We’ve received a number of questions regarding the recent post on the trajectory of the US loan-to-deposit ratio (see post). Many are wondering how such fluctuations are even possible. That’s because the classic view in economics is that deposits are created only through loans. When a bank provides a loan, deposits are created as a result. So how is it that US deposits are growing, while loan growth has stalled?
But the biggest problem with the “loans=deposits” school of thought is the assumption that banks operate in a static monetary base environment. This assumes that banks in effect are the only lenders. But these days the Fed is the largest single lender in the US and that’s where a large portion of the deposit growth is coming from. The Fed is lending to the federal government and to the GSEs, which ends up generating deposits at commercial banks. Every dollar the Fed uses to buy securities outright ends up as a deposit at some bank(s). As the chart below shows, this is one of the situations that increases deposits without any loan growth at commercial banks.
Through this process QE floods the banking system with deposits in hopes that all this liquidity (excess reserves) will spur banks to increase lending. However, for a number of reasons – some of which has to do with low demand for credit – that approach is not working out as “planned”.
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