We’ve been told to think of the business of banks as accepting deposits from savers and lending them out to those who need funds to invest. From this simple understanding flow many implications about how monetary policy and banking regulation affect the rest of the economy. The problem is that the “folk” view of banking is wrong. Does it follow that policy thinking implicitly based on it is wrong, too?
Rather than waiting for pre-existing savings to be deposited to then lend them out, things work in reverse. Banks create deposits and credit them to borrowers whenever they want to make a loan — that is how the loan is made — and they will do so when they find the profit of making the loan outweighing the risk.
It’s important to understand that banks are not constrained by the government (outside the regulatory framework) in terms of how they create money
Reserves are used for two purposes — to settle payments in the interbank market and to meet the Fed’s reserve requirements.
That banks are not reserve constrained can mean only one thing — banks lend when credit-worthy customers have demand for loans. Loans create deposits, not vice versa. In the loan creation process banks will make loans first (resulting in new deposits) and will find necessary reserves after the fact (either in the overnight market or through the Federal Reserve).
It is better to think of banking as a spread business in which the bank simply acquires the least expensive liabilities to sustain its payment system and maximize profits. Banks need funding sources to run their businesses, but they do not necessarily need reserves or deposits to make those loans.
The key lesson here is to understand that money in the modern monetary system is largely endogenous and exists through the creation of the loan process within the private sector.
