quantative easing question

bobhopeful · 10 July 2018 at 1:04PM

Central banks increase money in the economy by creating cash and using it to buy bonds held by banks, and the banks then have more cash to lend which then enters the economy.
Presumably banks can sell the bonds they hold at any time, so if the banks were holding bonds, presumably for a reason, why are the banks happy to sell the bonds they were holding in return for cash?
I cannot find a basic answer to this. Thanks if you know!

System · 10 July 2018 at 1:19PM

The central bank buys bonds /gilts in the market so from banks and anyone else that holds bonds/gilts. They sell because the price of the bonds/gilts has gone up (simple economics) and they can get a better return on other (more risky) assets.

grey_gym_sock · 10 July 2018 at 9:07PM

bobhopeful wrote: »

Central banks increase money in the economy by creating cash and using it to buy bonds held by banks, and the banks then have more cash to lend which then enters the economy.

it's not what you asked, but this part isn't correct. banks don't lend out cash they've received as a result of quantitative easing. in fact, they don't lend out cash they've previously received at all. instead, when they make loans, the process of granting a loan itself creates more cash! this may seem counter-intuitive, and it's widely misunderstood (including by most MPs, for instance), but there you go!

look at it like this: there are 3 kinds of players in the money system in the UK:

1) the UK treasury + the bank of england. it's simplest to look at them as a single entity, because the BoE is 100% publicly owned. it's all the UK, or the State.

2) commercial banks.

3) everybody else who uses sterling. i.e. businesses who aren't banks, real people, other organizations, etc.

from the point of view of (3) (i.e. most of us), cash comprises 2 things:
a) physical notes + coins.
b) credit balances in instant-access bank accounts.
and there is a lot more of (b) than of (a) in existence, i.e. cash is mostly what we hold in bank accounts.

but from the point of view of (2) (i.e. commercial banks), credit balances in bank accounts are not really cash. they're not assets at all, but liabilities: it's what they owe to their customers. from banks' point of view, loans they've granted to their customers are assets - it's what the customer owes to them.

when banks grant a new loan, they create entries in 2 different accounts: they credit a bank account, which is how the customer receives the money, and they create a loan account, which records the amount the customer now owes the bank. from the customer's point of view, they have an asset in their bank account, and a liability in their loan account. from the bank's point of view, it's the exact opposite. but the interesting point is that there is now more cash in existence (because of the increased balance in the customer's bank account), and this cash wasn't taken from anywhere else, it sprang into existence "out of thin air", as a result of the parallel creation of entries in 2 different accounts (bank account and loan account).

repaying a loan is the reverse of the process of granting a loan. the amount of cash in existence decreases, as the credit balance in a customer's bank account is reduced (and their loan account is wiped out).

but what about QE? does it give banks more cash, and if so, how?

well, the relationship between (1) and (2) (between the central bank and commercial banks) is a bit like (but not 100% the same as) the relationship between (2) and (3) (between commercial banks and their customers). similar to commercial banks maintaining records of the credit balances in their customers' accounts, the central bank maintains records of the reserves which each commercial bank holds. from the point of view of a commercial bank, its reserves are an asset, and you could say that reserves are a bit like cash from their point of view.

in QE, the central bank buys gilts from somebody. to keep it simple, let's suppose they do buy them from a commercial bank. in that case, that bank now holds a different mix of assets: more in reserves, less in gilts. overall, it has assets of more-or-less the same value as before.

can the bank now lend out some of its increased reserves to customers? no! because it can't lend out reserves at all. lending money to customers doesn't work like that. (i've already tried to describe how it does work.)

so does QE have anything to do with increasing bank lending? well, maybe, indirectly. QE tends to increase the price of gilts (because the BoE is an extra buyer in the gilts market), which reduces longer term interest rates. it is possible that lower interest rates will encourage borrowers to borrow more, because the interest on debt will be more affordable now. and it may encourage banks to lend more, because they can see that borrowers are less likely to default when they're paying lower interest rates.

OTOH, it may be that reducing longer term interest rates has no effect on borrowing, because borrowing is low for reasons other than interest rates being too high. e.g. lack of good investment opportunities, weak demand (for whatever products/services would to be made using the borrowed money), etc.

so there may be some increase in lending as an indirect result of QE. but it is probably a very small effect. so we've had £435bn of QE in the UK; but if there's been any increase in bank lending as a result, it's surely been a much smaller figure.

DiggerUK · 10 July 2018 at 10:05PM

This article from The Bank of England, published in 2014, explains how money is created, including QE.
If you get a handle on it, you will also begin to understand why savings accounts are so dire. The separation of investment and commercial banking is to blame.

It is in pdf so if you really are keen to learn, download and keep coming back to it. I've read it a few times now, and each time a bit more sinks in ..._

https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf

Terry_Towelling · 11 July 2018 at 4:52PM

So, if banks are effectively creating cash when they lend, it is to be hoped that there exists a set of rules which prevents them from being too creative.

I also guess that where a bank creates cash like this it takes on an obligation to remove it from the money-go-round at some point in the future. Usually, this would be done as the customer gradually repaid the loan but, if the customer defaulted on the loan payments, and no such obligation existed on the bank why would they care about the default and why would they bother making provision for bad & doubtful debts?

bowlhead99 · 11 July 2018 at 8:28PM

Terry_Towelling wrote: »

I also guess that where a bank creates cash like this it takes on an obligation to remove it from the money-go-round at some point in the future. Usually, this would be done as the customer gradually repaid the loan but, if the customer defaulted on the loan payments, and no such obligation existed on the bank why would they care about the default and why would they bother making provision for bad & doubtful debts?

If you were following Grey Gym's explanation...

Yes, banks effectively create cash when they lend, because they say to the borrowing customer, "hey mr customer, I am now holding £5000 in your current account on your behalf, and in turn you owe me £5000. Feel free to settle that loan by leaving your money in there for me to have it back... but I know we didn't just sign loan paperwork for me to take the money back straight away, so more likely, take your money away to some other financial institution or to pay someone off, and then you can pay me back later in line with our loan agreement".

So at that point in time, the bank has an asset of £5000 (a loan owed to it by a customer which can be collected in due course), supported by a customer current account deposit of £5000 (a liability from the bank's perspective, because it's money that the bank is now officially holding on behalf of the customer, and the customer can demand that the bank transfers the money elsewhere... the contents of the customer account belong to the customer not to the bank, who is merely providing a depositary service for that newly-created money)

At the moment of creation then, the bank's net assets didn't change, it simply has a new asset and a new liability. But as noted in the above posts, the 'supply of money' has increased, because there is more total money in current accounts that could be taken away and spent. Within reason at least... the bank's can't just issue unlimited loans because they have practical regulatory constraints.

So let's say I am Bank1plc and I enter into a loan agreement with you the customer. At inception of the agreement, you owe me a loan of £5000 reference ABCDE, and I am holding £5000 of cash for you in your account #12345678. Fair enough.

Then you as Mr Customer say, OK, there's this £5000 in my current account #12345678 at Bank1plc and I need to pay a gas bill of £200 and a credit card bill of £2800 and I'd like to put £1900 into my Nationwide account so I can earn a high interest rate on it before I do all my home improvements etc. So, Bank1plc, please transfer £4900 of cold hard cash to those three locations and you'd better keep hold of the last £100 in my current account because in a few weeks time I need to give you £100 as the first installment of the loan, and I'll pay it to you by direct debit out of that account.

As a consequence, the bank sends £4900 of cold hard cash to the other three locations. In doing so, its loan asset of £5000 didn't change (the customer owes it the money) but now it has massively reduced its liability to the customer (as it is no longer holding £5000 of the customer's cash in a current account deposit, but only £100) and it has sent the bank's own cash out of the door to those three named locations as instructed by the bank.

So, instead of Bank1plc having £5000 of loan asset owed by Mr Customer and £100,000,000 of its own cash, supported by £5000 of deposit from Mr Customer and £50,000,000 of deposits from other customers and £40,000,000 debt to investors and £10,000,000 of share capital...

It now has £5000 of loan asset owed by Mr Customer and only £999,995,100 of its own cash and liquid assets (because it sent £4900 of its cash to other locations on demand of Mr Customer); supported by £100 of deposit from Mr Customer (no longer £5000 because it sent £4900 of the customer's deposts to those other places) and £50,000,000 of deposits from other customers and £40,000,000 debt to investors and £10,000,000 of share capital.

Then the next month it takes £100 by standing order or direct debit as part settlement of the loan, from Mr Customer's current account.

So now the bank has £4900 of loan asset owed by Mr Customer and £999,995,100 of cash and liquid assets (because it was paid £100 of the loan back); supported by £0 of deposit from Mr Customer (because Mr Customer used the remains of his current account to part settle the loan) and £50,000,000 of deposits from other customers and £40,000,000 debt to investors and £10,000,000 of share capital and reserves which belong to the owners of the bank.

Your contention is that because the money came from out of nowhere, the bank doesn't care about getting paid back, and won't need to make provision for bad debts - the customer could just flounce off with the money from their current account and never come back to pay off the remaining £4900. But that's just not true.

The £4900 of loan receivable by the bank (owed to the bank by Mr Customer) is still important to the bank. Because although it no longer holds any current account deposit monies on behalf of Mr Customer, it still owes £50,000,000 back to other customers for their deposits, and £40,000,000 debt to its investors, and £10,000,000 of reserves and share capital which belong to the owners of the bank.. but it only has £99,995,100 of cash and other liquid assets.

So, the bank can't simply ignore the £4900 debt owed to it by Mr Customer. If it doesn't collect it back in, it won't be able to pay back its [other customers for their deposits AND debt to its investors AND still have £10,000,000 of share capital and reserves]. It would have to write off some of its reserves for the bad debt expense, and the owners of the banking business (the shareholders) wouldn't be very happy with that.

quantative easing question

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