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The Grumpy Economist

I don’t follow you, Prof. Cochrane. Banks reduce their equity proportion when they create loans (possessions go up, liabilities go up, equity remains). This is a fact. However, when the FED buys the bonds even, commercial banks reduce their capital ratios! Because QE is not a deal between the FED and bond holders.

No, it’s a transaction where the commercial bank is an intermediary. Intermezzo: textbooks trapped in the 1965’s discuss money creation as though there is a certain amount of reserves (created by the central bank or investment company) in the economy, held by commercial banks. They then provide out money by “multiplying” the reserves. This is one way most people view banking indeed, but I don’t.

There’s an excellent Bank of England text on this. Google for “Profit the Modern Economy – Bank or investment company of England”. These deposits are the fresh money that was around before never. It’s obvious that this decreases equity in the bank operating system. Second, if the FED purchases bonds, the FED will not create deposits.

Instead, it creates reserves. Reserves are bottom money, which only central banks can create. It’s a liability for them, and they utilize it to buy assets, like government bonds. Reserves can’t be created, lacking any asset being bought from someone. Let’s say a shared account has a relationship that the FED need it.

The FED then creates reserves, they transfer these reserves to the commercial bank or investment company where the mutual account has its checking account, and that the bank or investment company in exchange creates debris on the checking account of the account. All balance linens are still in equilibrium. This is how QE works. At least, this is one way it works in Europe and England.

I’m uncertain if in the US, the FED can purchase directly from the Treasury, but I’m guessing not, since only commercial banking institutions can create deposits that you and I and everyone but banks themselves pay with. Nobody in the true economy cares about reserves. Reserves are only used by the FED and commercial banking institutions.

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It’s the amount of money of banks and banks only. Nevertheless, this implies that a rise in the amount of deposit money ALWAYS decreases capital ratios. So both loan and QE creation reduce capital ratios. To allow them to rise again in the banking system, there be considered a transfer from deposits to equity MUST, i.e. money destruction. The balance sheet is in equilibrium. So it’s simple: in order to increase capital ratios for the bank sector, there needs to be a transfer from deposits to banking collateral. I am buying a bank or investment company stock might change my allocation, but it won’t change the aggregate allocation, since someone else will have my deposit and I’ll have his bank or investment company stock.

So it’ simple: banks need to either retain revenue (which really is a transfer from liabilities to collateral) or banks need to sell new collateral (which is also a transfer from liabilities to equity). For the aggregate collection, this means the amount of cash must drop (since deposits decrease) and the amount of banking stock must rise (since equity increases). Therefore, it indicates a big change in investment allocations of traders. Less cash, more equity. I.e. a transfer of risk from banks to the social people. Banks become safer but investors hold more risky equity.