Banks are not intermediaries, the loan comes before the deposit

20130323_LDP001_0A key thing missing in last week’s coverage of the Cyprus crisis is that banks create a loan before they create a deposit.  Almost all journalists and commentators all fall into the trap, believing that banks are true intermediaries between saver and borrower.

Michael Kumhof, a former bank manager at Barclays, disposes of this myth in his article with Jaromir Benes called the Chicago Plan Revisited, and in subsequent lectures and papers. Kumhof, an IMF economist, says clearly; “The loan precedes the deposit. I know because I did it and if anyone like Paul Krugman tells you otherwise he doesn’t know what he is talking about.”

I was explaining to a friend the other day that if banks have 100% backing for their deposits there is no risk of a run on the bank. Her reply was “But then they would have nothing left to lend out.” This friend was believing, as is fed to her in the daily media, that banks lend out their deposits. Kumhof goes further than this by saying “The chief function of banks is to create the nation’s money supply. They are solely in charge of it.”

So when rich Russians deposit their money in the Laiki Bank in Cyprus the deposits are not lent out at all. The bank itself decides who will have loans, issues the loan and at the same time writes an equivalent deposit on the other side of the ledger. How do you think the size of the banking sector in Cyprus reached eight times the size of the economy in 2011?  The banks made loans and were solely in charge of the credit blowout.

And it is the same with the rapid expansion of the Iceland banking system. Banks made loans for houses, cars, aeroplanes, condominiums and seldom asked questions. In fact as Hordur Torfason the Iceland activist explained, he was called into the manager’s office and offered a big loan when he didn’t even want one. We know that the bank staff have incentives for issuing more loans. They are paid more if they do.

The tragedy of all this is that the universities are not teaching it honestly to each generation of students of economics. The economists tell the journalists and so the myth continues. Hopefully Cyprus will help the public understand the whole horrible faults of the way we rely on banks to create and decide on the country’s supply of credit.

A transcript of the first seven minutes of Michael Kumhof’s talk is here.


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