Firstly, here’s a short explanation of bank lending. Under normal circumstances, deposits and loans are more-or-less equal across the banking system as a whole. This is because when a bank creates a new loan, it also creates a new balancing deposit. It creates this “from thin air”, not from existing money: banks do not “lend out” existing deposits, as is commonly thought. You can see this clearly on the chart. Until 2009, deposits and loans were roughly equal.
But since 2009 there has been a very evident change. There is a large and growing gap between loans and deposits. So what is causing this?
Firstly, banks, households and businesses have been deleveraging. That means they are paying off (or writing off) loans and not taking on any more. Damaged banks don’t want to lend, damaged households don’t want to borrow and fearful businesses don’t want to invest. The combination of these three factors means that both the supply and the demand for loans are considerably below the levels prior to the financial crisis. This explains the evident fall in loan creation (red line) in 2009. Though the line is now rising. Seems banks are lending, actually, though not at the rate they were before the crisis.
Secondly, the Fed has been doing QE. QE involves buying assets held by the private sector, both banks and investors. When the Fed buys from banks, the bank simply exchanges one asset (UST or MBS) for another (new reserves), and there is no change in deposits. But when the Fed buys assets from private sector investors, the purchases are intermediated through banks, and the newly-created dollars that investors receive in return for their assets are credited to their bank deposit accounts. Consequently bank deposits rise. This is the reason why the blue and red lines have diverged. Without QE, the two would have remained in sync: we would have seen a fall in both loans and deposits, since money is destroyed when loans are paid off or written off.
But, what about all those reserves on which the Fed is paying interest? Surely this is a major reason why bank lending is so far below deposit creation? After all, if banks can be paid interest on risk-free deposits at the Fed, they won’t want to lend, will they?
This chart appears to support that argument. Sober Look has “added back” to the loan line the excess reserves held by banks at the Fed:
Well, that’s amazing. Loans + excess reserves = deposits. Therefore placing excess reserves at the Fed must be crowding out lending, mustn’t it? So what we need to do is cut the interest rate on excess reserves, preferably into negative territory. Then banks will be forced to lend out the money.
No, just no. Double entry accounting is sufficient to explain this effect. It tells us absolutely nothing about the lending behavior of banks.
When the Fed buys private sector assets from investors, it not only creates new deposits, it creates new reserves. This is because a new deposit (liability) in a bank must be balanced by an equivalent asset. When banks create deposits by lending, the equivalent asset is a loan. When the Fed creates deposits by buying assets, the equivalent asset is an increase in reserves, also newly created. So it does not matter how much lending banks do, if the Fed is creating new deposit/reserve pairs by buying assets from private sector investors then deposits will ALWAYS exceed loans by the amount of those new reserves.