The rise, and rise, of Commercial Bank Lending.
What is the limit on the amount the Commercial Banks are allowed to lend?
The story of credit crises is usually told from the demand side. The irrational exuberance of speculators down the ages drives inflated prices for over priced assets. Inevitably the bubble bursts. Inevitably everybody pays the price. But the supply side of this formula always seems to get overlooked. Why are the commercial banks able to supply a seemingly limitless quantity of loans to fuel the credit bubble? Why does a speculative bubble in Beanie Baby’s merely cause general embarrassment, while one in real estate cause massive economic dislocation?
This is a deceptively simple question, in the context of the larger fractional reserve banking system, since it is not just the quantity of the loans that is potentially problematic. Through the fractional reserve process, commercial bank lending also has potential money supply implications. If there is no limit on the total quantity of commercial bank loans, then there is effectively no limit on the commercial banks’ ability to create money through the fractional reserve re-deposit process.
It is also notable that discussion of the problem of credit supply last year, concentrated on the supposed fear that the banks have of the risk in lending to each other in the inter-bank markets, rather than the possibility that they might simply not have had any money to lend.
Hypothetically then, the question can be framed in at least three ways. Either there is a limit on bank lending, in which case it might be reasonable to suppose that it is that limit that is preventing inter-bank lending, and not a sudden outbreak of pathological loan aversion in bankers; or there isn’t, in which case the money supply is being controlled by the commercial bank’s individual lending policies rather than the central banks, which would be contrary to every foundational Economics textbook. The third possibility is that there is supposed to be a limit on lending, but some elements of the financial industry have found a way around it. However, given the entanglement that fractional reserve lending creates between the money and loan supplies, how exactly could this even be detected?
Going back to the previous post, a side effect of the fractional reserve banking system is that it creates two different kinds of debt within the economy. One is straightforward transfers in exchange for IOU’s of various kinds, either between individuals, businesses primarily in the form of bonds, and the government (treasuries). The other are the loans from the commercial banks, which represent a deposit somewhere in the banking system. For want of any better ideas, I’m going to channel physic’s particle/anti-particle structure and call them anti-deposits. Commercial bank originated loans for long. Debt that results from a direct transfer of monetary tokens will be referred to as transfer debt.
If there is something going wrong uniquely within the fractional reserve banking system, then one expected outcome might be a change in the proportion of anti-deposits to transfer loans within the general economy. If the amount of outstanding commercial bank loans is increasing faster than the quantity of transfer loans for example. Conversely, if the actual cause of the systemic problems that we’re currently living through is in fact government transfer debt, or increases in “fiat money” as I was confidently told by an Austrian economist back a few months, then we would also see a change, but it would be an increase in the amount of government originated transfer debt relative to commercial bank originated anti-deposits.
The quantity of outstanding debt within the United States economy is reported on a sector basis in the Z1 Flow of Funds report, Table D.3 The chart below shows the per sector information on Debt Outstanding.
From the explanatory notes in the current report. Foreign debt represents amounts borrowed by foreign financial and non-financial entitities in U.S markets only. Domestic financial sectors consist of government-sponsored enterprises, agency and GSE backed mortgage pools and private financial institutions.
The sectors aren’t totally clean with respect to being able to divide into transfer versus anti-deposit (bank originated debt). The domestic financial sector debt is for the most part being derived from bank loans in the forms of mortgages, since it includes Fannie Mae and Freddie Mac, who buy mortgages from U.S. banks and repackage them as bonds. Presumably also student loans, under the guise of Ginnie Mae.
Even so, it’s noticeable from the chart above that bank originated debt is growing faster than other sources. Comparing proportionately the amounts owed by each sector in 1975 versus 2008, shows this quite clearly:
Proportionally, the last 30 years have seen a shift away from government debt towards commercial bank debt, primarily in the form of mortgages, since that is the main component of the Domestic Financial Sectors sector. They have also seen an extraordinary rise in the total amount of debt, as was shown in the original flow of funds chart, and it also appears that this new debt has predominantly originated from the commercial banks, chiefly in the form of mortgages.
In theory, the fractional reserve mechanisms don’t allow banks to issue arbitrary amounts of debt. Originally they were limited to a fraction of their deposits, now they are limited to a multiple of their equity capital. So what exactly has gone wrong that is allowing the commercial banks both to create so many loans, and to increase the money supply?
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