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The ambiguity of multiple interpretations of money workings is by design, surely enough.

But the stated scenario does not give a full picture to me.

The bank knows that its overhead amounts to 1½ % of its portfolio

Seriously, is the overhead so practically proportional to the portfolio, or to the loan size? Would love to see how this proportionality works.

Having lent Bob money, the bank now has more liabilities that it needs to provide regulatory liquidity reserves for. It therefore goes to the interbank market to borrow the money at the central bank's policy rate.

But the CB loan only increases liabilities!

This liquidity ratio is not the same as fractional reserve ratio, right?

Does our bank has to borrow exactly the same amount from the CB as it lends to Bob? If not,

The bank looks up the central bank's policy rate, which turns out to be 2 %.

why does it add the full 2% to the costs, rather than a fraction of it?

And of course, if our bank has excess reserves, it has to borrow from the CB (even) less if at all. In a booming economy, the newly created money gets deposited in some bank, and liquidity reserves increase for virtually all banks, right? So there is hardly any need to borrow from the CB at those times, I guess.

Of course, things are very different when the credit market is collapsing and loans are underperforming. But then I see problems only in the assets/liabilities ratio, not in liquidity...

[The] central bank wants to suppress investments that would be profitable on their merits, in order to create enough spare capacity (read: Unemployment) in the economy to prevent inflation.

The implied wages/inflation "mechanism" is still not convincing to me. Certainly I don't see inflation following wages during a hyperinflation. If the problem is excessive money creation, then it is happening during a credit boom (like pre-2008). Why no one was crying about inflation then? At these times of desperate debt paybacks monitory obligations and volumes are actually being destroyed. How much does the CB "printing" offset decreasing M-volumes?

Then I have a problem with the assumption that the bank tries to balance it costs and profits like any other business. From what I could notice in post-Soviet transitions, banks were prospering well immediately, while they were basically just collecting liabilities (like saving accounts), not taking streams of asset returns yet. And then they get into problems when they should only enjoy asset returns?!!

Banking has more social impact than governing. Even if banks underperform as businesses, most of them are having better lunches than ever.

by das monde on Thu May 19th, 2011 at 06:46:58 AM EST
The ambiguity of multiple interpretations of money workings is by design, surely enough.

I don't think so. But it is probably not a coincidence that there is no great effort made to dispel the confusion.

The bank knows that its overhead amounts to 1½ % of its portfolio

Seriously, is the overhead so practically proportional to the portfolio, or to the loan size?

No. If it were, it would not be "overhead."

The marginal cost for the bank of making a loan is basically the funding rate - aside from the need to obtain regulatory reserves, there is no direct cost to the bank. However, running a bank involves costs, and revenue must cover those costs. And since properly run banks in properly run economies have a more or less predictable portfolio size and more or less predictable overhead, you can divide one by the other to arrive at some overhead markup. Just like an industrial firm can divide its total expected overhead by its total expected sales volume to get its required markup, even though there is no direct connection between any individual sale and its particular contribution to the overhead.

Having lent Bob money, the bank now has more liabilities that it needs to provide regulatory liquidity reserves for. It therefore goes to the interbank market to borrow the money at the central bank's policy rate.

But the CB loan only increases liabilities!

No, it also increases assets, by providing the bank with central bank money.

The reason the bank wants to do this is that insured deposits must be covered by central bank money, but debt to the central bank must not. So borrowing from the central bank increases liabilities but does not increase the amount of regulatory reserves required.

This liquidity ratio is not the same as fractional reserve ratio, right?

Yes it is. Or, depending on how you define the fractional reserve ratio, it may be the inverse.

Does our bank has to borrow exactly the same amount from the CB as it lends to Bob?

No. Under current institutional arrangements, it only has to borrow between 5 and 10 %. However, if Bob takes the money he borrowed out of the bank, the bank must borrow the remaining 90-95 % of the amount he takes out.

If not,
The bank looks up the central bank's policy rate, which turns out to be 2 %.

why does it add the full 2% to the costs, rather than a fraction of it?

Because in principle Bob could take out the money he borrowed (by, for instance, paying somebody who banks with another bank). In that case, Bob's bank would have to borrow the money Bob takes out (minus the regulatory reserves it has already borrowed).

And of course, if our bank has excess reserves, it has to borrow from the CB (even) less if at all.

Yes, but that doesn't matter, because the bank can lend excess reserves either on the interbank market or directly to the CB. And the CB always makes sure that one of those two options would pay the policy rate. Because that's what CBs do.

In a booming economy, the newly created money gets deposited in some bank, and liquidity reserves increase for virtually all banks, right?

No, because liquidity reserves are decreased by exactly the same amount when you take the money out of the first bank as they are increased when you put it into the second one. The only way you can "put money into" the banks without taking it out first is by running government deficits. Which you typically do not want to do in a boom, unless you have a serious foreign deficit that you really should be doing something about.

[The] central bank wants to suppress investments that would be profitable on their merits, in order to create enough spare capacity (read: Unemployment) in the economy to prevent inflation.

The implied wages/inflation "mechanism" is still not convincing to me.

That is because you have a good bullshit detector. The implied wages/inflation mechanism is a nonsense. But as a matter of contemporary institutional reality, it is a nonsense that sets central bank interest rate policy.

Now, you certainly can suppress domestic inflation with higher interest rates. Because if you increase interest rates, you can create excess capacity in the economy. And when there is excess capacity, businesses can not well afford to raise prices, for fear of losing market share. But that is the dumb way to control inflation. It is also completely ineffective against imported inflation, and for countries with large hard-currency debts it creates a very real risk of a currency collapse.

Certainly I don't see inflation following wages during a hyperinflation. If the problem is excessive money creation,

But it's not.

Hyperinflation is what happens when a country with a structural foreign deficit (due to import dependencies, war reparations or failing to default on unpayable hard-currency debts) suddenly loses access to hard-currency credit. It has only the most platonic of relationships with the ordinary, everyday version of inflation (and the latter can certainly not turn into the former unless the country's currency policy is grossly mismanaged).

then it is happening during a credit boom (like pre-2008). Why no one was crying about inflation then?

Because the inflation was happening to asset prices. Which lazy money likes. It's consumer price inflation that lazy money doesn't like.

How much does the CB "printing" offset decreasing M-volumes?

In the €-zone it does not. In the US it does to some extent, since the US has made a reasonably determined fiscal response to the depression.

Then I have a problem with the assumption that the bank tries to balance it costs and profits like any other business.

Well, that's what they should be doing.

What they are actually doing at the moment is aiding and abetting (and participating in) asset-stripping the productive economy.

From what I could notice in post-Soviet transitions, banks were prospering well immediately, while they were basically just collecting liabilities (like saving accounts), not taking streams of asset returns yet.

Oh, but the banks in the post-Soviet transition were taking in rather a lot of asset streams. They were in the middle of the scams that let various mafiosi and oligarchs (but I repeat myself) rise to power and wealth. In fact, privatising and deregulating the financial sector may well have been the single most pernicious policy of the Yeltsin era, in terms of both economic consequences and deterioration of the rule of law.

Banking has more social impact than governing.

Banking is a form of governing, which is why it needs to be accountable to the government.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu May 19th, 2011 at 07:05:40 PM EST
[ Parent ]
Thank you a lot. A few further questions.

The marginal cost for the bank of making a loan is basically the funding rate - aside from the need to obtain regulatory reserves, there is no direct cost to the bank. However, running a bank involves costs, and revenue must cover those costs.
But are those running costs so high that they are comparable to a fat % of the portfolio, in properly run economies? I see only own real estate upgrades as comparably substantial costs.

This liquidity ratio is not the same as fractional reserve ratio, right?

Yes it is. Or, depending on how you define the fractional reserve ratio, it may be the inverse,

Wikipedia says somewhat otherwise:

In the United States the required reserves, also called the liquidity ratio, is set by the Board of Governors of the Federal Reserve System. Requirements vary based upon the size (in total amount of transactions) of the depository institution. For institutions with up to $10.7 million, there is no minimum reserve requirement. Institutions with over $10.7 million and up to $55.2 million in net transaction accounts must have a liquidity ratio of three percent. Institutions with more than $55.2 million in net transactions must have a liquidity ratio of 10%.

These requirements apply only to transaction accounts such as checking accounts (collectively called M1 transactions in the analysis of money supply), and do not apply to time deposits such as CDs, savings accounts, or deposits from foreign corporations or governments. For these account classes, the fractional reserve requirement is one percent (1%) regardless of net account value. When a bank falls below its reserve requirement, it can take out a very short-term loan (often for a period of 24 hours of fewer) from the Federal Reserve or from another bank with excess reserves.

What is then the difference between liquidity and solvency? For any other business entities, the liquidity ratio is just the quotient Liquid assets / Total assets.

And of course, if our bank has excess reserves, it has to borrow from the CB (even) less if at all.

Yes, but that doesn't matter, because the bank can lend excess reserves either on the interbank market or directly to the CB. And the CB always makes sure that one of those two options would pay the policy rate. Because that's what CBs do.

So, consumers have to pay to compete with the lending excess reserves option. Does this mean that the banks automatically get the CB rate gains of the liquidity reserves? Or does, in effect, the CB claims that rate out of all M1 circulation? Do the CB assets increase at all times?

by das monde on Fri May 20th, 2011 at 03:32:26 AM EST
[ Parent ]
What is then the difference between liquidity and solvency?
Solvency is the abstract quality of being able to use one's assets to meet one's liabilities. Solvency is in principle, assuming the book value of an asset allows it to be used in payment of the liabilities.

Liquidity is the ability to use an asset for payment of momentarily maturing liabilities, or more narrowly the ability to liquidate the asset for cash with which to pay the liabilities.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Fri May 20th, 2011 at 05:21:28 AM EST
[ Parent ]
But are those running costs so high that they are comparable to a fat % of the portfolio

Well, profits alone is a cost that can't go much below half a percent of the portfolio: 5 % return on equity is not outrageous, and you don't want banks to be gearing harder than about 10 or 20 to 1 in the ordinary case.

Wikipedia says somewhat otherwise

No, it says the same thing.

So, consumers have to pay to compete with the lending excess reserves option.

Yes.

Does this mean that the banks automatically get the CB rate gains of the liquidity reserves?

Yes, any excess liquidity will be remunerated at the policy rate.

Do the CB assets increase at all times?

Yes, if the CB is doing its job right, its balance sheet should continually increase.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri May 20th, 2011 at 08:32:45 AM EST
[ Parent ]
One more thing.

Because the inflation was happening to asset prices. Which lazy money likes. It's consumer price inflation that lazy money doesn't like.

I reckon this is a social-political preference, not an economic imperative. Where are Randians on this?

by das monde on Fri May 20th, 2011 at 03:44:56 AM EST
[ Parent ]
I reckon this is a social-political preference, not an economic imperative.

Yes. See Mig's sig.

Where are Randians on this?

Insane. And blaming the government in defiance of obvious facts. As they are on every other subject.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri May 20th, 2011 at 08:25:57 AM EST
[ Parent ]

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