Macroeconomics — Bank Credit and the Central Bank Balance Sheet

Macroeconomics — Banks Are Not Coefficients in a Multiplier but Decision-Makers with Balance Sheets

The money multiplier of Chapter 3 assumed that banks mechanically lend a fixed share of the deposits they receive. This chapter follows the balance sheets directly to see how money is actually created, and where bank capital and loan demand block the transmission of monetary policy.

1. Two balance sheets

The sum of currency and reserves among the central bank’s liabilities is the monetary base. When the central bank buys government bonds, its assets (bonds) rise, and the payment is credited to the selling bank’s reserve account, so its liabilities (reserves) rise too. The monetary base is created when the central bank buys assets.

2. Loans create deposits

The textbook multiplier story runs in the order “deposits come in first, and the bank lends part of them.” In real banks the order is often the reverse. When a bank lends 100 million won to a firm, 100 million won is credited to the firm’s deposit account. On the balance sheet, 100 million won of assets (the loan) and 100 million won of liabilities (the deposit) appear at the same time. A new deposit — new money — has been created by the loan.

That does not mean banks can lend without limit. The decision to expand lending is constrained by:

• Profitability: the loan rate must exceed the cost of funding and expected losses. The central bank’s policy rate sets the cost of funding.
• Loan demand: there must be creditworthy borrowers who want to borrow.
• Capital regulation: adding risky assets requires adding equity capital.
• Liquidity: when deposits move to other banks, they must be settled in reserves.

A central bank operating an interest-rate target supplies the reserves banks need at the policy rate. The main constraints today are therefore not the quantity of reserves but interest rates, loan demand and capital.

3. Capital ratios constrain credit

A bank with risk-weighted assets of 100 trillion won and equity of 10 trillion won has a capital ratio of 10%. If loan losses reduce equity by 2 trillion won, the ratio falls to 8%. To restore 10%, the bank must raise 2 trillion won of capital or cut risk-weighted assets by 20 trillion won, to 80 trillion. A loss of 2 trillion won is amplified into a 20-trillion-won cut in lending. This is how bank losses turn into a credit crunch in a recession.

4. Quantitative easing

When interest rates approach their lower bound, central banks buy large quantities of long-term government bonds and other assets (quantitative easing). On the balance sheet, central bank assets (bonds) and liabilities (reserves) grow together.

Even when quantitative easing multiplied the monetary base, money and lending did not rise proportionally, because banks built up excess reserves instead of lending. The money multiplier $m$ collapsed. A monetary base of 50 trillion won with a multiplier of 4 gives money of 200 trillion won, but if the multiplier falls to 2, the same base gives 100 trillion won.

5. When the credit channel is blocked

Check your understanding

A bank with risk-weighted assets of 200 trillion won and equity of 24 trillion won (a capital ratio of 12%) loses 4 trillion won of capital on bad loans. If the regulatory minimum is 10%, how much must it cut lending? With equity of 20 trillion won, risk-weighted assets may be up to 200 trillion won, so no cut is needed. If the bank wants to keep a 12% ratio, it must cut risk-weighted assets to $20/0.12\approx 167$ trillion won, by about 33 trillion. The size of the buffer a bank wants to keep determines the size of the credit crunch.

References

• Michael McLeay, Amar Radia and Ryland Thomas, “Money Creation in the Modern Economy,” Bank of England Quarterly Bulletin (2014)
• Ben Bernanke and Mark Gertler, “Inside the Black Box: The Credit Channel of Monetary Policy Transmission,” Journal of Economic Perspectives (1995)
• BIS, Basel Framework
• Bank of Korea, Monetary policy framework (Korean)