interest rates.
Largely as a result, North Dakota now has more banks per capita than any other state. According to a
May 2011 report by the Institute for Local Self-Reliance:
Thanks
in large part to BND, community banks are much more robust in North
Dakota than in other states. . . . While locally owned small and
mid-sized banks (under $10 billion in assets) account for only 30
percent of deposits nationally, in North Dakota they have 72 percent of
the market. . . .
One of the chief ways BND strengthens these
institutions is by participating in loans originated by local banks and
credit unions. This expands the lending capacity of local banks. . . .
BND also provides a secondary market for loans originated by local banks. . . .
Although
municipal and county governments can deposit their funds with BND, the
bank encourages them to establish accounts with local community banks
instead. BND facilitates this by providing local banks with letters of
credit for public funds. In other states, banks must meet fairly
onerous collateral requirements in order to accept public deposits,
which can make taking public funds more costly than it’s worth. But in
North Dakota, those collateral requirements are waived by a letter of
credit from BND. . . .
Over the last ten years, the amount of
lending per capita by small community banks (those under $1 billion in
assets) in North Dakota has averaged about $12,000, compared to $9,000
in South Dakota and $3,000 nationally. The gap is even greater for
small business lending. North Dakota community banks averaged 49
percent more lending for small businesses over the last decade than
those in South Dakota and 434 percent more than the national average.
In other states, increased regulatory compliance costs are putting small banks out of business.
The number of small banks in the US has shrunk
by 9.5% just since the Dodd-Frank Act was passed in 2010, and their
share of US banking assets has shrunk by 18.6%. But that is not the case
in North Dakota, which has 35 percent more banks per capita than its
nearest neighbor South Dakota, and four times as many as the national
average. The resilience of North Dakota’s local banks is largely due to
their amicable partnership with the innovative state-owned Bank of North
Dakota.
Ellen Brown is an attorney, chairman of the
Public Banking Institute, and author of twelve books including the bestselling
Web of Debt. In her latest book,
The Public Bank Solution, she explores successful public banking models historically and globally. She is currently
running for California State Treasurer on a state bank platform.
