Three Dangerous Myths About Bank Lending, Debunked
MMT Economics: A plain language explanation of bank lending, and why it’s important to demolish these myths – from a Modern Monetary Theory (MMT) perspective.
MMT Economics: What you will learn:
An understanding of how bank lending actually works; why banks don’t lend out customer deposits; why their ability to make loans does not depend on the amount of reserves they have at the central bank; why the idea of a ‘money multiplier’ is a myth; and how misunderstanding bank lending leads to flawed policies and unnecessary fear about public spending.
Technical Terms/Jargon Used in This Article
You will find definitions of all of the technical terms/jargon used in this article in my series of MMT Economic Jargon Buster articles. Paid subscribers can also download my MMT Dictionary.
Exposing the three most common myths related to bank lending
In this article, I look at three of the most common myths about bank lending. I explain not only why they are wrong but also why I believe they can negatively impact our wellbeing and the wellbeing of our fellow citizens. A lack of understanding of the banking system can result in us handing over the ‘power of the purse’ to individuals who don’t necessarily have our interests at heart.
So, with that in mind, let’s get to work and undermine these myths.
Myth 1: Banks Lend Depositors' Money – The Loanable Funds Model
At the heart of this myth is the idea that banks first need to attract money from savers before lending that money to businesses and individuals. Their ability to provide loans is directly connected to the savings they can acquire.
In this scenario banks are mere middlemen connecting savers to borrowers.
This story implies that there is a finite amount of money circulating around the economy. And that the role of banks is simple: to shift that money from people/businesses, who don’t need it, to those who do.
The loanable funds model tells us that government borrowing crowds out private sector investment
In this story, when the government spends into the economy, it first has to borrow that money. And it does that by dipping into the available pool of private sector money, removing a chunk of the private sector ‘money pie’.
Orthodox economists call this ‘crowding out’. The private sector has been crowded out by the government from accessing the funds it needs to invest and grow. The implication is that every pound the government spends is a pound less for businesses or households to use.
The Loanable Funds Model And Interest Rates
Within the loanable funds model, competition for the fixed amount of savings held by banks determines both the interest rate and how much lending takes place in the economy.
“It posits a demand for loanable funds and a supply of loanable funds available for the macroeconomy, and contains classic supply-demand curve assumptions from goods markets, that higher prices (in this case interest rates) will elicit more "supply" (as in investors will divert more funds from other uses, such as risky venture investments, and make them available for lending).” Scott Fullwiler Modern Monetary Theory—A Primer on the Operational Realities of the Monetary System
However, as we will now find out, the loanable funds model is entirely wrong.
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The Reality: How Banks Actually Lend
The loanable funds idea is inconsistent with how banks actually operate. The reality is that banks expand their balance sheets without needing prior deposits or reserves.
Banks create loans ‘out of thin air’. They do not have to collect money from savers before they can lend and are not constrained by a limited pool of savings.
When a bank provides a loan, it simply types numbers into the customer’s account. The deposit becomes a liability for the bank (the bank now owes that money to the customer) and an asset for the customer (they have money to spend).
At the same time, the loan contract is an asset on the bank’s balance sheet and a liability for the borrower, because they now have a debt they have to pay back.
All bank loans are newly created financial assets: money is not taken from other accounts.
Bank lending is driven by whether the bank has confidence in the ability of the lender to repay the loan i.e. their assessment of whether the potential customer is a good risk.
It is not restricted by how much money is in a bank’s vault or on deposit. If the lender qualifies for the loan, the bank simply updates the customer’s account balance with a new figure.
“Can commercial banks create money out of thin air? As a matter of fact, the Bank of England can always create money out of thin air. But can commercial banks really do so? The answer is yes, subject to a massive caveat – which is that they can only do so under licence from the Bank of England, which means that the buck for all money creation ultimately stops with the government.” Emeritus Professor Richard Murphy - Sheffield University Management School
Why is this myth dangerous?
This myth is dangerous because it promotes the falsehood that banks are no more than benign middlemen. And that their activities are naturally constrained by their level of saving. Therefore, there is less need for strong financial regulation. It is helpful for us to remember that it was a lack of strong financial regulation that contributed to both the 1929 and 2008 financial crashes.
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Myth 2. Lending is constrained by existing customer deposits – Fractional Reserve Banking
Fractional reserve banking is related to our first myth – in that it says a bank’s lending is restricted by the amount of existing customer deposits. However, it is different in that it stipulates what percentage of those deposits they are allowed to lend.
More precisely, it says that a bank’s lending should be restricted by the amount of cash they have in their vaults plus the deposits they have with the central bank (i.e. reserves). That is, lending is restricted to the bank’s most ‘liquid’ assets. (Note that I am not saying that a form of fractional reserve banking has never existed – what I am saying is that it is no longer an accurate description of how bank lending works today.)
In this scenario banks are only allowed to lend out a particular percentage of their existing deposits. This is called the ‘reserve requirement’. For example, with a 10% reserve requirement, they must hold on to at least 10% of their existing deposits. So if they have deposits of £100, they are allowed to lend out £90 to customers.
The justification for fractional reserve banking is that it provides both the ability to expand the money supply, while at the same time enabling central banks to manage the economy through monetary policy.
The central bank dictates reserve requirements (10% to 5% or whatever) and thus (in theory) can control the money supply.
The idea is that the fractional reserve system allows the central bank to control both the money supply and interest rates, which they believe are related to the amount of reserves available to commercial banks.
Fractional reserve banking is still being taught in many introductory economics courses and, on some courses, continues to be described as the cornerstone of how banks work.
“Fractional reserve banking is a cornerstone of modern financial systems, playing a crucial role in how banks operate and economies function. This system allows banks to hold only a fraction of their depositors’ money in reserve while lending out the rest, thereby facilitating economic growth through increased lending capacity.” — Fractional Reserve Banking: Principles, Impacts, and Innovations by Accounting Insights.
However, the belief in fractional reserve banking as a valid description of current banking practice is ‘on the way out’ - for the reasons I describe below:
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The Reality: Bank Lending Is Not Restricted By Existing Deposits
Bank lending is not restricted by the amount of cash banks hold in their vaults nor the magnitude of deposits they have with the central bank i.e. reserves.
In fact, many countries do not have reserve requirements at all, including the UK, Canada, Australia, New Zealand, Sweden and Hong Kong. And as of March 15, 2020, the United States reserve requirement level is set to zero percent.
“At the time of the financial crisis, for example, banks held just £1.25 in reserves for every £100 issued as credit. Banks operate within an electronic clearing system that nets out multilateral payments at the end of each day, requiring them to hold only a tiny proportion of central bank money to meet their payment requirements.” – Ryan-Collins, Josh; Tony Greenham; Richard Werner; Andrew Jackson. Where Does Money Come From?
As we discovered when exploding our previous myth, loans create new bank deposits, not the other way around, i.e. existing deposits are not the source of new loans.
“The textbook model of banking implies that banks need depositors to start the money creation process. The reality, however, is that when a bank makes a loan it does not require anyone else’s money to do so. Banks do not wait for deposits in order to make loans.” – Ryan-Collins, Josh; Tony Greenham; Richard Werner; Andrew Jackson. Where Does Money Come From?
And banks don’t need to hold a certain level of reserves in order to make new loans. They need to have a certain level of reserves to settle payments with other banks and/or to meet regulatory requirements. However, if and when those are needed, reserves can be added ‘after the fact’, i.e. after a loan has been made not before.
If a bank is low on reserves it can borrow from another bank or, as a last resort, it can borrow from the Central Bank.
The aggregate level of Central Bank reserves is managed by the Central Bank itself, in order to meet its target interest rates. The level of a bank’s reserve is not wholly in the hands of the banks themselves.
The Real Constraints: Capital Constraints And Regulations
Banks do indeed have constraints on what they can do. However, those constraints relate to banking regulations and the related capital adequacy rules. For example, in the UK these rules, policed by the Bank of England’s Prudential Regulation Authority, state that banks (and other financial institutions) must hold enough of their own capital (the value of a bank's assets after liabilities are deducted) to cover potential losses and ensure financial stability.
Beyond that, the constraints outlined by fractional reserve banking in our modern banking system are illusory.
Why Is This Myth Dangerous?
This myth is dangerous because it assumes that the Central Bank can control lending and, therefore, control ‘the money supply’ by controlling the level of reserves.
This is the mistake that Milton Friedman made when he assumed that governments could control inflation by utilising their ability to control the money supply. It is dangerous because it leads to ineffective policy choices while ignoring the fact that it is banks who effectively control the money supply.
“Inflation is always and everywhere a monetary phenomenon” Milton Friedman
Myth 3. Commercial Banks Create Net New Money
It is commonly believed that commercial banks are the source of all (or almost all) new money in the economy. The story goes like this: a bank issues loans; those loans fuel economic growth; economic growth allows individuals and businesses to pay their taxes; and it is these taxes that enable governments to pay for public services.
Ergo, government funding is dependent on the largess of taxpayers and, in particular, wealthy individuals who are responsible for a high proportion of government tax income.
So, without the availability of commercial banks providing new money to fund growth, not only would there be no growth but there would be no government services.
The Reality: Only The Central Bank Has The Power To Create Net New Money
Banks do create money when they create loans but they do not create net new money - only the Central Bank can do that. Banks create loans (financial assets) and corresponding deposits (liabilities) - which are effectively two sides to the same account, i.e. they cancel each other out.
“The banks can create money, yes they can. But they lent money and that has to be repaid. So, Over time the net creation of banks is close to zero. Because all the money they create through lending they get back. Because the loans are repaid.” Economist Dirk Ehnts on the MMT Podcast
It is true to say that commercial banks largely control the money supply. When customers feel confident that they will get a return on their investments - whether that be to purchase property or to grow a business - they apply for loans. Banks assess their potential customers’ plans based on credit worthiness and the value of their collateral.
The appetite for loans waxes and wanes as confidence in the future of the economy waxes and wanes. However, this does not negate the fact that loans have to be repaid.
Not only is it true to say that no net new money is added to the economy but money is potentially removed from the private sector when the interest is paid on loans - which is the bank profit. If bank profit are not added back into the private sector via a dividend - then the result is actually less money in the private sector after the loan has been made and paid of - than before the loan was issued.
As we learned earlier, banks create credit from thin air, they do not lend out customers’ deposits and their ability to lend is not constrained by reserve requirement rules.
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Why is this myth dangerous?
To explain why this myth is dangerous, I will first set out the context within which banking takes place: the primacy of government issuance of currency and the impact of private sector debt.
Bank loans are private sector debt
What we must not forget is that all private sector loans are private sector debt. I mentioned earlier that it is bank loans that increase or decrease the private sector money supply. I could rephrase that as: bank loans increase or decrease private sector debt.
Currency-issuing governments are the monopoly issuer of their own currency
What we must not forget is that all net new currency comes from, and can only come from, the government. That money is a ‘loan’ only in the sense that you are expected to pay back some of it with your taxes. But it’s unlike a bank loan, insofar as a portion of that money stays in the non-government sector – i.e. deficit spending.
A government deficit represents the difference between what the government spends and what the government brings back in via taxes.
Without a government currency, there is no modern banking system
What we must not forget is that without governments issuing currency, there is no modern banking system as we know it today. Banks are, in practice, financial agents of the state. They operate within a framework defined by the state, extending credit in a unit of account issued by the government. They rely on the support of the central bank to function.
“I realised. Wait a minute. The government created charters and gave it to banks. It says, ‘Here’s what you can do with our unit of account.’ There’s a fundamental difference between bank money and government-spent money. Government-spent money can create net financial assets. In other words, after taxes and everything else goes away, the government-spent money still exists.”
– Steve Grumbine, Macro N Cheese
And without deficit spending, ‘working money’ would gradually disappear from the economy. In practice, economic activity would grind to a halt.
Here is a list of things that take money out of the economy: savings; paying back loans; taxes; paying for imports; retained corporate profits; foreign debt repayments.
Here’s a list of things that put money in: government deficit spending; export earning, foreign sector investment inflows; gifts and inheritance. While these factors put money into the private sector, government deficit spending remains the most important source of net financial inflows, sustaining private sector activity.
And, when people take out loans – which they do to a greater extent when governments stop spending (i.e. when governments enact austerity) – there comes a point where the burden of existing loans makes repaying or taking out further loans impossible.
“What a revelation. The idea that banks make loans – but you’ve got to pay back those loans. And if the government did not deficit spend, the interest payments on the bank loans themselves would wipe out every dollar in the economy… you need the government to deficit spend, or no one has any private savings.” – Steve Grumbine, Macro N Cheese
So why is this myth dangerous?
When citizens believe that money comes solely from private sector banks, they lend support to the story that governments must be removed from ‘interference’ in the economy.
They are supporting the story that it is the wealthy who fund public services. They are supporting the story that it is the wealthy who fund economic growth and that when governments spend, higher taxes are required to ‘fund’ that spending.
The result is greater concentration of power in the hands of the wealthy, greater pressure to limit public spending (weakening public services), and greater inequality and poverty.
In Conclusions: The Three Dangerous Myths of Bank Lending
Understanding bank lending is not a benign academic exercise. It impacts our understanding of how public services are funded. And it justifies the influence of wealthy individuals over government policy - which can lead to greater inequality and poverty. Understanding how banks really work, also helps us to understand how government spending works. And if we understand how government spending works we are in a better position to hold our politicians to account.
That’s all for now.
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MMT Factsheet 3: If Taxes Are Not For Spending What Are They For?
In truth banks do not ‘lend’ their, or others’ money to anyone! Nor do they give up anything they own in creating credit. Bank alchemy’s done with double-entry accounting. In it, they buy collateralized repayment promises with interest with uncollateralized credit they create and give themselves for nothing! And the dirty deed is the banks often sell the customer’s debt to others.
You touch on some important stuff here, to share a different perspective from an old and very different system across the great ocean and I will share with you a little of the USA's Old Republic banking, finance, and monetary theory, which approached this issue from a different angle. Within its social theory , banking, finance, and monetary structures were not to be treated as isolated technical sectors or neutral mechanisms, but as integral components of the society’s deliberative and decision-making architecture itself. The theory held that credit creation, monetary instruments, and financial channels directly influence who holds actual governing power, who participates in economic, scientific, and cultural decision making and coordination, and how distributed or concentrated the political economy becomes.
Thus, the problem was not simply one of credit expansion or instability per se, but whether the structures of finance were embedded within broadly participatory, sectorally and geographically diversified, and publicly accessible governance systems, or whether they became centralized tools for elite coordination and private planning. This lens places credit not just as fuel for flows, but as part of the operational design of democratic policy making