What is a bank loan?
When a bank makes a loan, does it create money “from thin air“? Are banks merely intermediaries, where “if people are borrowing, other people must be lending“? I consider these sorts of questions less and less helpful. Let’s just understand what a bank loan is, in terms of real resources and risk.
Suppose I go to my local bank and ask for a loan. The bank says yes, and suddenly there is “money in my account” where there was not before. Am I now a “borrower” and the bank a “creditor”?
No. Not at all. The transaction that has occurred is fully symmetrical. It is as accurate to say that the bank is in my debt as it is is to say that I am in debt to the bank. The most important thing one must understand about banking is that “money in the bank” also known as “deposits” are nothing more or less than bank IOUs. When a bank “makes a loan”, all it does is issue some IOUs to a borrower. The borrower, for her part, issues some IOUs to the bank, a promise to repay the loan. A “bank loan” is simply a liability swap: I promise something to you, you promise something of equal value to me. Neither party is in any meaningful sense a creditor or a borrower when a loan is initiated.
Now suppose that after accepting a loan, I “make a purchase” from someone who happens to hold an account at my bank. That person supplies to me some real good or service. In exchange, I transfer to her my “deposits”, my IOUs from the bank. Suddenly, it is meaningful to talk about creditors and debtors. I am surely in somebody’s debt: someone has transferred a real resource to me, and I have done nothing for anyone but mess around with financial accounts. Conversely, the seller is surely a creditor: they have supplied a real service and are owed some real service in exchange. It would be natural to say, therefore, that the seller is the creditor and I, the purchaser, am the debtor, and the bank is just a facilitating intermediary. That is one perspective, a real resources perspective.
But it is an incomplete perspective. Because in fact, the seller would not accept my debt in exchange for the goods and services she supplies. If I wrote her a promise to perform for her some service of equal value in the future (which might include surrendering crisp dollar bills), she would not accept that promise as a means of payment. I circumvent her fear by writing to the bank precisely the promise that the vendor would not accept and having the bank “wrap” my promise beneath its own. The bank’s job is not to “lend” anything in any meaningful sense. The bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants to borrow. The bank’s role is to transform questionable promises into sound promises. It is a kind of adapter of promises, or alternatively, a guarantor. [*]
Let’s suppose for a moment that the bank’s promises are in fact ironclad. With 100% certainty, the bank will deliver to holders of its IOUs the capacity to purchase real goods and services as valuable as those that were surrendered to acquire the IOUs. Now, when I transfer to a seller IOUs the bank has issued to me in exchange for my somewhat sketchy promises, is it still meaningful to refer to the seller as a “creditor”? After all, she has already received something that is unquestionably as valuable as the goods and services she has surrendered. So her situation is flat, “even-steven”. In exchange for her real resources, she has “money in the bank” whose purchasing power is guaranteed. She bears no risk. But the bank still bears the risk that I will fail to honor my promise while it will be required to honor its own without fail. Which is the creditor then, the seller or the bank? It becomes a matter if definition.
So let’s define. A party that has supplied real goods and services in exchange for a promise of future reciprocation is a “creditor from a real resources perspective”. A “creditor from a risk perspective” is a party that bears the risk that a transfer of resources will fail to be reciprocated. When I have taken a bank loan and “spent the money”, the seller becomes a creditor from a real resources perspective, while the bank becomes a creditor from a risk perspective. The role of creditor becomes bifurcated.
More accurately, the role of creditor becomes “multifurcated”. It cannot be true that “the bank” is a creditor from a risk perspective. Remember: the bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants. The risk that we claim sits with “the bank” must in fact fall on people who control or have controlled or might control real resources. We need to consider the “incidence” of the bank’s risk. It might be the case, for example, that the bank’s IOUs, its “deposits”, are in fact not solid at all, such that if I fail to repay the loan, the bank will fail to make good on its promises to people who supplied real goods and services in exchange for bank IOUs. In this case, the “creditors from a risk perspective” are the depositors, people who have delivered real goods and services in exchange for promises from the bank. When depositors are on the hook — and only when depositors are on the hook — there is no divergence of identity between creditors from a risk perspective and creditors from a real resources perspective. Only when depositors absorb losses it is fair to describe a bank as a mere intermediary between groups of borrowers and lenders, perhaps performing credit analysis and pooling risk to facilitate transactions, but otherwise just a pass-thru entity.
That is not how modern banking systems work. Bank depositors are almost entirely protected. The actual incidence of bank risk is, um, complicated. In theory, the risk of loan nonpayment falls first on bank shareholders, then on bank bondholders, then on uninsured depositors, and then on the complicated skein of taxpayers and other-bank stakeholders who back a deposit insurance fund, and then finally on holders of inflation-susceptible liabilities (which include bank depositors). In practice, we have learned that this not-so-simple account of the incidence of bank risk is inadequate, it cannot be relied upon, that the incidence of bank risk will in extremis be determined ex post and ad hoc by a political process which favors some claimants over others when the promises that a bank has guaranteed prove less than valuable.
This may all sound confusing, but one thing should be absolutely clear. Under existing institutions, there is little coincidence in the roles of creditor from a real resource perspective and creditor from a risk perspective. Our banks are machines that permit vendors to surrender real resources in exchange for promises the risks of which they do not bear. The risks associated with those promises do not go away. They may be mitigated to some degree by diversification and pooling. They might be modest, in the counterfactual that banks were devoted to careful credit analysis. But these risks must be borne by someone. The function and (I would argue) purpose of a banking system is to sever the socially useful practice of production-and-exchange-for-promises from the individually costly requirement of assuming the risk that promises will be broken, in order to encourage the former. The essence of modern banking is a redistribution of costs and risks away from people who disproportionately surrender real resources in exchange for promises. Under the most positive spin, modern banking systems engineer an opaque subsidy to those who produce and surrender more real resources than they acquire and consume by externalizing and ultimately socializing the costs and risks of holding questionable claims.
Unfortunately, there are a lot of ways of acquiring protected claims on banks besides producing and surrendering valuable real resources. This divergence of “creditor from a real resources perspective” and “creditor from a risk perspective”, between the party to whom real resources are owed and the party who bears the cost of nonperformance, creates incredible opportunities for those capable of encouraging loans that will be spent carelessly in their direction. Incautiously spent loans are unlikely to be repaid, but the recipients of the money never need to care. Industries like housing and education and of course finance depend heavily on this fact. When industries succeed at encouraging leverage that will be recklessly spent or gambled in their direction, they create certain gains for themselves while shifting risks and costs to borrowers and the general public.
Banks are not financial intermediaries in any simple sense of the word. When they “make a loan”, they serve as guarantors, not creditors. The borrower does not meaningfully become a debtor until the loan is spent. Only then do creditors emerge, but the role of creditor is bifurcated. The people to whom resources are owed are not the same as the people bearing the risk of nonperformance. The question of who actually bears the risk of nonperformance has grown difficult to answer, and concomitantly, incentives among bank decisionmakers for caution in creating that risk have weakened, especially relative to the benefits of cutting themselves in on some share of borrowers’ protected expenditures. This bifurcation of the role of creditor also explains why creditors as a political class are relatively indifferent to the upside of a good economy but extremely intolerant of inflation. A good economy means better higher values and better performance on outstanding loans, but creditors who are owed resources but are absolved from risk do not care about the performance of the loans that have become their assets. Those fluctuations, like fluctuations of the stock market, are somebody else’s problem or somebody else’s gain. Protected claimants, people who are owed money by banks or the state (which is itself a bank), can only lose via inflation. They understandably work within the political system to oppose inflation, which would force them to bear some of the cost of the bad loans whose misexpenditures were, in aggregate, the source of much of their wealth.
[*] Update: JW Mason of the remarkable Slack Wire gently chides that I ought to have attributed this point to Minsky. And indeed I should have! From Stabilizing an Unstable Economy (Nook edition, p. 227):
[E]veryone can create money; the problem is to get it accepted.
Banking is not money lending; to lend, a money lender must have money. The fundamental banking activity is accepting, that is, guaranteeing that some party is creditworthy. A bank, by accepting a debt instrument, agrees to make specified payments if the debtor will not or cannot. Such an accepted or endorsed note can then be sold in the open market.
- 8-Jul-2012, 8:10 p.m. EEST: Added update/footnote with attribution to Minsky, many thanks to JW Mason.