How Banks Use Loans to Create Liquidity (2024)

How Banks Use Loans to Create Liquidity (1)

Article

21 Jun ’23

Research in Focus — Loans are more important than deposits when banks create liquidity. Edison Yu of the Philly Fed and his coauthor explore the policy implications of this counterintuitive finding.

Thanks to the U.S. fractional reserve banking system, commercial banks can lend out much of their cash deposits, keeping only a fraction as reserves. But there’s a second, less widely recognized source of liquidity for banks: the deposits they obtain through their own lending. This latter source of bank liquidity — called “funding liquidity creation” — enables banks to lend out more than what’s allowed based on their supply of cash deposits.1Consider this example: A bank loans out x dollars; it records the loan on its balance sheet as an asset of x dollars but also makes a deposit (liability) entry of x dollars, thereby creating a deposit even though no one deposited x dollars in the bank.

For their paper, “Funding Liquidity Creation by Banks,” Anjan Thakor of Washington University in St. Louis and Edison Yuof the Federal Reserve Bank of Philadelphia estimated the amount of funding liquidity created in the U.S. banking system. Building upon this estimate, they also isolated bank-specific factors that determine how much funding liquidity the system creates. Furthermore, they investigated whether banks can expand lending even when their inflow of cash deposits decreases.

To compare total U.S. bank lending to available cash deposits, they first calculated a bank funding liquidity creation multiplier(defined as the ratio of total deposits to cash deposits). Next, they measured the dollar value of bank funding liquidity creation as the difference between total deposits and cash deposits. For their calculations, they utilized Call Report data from 1973 to 2020, which contain quarterly information on bank balance sheets submitted to bank regulators.2 The authors also used data on natural disasters as a “natural experiment,” allowing them to determine whether liquidity creation can expand even when cash deposits fall during an emergency.

The authors find that total deposits created from aggregate funding liquidity varied over time and were influenced by swings in loan demand as well as Federal Reserve policy. In particular, they find a big rise in the liquidity multiplier starting in the early 1980s and ending with the financial crisis of 2008, representing a large expansion of loans and liquidity creation on the part of banks.3 This long expansion was followed by a big drop in the multiplier during the financial crisis (which the authors attribute to declining loan demand and a big infusion of reserves into the banking system by the Federal Reserve) and then a gradual increase in the multiplier until the COVID-19 pandemic. The liquidity multiplier dropped again after the Federal Reserve poured reserves into the banking system to address the COVID-19 shock.

Further, they find that, during the 2008 financial crisis, deposits and bank lending did not rise significantly following the Federal Reserve’s policy measures, which were meant to increase the flow of credit to firms and households. Moreover, no sizable increase in U.S. lending or deposits occurred following the Federal Reserve’s actions to greatly boost reserves in 2020 during the COVID-19 pandemic.

The authors also show that a very high percentage of deposits in the banking system reflects private money creation by banks. Averaging over the period from 2001 to 2020, 92 percent of deposits in the banking system resulted from funding liquidity created by the lending activities of banks, with the remaining 8 percent accounted for by cash deposits. This high percentage of funding liquidity, the authors explain, implies that “the availability of cash deposits is not a big constraint on bank lending.” Further, they report that banks created a huge amount of funding liquidity, with liquidity creation between 2011 and 2020 amounting to, on average, $10.7 trillion per year — equivalent to 57 percent of gross domestic product (GDP).

Finally, their analysis of natural disasters refutes the traditional view that only cash deposits lead to loan creation. Following the logic of this traditional view, people withdraw more cash during emergencies, so lending must go down. However, the authors find that the opposite occurred. Banks funded reconstruction projects by creating deposits through lending to meet the demand for loans associated with natural disasters. This means that banks were creating more liquidity funding even when cash deposit balances were falling. Delving deeper, they find that during emergencies, banks with higher capital and with branches closer to disaster sites created the most liquidity.

The authors conclude that both loan demand and how well capitalized a bank is — rather than a bank’s level of cash deposits — largely determine how much funding liquidity a bank can create. Given this finding, the authors suggest that efforts by the Federal Reserve to jump-start an ailing economy by increasing reserves, which will then show up as higher deposit balances in banks, “will not necessarily be effective in increasing bank lending.”

  1. The views expressed here are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  2. The idea that banks can create deposits by their own lending was recognized by Keynes, among other early economists. See, for example, John Maynard Keynes, A Treatise on Money. New York: Harcourt, Brace and Company, 1930.
  3. The Call Report data are from the Federal Deposit Insurance Corporation’s Consolidated Reports of Condition and Income.
  4. The authors attribute the rise in the liquidity multiplier between 1980 and the financial crisis to various factors, including lower reserve requirements and higher loan demand in mortgages.
How Banks Use Loans to Create Liquidity (2024)

FAQs

How do loans provide liquidity? ›

The loan portfolio is an important factor in liquidity management. Loan payments provide steady cash flows, and loans can be used as collateral for secured borrowings or sold for cash in the secondary loan market. However, the quality of the loan portfolio can directly impact liquidity.

How do banks generate liquidity? ›

According to this theory, banks create liquidity on the balance sheet when they transform illiquid assets into liquid liabilities. An intuition for this is that banks create liquidity because they hold illiquid items in place of the nonbank public and give the public liquid items.

How does a bank create money by giving loans? ›

Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it.

What are the sources of liquidity for banks? ›

A bank's liquidity exists in its assets readily convertible to cash, net operating cash flows, and its ability to acquire funding through deposits, borrowings, and capital injections.

What is the meaning of liquidity in loans? ›

Liquidity definition

Liquidity is a company's ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities. How much cash could your business access if you had to pay off what you owe today —and how fast could you get it?

Can a bank loan be a liquid asset? ›

A Liquid Asset Line of Credit or Loan is a great way to leverage money already saved in non-retirement investments to gain access to money for an unexpected opportunity – such as a real estate purchase.

Do banks do liquidity transformation? ›

Liquidity transformation, on the other hand, involves banks and financial institutions converting less-liquid assets, such as securities or other financial products, into more liquid liabilities, like demand deposits (e.g., checking and savings accounts) that customers can withdraw at any time.

When banks make loans do they create money? ›

Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans”. This misconception may stem from the seemingly magical simultaneous appearance of entries on both the liability and the asset side of a bank's balance sheet when it creates a new loan.

How do bank loans work? ›

You receive the loan as a lump sum and can use the money for almost any reason. You pay it back in fixed monthly installments. Banks typically offer loans from $1,000 to $50,000, with repayment terms of two to seven years. Personal loan annual percentage rates generally range from 6% to 36%.

How do banks lend money they don't have? ›

Banks use fractional reserves to create loans for businesses and consumers. Without the ability to do this, an economy's growth is stunted, leaving it to flounder while those that need money for large purchases and investments rely on a bank's substantial holdings.

How to generate liquidity? ›

Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.

What contributes to liquidity? ›

Traditional measures of market liquidity include trade volume (or the number of trades), market turnover, bid-ask spreads and trading velocity. Additionally, liquidity also depends on many macroeconomic and market fundamentals.

What is the liquidity risk of a loan? ›

Liquidity risk arises when an entity, be it a bank, corporation, or individual, faces difficulty in meeting short-term financial obligations due to a lack of cash or the inability to convert assets into cash without substantial loss.

How is liquidity achieved? ›

A company's liquidity ratio is a measurement of its ability to pay off its current debts with its current assets. Companies can increase their liquidity ratios in a few different ways, including using sweep accounts, cutting overhead expenses, and paying off liabilities.

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