“Money Born of Credit” – Christopher Kent, RBA

This is the title of an interesting speech given by Christopher Kent (Assistant Governor Financial Markets, RBA) focusing on the question of how money is created and, in particular, the relationship between bank lending and money creation.

I took the following points away from the speech:

  • The basics of the speech are not contentious
  • While people tend to think of money in terms of coins and banknotes, in contemporary economies, money mostly consists of deposits in banks, building societies and credit unions (for convenience collectively referred to as banks)
  • Bank deposits are created when banks make loans so the net supply of money in the economy is closely linked to the  rate of net lending growth by banks
  • The power of banks to create new money is constrained in numerous ways by regulation, the behaviour of borrowers and lenders and by monetary policy
  • Having made this broad point, Kent then examines the relationship between money and credit in the Australian economy over the past four decades:
    • Starting in 1980 when deposits represented more than 80 per cent of Australian bank liabilities and were more than sufficient to cover loans which represented around 60 per cent of bank assets
    • Australian bank assets grew faster than deposits as the financial system was deregulated
    • The cross over point where loans exceeded the sum of bank deposits occurred in the 1990s and deposits currently (2018) represent only 40 per cent of bank liabilities while loans continue to represent around 60 per cent of bank assets

Reflecting on these trends, Kent concludes

“Looking back, it is clear that there have been many instances of sustained gaps between the growth of deposits – and broad money more generally – and the growth of credit (Graph 7). While broad money growth outpaced credit growth for most of the period since the financial crisis, this was not the experience of the two decades or more prior to the crisis, when credit typically outpaced broad money.

Graph 7

Graph 7: Credit and Broad Money Growth

This long history suggests that we should not be concerned about a so called deposit ‘funding gap’. Some commentators have suggested that the recent decline in the growth rate of money has left banks with insufficient deposit funding to support credit growth. According to this hypothesis, banks have been forced to seek other forms of funding, including from short-term money markets, which, so the argument goes, can help to explain the notable rise in rates in those markets in recent months.[13]What are we to make of this hypothesis? First, such a gap between the growth of deposits and credit has been commonplace over recent decades – and conditions in short-term money markets were benign through much of those earlier episodes. Second, loans are not the only assets on banks’ balance sheets; indeed, in recent quarters, growth in these other assets has been particularly slow – slower than both credit and deposits (Graph 8). So deposit growth has more than matched the growth in total assets.

Graph 8: Loan, Deposit and Balance Sheet Growth

Graph 8

Third, if some banks really did have insufficient deposit funding, we would expect to see them competing more vigorously for deposits by raising interest rates on those products. But retail deposit rates have been flat to down over the past year (Graph 9).

In short, there is little evidence that there is any relationship between the slowing of deposit growth and recent funding pressures in short-term money markets. More generally, given my earlier discussion about the extension of credit leading to the creation of banking system deposits, worrying about slower deposit growth impinging on the banking system’s ability to generate credit is putting the cart before the horse.

The overall message of the speech seems to be that slowing deposit growth should not be a concern because:

  • Credit has grown faster than deposits in the past, and bank lending creates deposits in any case, so “worrying about slower deposit growth impinging on the banking systems’s ability to generate credit is putting the cart before the horse
  • If deposit growth was really a problem then we would expect to see more evidence of banks competing aggressively on the interest rates they offer depositors

It may be that I am missing something here but, I don’t find these two arguments comforting. It is certainly true that bank lending creates a deposit in the first instance but I have two concerns with this line of argument. Firstly, the deposit created will not necessarily be the right kind of deposit required to ensure that banks can meet their Liquidity Coverage Ratio and Net Stable Funding Ratio requirements. My second concern relates to the capacity for deposits to grow faster than loans. This speech notes that this was the case in the period since the GFC. What is less clear is the mechanism by which this happens. This speech notes “households and businesses increased the share of their assets held in the form of deposits”

“Following the crisis, credit growth fell for a while (reflecting a decline in both the supply of and demand for credit). At the same time, the stock of (broad) money increased noticeably, rising by around $1.1 trillion dollars, from around 80 per cent of GDP in 2007 to around 115 per cent in 2018. This strong growth reflected a sharp increase in the share of funding sourced from deposits at the expense of short-term debt securities, consistent with banks seeking more stable funding. Meanwhile, households and businesses increased the share of their assets held in the form of deposits.”

I can see how net growth in bank lending creates a larger pool of deposits, but it is less clear how the overall pool of deposit funding grows in response to people wanting to hold more deposits. An individual household or business can obviously increase the share of their assets held as bank deposits. But, in doing so, someone else must be holding the other types of assets (bonds, shares, property) that the individuals have chosen not to buy or which they sold to increase the money they have on deposit. This preference to hold onto cash or bank deposits will I assume translate to downward pressure on the value of those alternative (more risky) assets, but I don’t see how the overall pool of deposits increases. The decline in the value of these other financial assets will I assume mean that the share of deposits increases in relative terms but that does not help the banking system fund loans. The relationship between deposits and credit growth impacts the health of the financial system so it is worth investing the time to understand it. It is entirely possible that I am missing something here but I can only call it as I see it.