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When a bank gives out a loan, a simultaneous liability and asset is created on their balance sheet, and 'external' funding doesn't fit into this picture... so why do they need to borrow money?

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  • $\begingroup$ voxeu.org/article/banks-do-not-create-money-out-thin-air. Worthwhile alternative perspective to the literature. I.e. Positive Money, Kumhof, etc. $\endgroup$
    – EB3112
    Sep 17 at 15:18
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    $\begingroup$ Because they can't re-loan a loan? Their balance sheet cash is now a requirement for them to hold because of the liability, so they can't just loan it again. And they have a different kind of asset on their balance sheet, one that is not loanable. $\endgroup$
    – user253751
    Sep 17 at 15:40
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Because banks have to satisfy their capital requirements and they are not able to create high powered money.

Capital requirements are different for different banks because under the current rules they depend on how risky are assets that the bank holds (you can read about that here). Suppose the capital requirement rules require some bank to hold capital worth of 10% of a loan it makes. Then if the bank wants to issue \$100 loan it has to keep \$10 as an extra capital reserve.

A consequence of this is that bank needs to have some extra money not created by the loan. If someone comes asking for \$100 loan they would have to have \$10 as a capital reserve that they cannot create themselves (this is also called high-powered money). To get these reserves they can either borrow money from other banks (which might have excess reserves), central bank (which can create reserves/high-powered money at will) or get deposits. Typically it is hard to attract new deposits quickly enough so most of the time bank is making more loans they have to get extra capital for their capital requirements by borrowing either from central bank or other banks.

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  • $\begingroup$ This makes sense, thanks for this. However, assuming this is true, it seems odd that a bank may have equal funding from domestic deposits and short-term money markets (source below). Would you have any reason why? rba.gov.au/publications/bulletin/2018/mar/… - check out the first graph $\endgroup$
    – chenchen
    Sep 18 at 9:51
  • $\begingroup$ This makes sense, thanks for this. However, assuming this is true, it seems odd that a bank may have equal funding from domestic deposits and short-term money markets (source below). Would you have any reason why? rba.gov.au/publications/bulletin/2018/mar/… - check out the first graph $\endgroup$
    – chenchen
    Sep 18 at 9:51
  • $\begingroup$ @chenchen why would that be odd as explained above deposits are also sources of reserves $\endgroup$
    – 1muflon1
    Sep 18 at 10:04
  • $\begingroup$ For example, a bank makes \$100 in loans, and must hold \$10 capital reserve. Then it will borrow that \$10 from somewhere, so on their liabilities, we should see something like deposits/(other funding types) = 10/1, based on what you're saying $\endgroup$
    – chenchen
    Sep 18 at 10:25
  • $\begingroup$ @chenchen yes that 10USD can come from not just loans, central bank but also deposits, it does not really matter how the bank gets that capital reserve (owners of the bank could inject extra money as well etc) but it has to have some otherwise it violates the law (although 10% was just an example, every country will have different requirements and some countries still have reserve requirements instead of capital reserves but they work in similar way except reserve requirements are usually fixed at same level for all banks whereas capital reserves are different for assets of different risk $\endgroup$
    – 1muflon1
    Sep 18 at 10:32
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Banks issue debt because they need to satisfy various capital requirements set by regulators (in the US, the Fed). What is capital exactly? Basically, capital is the sum of Tier1 capital and Tier2 capital. Tier1 capital is essentially issued equity and retained earnings. Tier2 capital is essentially eligible debt securities that have been issued. See here for a good presentation https://www.davispolk.com/sites/default/files/2017-01-11_davis_polk_federal_reserves_final_rule_on_tlac.pdf

Why do these rules exist ? Essentially the Fed wants to be able to easily wind down a bank without causing chaos as occurred in 2008/9. They envision doing this by causing holders of Tier1 capital to receive zero in bankruptcy (stock goes to zero) and holders of Tier2 capital (debt) will receive haircuts as necessary after the assets are resolved.

For all this to work, banks must have issued enough eligible debt securities, even if they have no immediate use for the funds. That is the case today in the US.

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Even if there are no liquidity or capital requirements imposed by regulators a prudent bank, which must make interbank payments as a going concern, must issue a mix of liabilities and equity to retain legal control over its portfolio of assets.

Classify the bank assets as reserves, securities, and loans. Classify the bank liabilities and equity as deposits, borrowings, bonds, and equity. Here the borrowings are short term debt to distinguish from bonds as longer term debt.

If the bank does not issue the mix of liabilities and equity equal to the assets then it will be unable to make interbank payments as the outflow of reserves to other banks in the bank sector. So the bank must actively attract liabilities and equity, so it can keep making its payment obligations through the cash reserve account, so it can expand and hold the asset portfolio in the balance sheet.

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