3.4 Constraints on bank lending

for each bank consist of cash (C) of 10 and deposits at the central bank (D) of 40.

bb

Imagine now that banks feel this is too low and that bank A tries to improve its

situation by bidding deposits of 10 from each of B and C. If bank A succeeds, its

customer deposits rise to 1,020 matched by an increase in its deposits at the central

bank from 40 to 60. Bank A’s reserve ratio has increased dramatically to 6.86 per

cent (60 10 1,020). But total reserves in the system are unchanged: Bank A’s

position has improved only because the position for B and C has deteriorated. If B

and C now retaliate by trying to retrieve their lost deposits from A, the aggregate

position will still be unchanged, individual ratios will be returned to 5 per cent,

but there is a distinct possibility that interest rates will have been bid up in the

competition for deposits.

The second possibility is that a bank could rearrange its assets by selling securities.

Assume that it sells to people who bank elsewhere. When their cheques are cleared

our bank will have fewer securities but more operational balances to its credit and

its position will have improved. Customers of other banks will have more securities,

fewer bank deposits and their banks will have fewer operational balances. As a

solution to a general shortage of balances, however, the fallacy is already apparent

because it is very similar to the previous case. If all banks sell securities, they will

all lose deposits and balances as their own customers buy securities. Of course, they

will retrieve some of those balances from their own security sales, but the message

is clear. The total stock of Dwill not increase.

b

Will anything have changed? Since banks have sold securities to people who

surrender deposits for them, the xed stock of balances will be larger in proportion.

The ratio will have improved, but this is no solution to the original problem which

was that banks wanted to expand their business by lending more. In fact, their

balance sheets are now smaller by the loss of securities on the asset side and of

deposit liabilities. Notice also that this generalised sale of securities by banks is likely

to have driven down their price and therefore to have pushed up interest rates.

A third possibility also involves a rearrangement of assets. Banks could call in

funds lent ‘at call’ to the money market (‘market loans’ in Table 3.3). Holders of

the funds, generally other banks, have no option but to repay. Some of their opera-

tional balances are therefore transferred to the rest of the monetary sector and banks

initially appear to have achieved what they want: more deposits at the central

bank, fewer market loans and a more favourable ratio which would allow them to

lend more.

However, the shortage of liquidity is transferred to banks active in the money

market. Normally to raise funds the banks could think of selling off bills, but with

a generalshortage of liquidity the only possible buyer is the Bank of England. As

we have seen, the Bank agrees always to provide assistance in such circumstances,

though as a monopoly buyer of bills/monopoly supplier of liquidity it can impose

its own terms. But if we start, as we did, with the assumption that the authorities

were not willing to expand the quantity of base money, then the Bank is going to

refuse assistance.

The money market banks would then be obliged to pay whatever level of interest

was required to prevent other banks demanding money at call, i.e. that rate of interest

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Chapter 3 • Deposit-taking institutions

on call money which persuaded banks not to use this route to increase their balances

at the Bank but to forgo instead their intention of increased lending. Conceivably,

interest rates could rise very high indeed.

What this discussion reveals is twofold. Firstly, that the monetary sector can

expand its assets and liabilities up to a limit imposed by its available reserves. The

desired ratio of reserves:deposits may be a matter of commercial prudence and may

therefore vary in the light of circumstances (as in the UK) or it could be ‘mandatory’,

imposed as a matter of regulation by the monetary authorities. Whatever its origin,

however, there will at any time be some such ratio which banks will wish to

observe.

Secondly, because the reserves in question – notes and coin and balances at the

Bank of England – are liabilities of the Bank of England, the Bank is itself the sole

supplier of such reserves. The fact that all banks require some reserves in the form

of bankers’ deposits at the Bank of England makes such deposits an essential input

into the money-creation process. If the authorities refuse to increase the size of the

monetary base, therefore, there must come a point at which further lending, and

monetary growth, are inhibited.

In a system where the authorities exercise rigid control over the size of the

monetary base, leaving interest rates to settle at whatever level matches the demand

for loans to banks’ ability to supply them, the money supply is said to be exogenously

determined. ‘Exogenous’ means that the money supply is determined ‘outside of’

or independently of the rest of the economic system. It is imposed, in effect, by

the authorities. This is the sort of system that underlies the vertical money supply

curve which is often drawn in diagrams showing the interaction between money

supply and money demand. In the alternative case, where the central bank supplies

whatever reserves banks require to enable them to lend, hoping that setting the level

of interest rates will curb the demand for bank lending, the money supply is said

to be endogenouslydetermined. The central bank sets the price of bank loans and the

money supply is then determined within the economic system by those variables

which give rise to agents’ demand for bank loans.

It should be clear by now that in most monetary systems the money supply is

endogenously determined. The central bank supplies reserves on demand but sets

the price. At that price the quantity of money and credit will depend upon the

demand for it. Nonetheless, the joint facts (a) that sound banking requires banks

to hold a minimum level of reserves and (b) that the central bank is a monopoly

supplier of reserves have led many textbooks (and some commentators) to describe

the money supply process as though it were exogenous. (The vertical supply curve

just mentioned is a case in point.) In these circumstances, the money supply is

shown to be determined by the quantity of reserves, xed by the central bank, and

a deposit or credit ‘multiplier’. Notice that in this model it is the quantityof reserves

which the central bank is assumed to control. A monetary policy based upon this

model, i.e. one in which the central bank xes the quantity rather than price of

reserves, is known as ‘monetary base control’ and was actively promoted by some

economists in a debate about monetary policy in the UK in 1981. We know that it

was rejected, and the reasons are given in Box 3.5.

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