Big banks are raking in record profits. Yet lending is slowing down. Why?
As banks reap ever greater returns, a curious disconnect has emerged. Profits are rising, but lending is not.
"JPMorgan Chase, Citigroup, and PNC all reported another quarter of healthy profits, most of which will end up in shareholders' pockets," The New York Times reports. "Overall, lending at the four banks grew only 2.1 percent in the second quarter from a year earlier." That's down from an increase of 3 percent in the first quarter and 4.6 percent in 2016. This lending slowdown has many analysts scratching their heads: How can banks rake in more money if they aren't issuing more loans?
But there's actually no real mystery here. To explain why, let's first bust one of the economy's most persistent myths.
Most Americans think of banks as intermediaries. Banks bring money in from savers and deposits (and a whole bunch of other instruments, in the case of the big Wall Street banks) and then they spit that money out in the form of new loans to individuals and businesses. In other words, banks loan money out of the existing resources they have on hand. The whole question of why banks aren't lending more — as framed by the Times — implicitly adopts this view. Indeed, most economists assume banks operate this way when they design their models of the macro-economy.
Except banks don't operate this way at all. When they lend, they're actually creating new money out of thin air.
If you want a deep dive into how this works, here's a useful explanation by the Bank of England. But the short version is that banks only need reserves on hand when people want to exchange their bank deposits for physical cash. For the most part these days, we use our deposits themselves to trade with another. Money gets moved from account to account without ever actually leaving the banking system. And when a bank lends, it just changes the amount of money in your account. Unless you immediately try to exchange the total amount lent to you for physical dollars, the money doesn't have to "come from" anywhere.
In fact, most of the new money creation in our economy is undertaken by private banks creating new loans. When people say the U.S. Federal Reserve "controls the money supply," what that really means is the central bank manages the money creation of private banks by setting the general interest rate target for the whole economy.
Now, when people do want to exchange their bank deposits for cold hard cash, a bank might find itself in a situation where it doesn't have enough reserves on hand. That's what caused the classic bank runs of yore. (And led to the creation of the Federal Reserve in the first place.) Furthermore, banks don't just lend because they can: They lend to make a profit, which they bring in by charging interest on their loans. And what interest they charge is heavily influenced by how much credit demand there is among business and consumers.
All of which is to say that banks can't just do whatever they want. Their lending is constrained by the need to be profitable, and by monetary policy as set by the Fed. But how much money banks have on hand doesn't limit their lending.
What does all that mean, practically speaking?
First off, if banks aren't lending more, it's likely because people and businesses aren't clamoring for new credit. "As we sit here right now today, I would characterize demand as being solid, as being decent — it's not what it was two years ago,” JPMorgan Chase's finance chief, Marianne Lake, told reporters.
Some of that is certainly the debt overhang from the Great Recession, which many Americans and firms are still working their way through. But ultimately, demand for new investment is driven by untapped consumer markets. Those are driven by consumer spending, which is largely a function of workers' incomes. And despite absolutely gargantuan corporate profits — which are largely getting pumped into record-setting amounts of stock buybacks for the wealthy — paychecks really aren't growing much. In fact, once you account for inflation, which isn't even high itself, real wages actually fell compared to last year.
Yet even so, it's still pretty weird that banks are making big profits, even in the midst of sluggish consumer demand. The explanation is probably a combination of several different things.
Part of what's going is almost certainly Trump and the GOP's giant tax cuts. Another part is that the Fed is already hiking interest rates despite the absence of noteworthy inflationary pressure, which means banks are just bringing in more revenue from their loans. Yet another part is probably how the Fed now pays the banks interest to convince them to store their reserves at the Fed — a change it made once the 2008 crisis upended the traditional tools the central bank used to set interest rates.
Soaring inequality has also eaten away the wages and financial security of ordinary Americans for decades. That forced the Fed to drive interest rates ever lower to keep the economy afloat. Smaller banks have died off as a result. But that's also given the bigger banks a much more dominant, even monopolistic position in the economy.
Finally, inequality also means that business and corporations are spitting out tons of money to wealthy shareholders. There's a massive glut of capital out there looking for a place to go. And a massive supply of capital means cheap capital. For banks, which are purely financial institutions, the costs of capital are basically the costs of doing business. Even with overall interest rates lower than they've been in decades, the spread between them and super cheap capital is enough to hand the big banks a hefty profit.
Sure, the realities of how banking actually operates makes it possible for banks to haul in giant profits while paychecks sputter. But it certainly doesn't make it good when that happens.