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Banks as entrepreneurs of credit

Reading the comments on Larry White's testimony, it occurred to me that a single word might make a difference in the perennial debate about whether banks are creators of credit. The word is "entrepreneurs." Often, economists who are discussing banking call banks "intermediaries of credit." I have used the phrase myself. It fails to capture an important aspect of what is involved, because it gives the impression that banks always act as pure intermediaries, connecting lenders to borrowers with few mistakes. If banks are pure intermediaries, though, why do they so often make huge, costly errors?

It is more accurate to call banks "entrepreneurs of credit." When a bank grants a loan, it is testing whether demand exists to hold the credit it has granted. That is an act of credit entrepreneurship. If the public in the aggregate wishes to hold the funds rather than spend them, it desires to engage in more saving than before, and the bank can expand its liabilities without losing reserves. To that extent the bank is acting as an intermediary, fulfilling a previously unsatisfied demand by the public to extend credit. In contrast, if demand to hold the credit does not exist, the bank loses reserves. To that extent it is acting as a creator of undesired credit in the interval until losses of reserves restrain it. The undesired credit, by the way, is not fraudulent. It is simply a product that failed, as happens frequently in every other line of business.


  1. The problem is that banks in the sense of lenders do not exist except at the local level in the form of state chartered banks. Money center bank branches act to siphon credit away from local communities. Loan to deposit ratios tell the story. Section 109 compliance is a joke because a branch can simply loan at 50% of the statewide average and be in compliance. Deposit production is alive and well and your deposits go to fund risky investments far away from your local community.

  2. Kurt,

    Excellent point, and it might be sometimes a forgotten insight of Ludwig von Mises. The notion of entrepreneurship is implicit not just in his discussion of free banking in Human Action, but also in the fact that it's banks which "decide" (but, constrained by market discipline) the "market rate of interest" which is the product of entrepreneurship (and imperfectly correlates with the "natural rate of interest").

  3. Frank Fetter, America's first Austrian economist, had a similar take to yours, Kurt:

    "A bank is a business whose income is derived chiefly from lending its promises to pay."

    (Principles of Economics, New York: Century Edition, 1905, p. 247. Online edition by the Ludwig von Mises Institute, 2003.)

  4. Let us leave aside the discussion of banks creating credit (i.e. lending out "money" that was never really saved), that has been discussed enough.

    Let us instead concentrate on a bank that just takes in savings and lends them out.

    Such a bank can still LOSE the savings – and lose them without any ill intent.

    This is because the bank is an INVESTOR.

    The bank takes in savings (the word "deposites" is wildly misleading as the money is lent out not "deposited") and lends them out – in the hope that they will be repaid with interest.

    But a banker can make mistakes – he (or she) may lend to people who do not (because of bad luck, bad judgement, or dishonesty)repay the money.

    In this case a bad BUSINESS JUDGEMENT has been made by the banker – and the savings of the "depositors" are lost.

    It is to be hoped that MOST loans are repaid – for if MOST loans are not repaid then the bank will fail and the savings be lost.

    There is no way round this.

    "Insurance" against BAD BUSINESS JUDGEMENT is clearly an absurdity.

    When one entrusts savings to a bank one is placeing trust in the JUDGEMENT of the bankers concerned.

  5. The business of extending credit is entrepreneurial whether or not a particular institution is entrepreneurial or strictly an intermediary. I can imagine a "bank" playing a strictly intermediary role, but if a bank itself decides who receives credit and on what terms, this bank is not playing a strictly intermediary role.

    Ebay plays an intermediary role between sellers and buyers. It does not sell goods itself, and it does not decide terms of trade. An online "bank" could link creditors to borrowers similarly, but the institutions we call "banks" in the U.S. clearly do not play this role.

    Here's the problem in a nutshell. Bank depositors don't want banks playing an intermediary role. They want entrepreneurial banks, because they want entrepreneurial profits, but they don't want entrepreneurial risks. Politicians offer depositors what they want, regardless of the internal contradictions, so states peddle entitlement to tax revenue and deposit "insurance" and big bank bailouts.

    In other words, capitalists are the greatest enemies of unregulated, unsocialized, entrepreneurial risk. The problem is capitalism, but "capitalism" does not describe free capital markets without socialized losses. It describes what real capitalists actually want.

  6. Money lending is (or, at least, can be) a respectable business – a money lender takes savings (their own and the savings of other people – savings that they have entrusted to the money lender) and invests them, thus helping business enterprises to grow.

    However it is a streach (although YES the case can be made) to call a money lender an "entrepreneur" – that title should (perhaps) be reserved for the people who create the business enterprises. The money lender (investing his own savings and the savings of others entrusted to him) is an INVESTOR – not really an "entrepreneur". Although YES it takes great skill (judgement and experience) to decide what business ventures to invest in and what business ventures NOT to invest in. And on what terms.

    And, yes indeed, it also takes great skill to decide who to lend to for CONSUMPTION – who will turn out to be "good for the money" in future when it comes to PAYING BACK THE LOAN (taken out to buy a house or whatever).

    That is why "selling a debt" (let alone getting a lot of different debts together and making "securities" out of them) is an unsound practice (unless someone has already defaulted on the debt – in which case you might sell the debt to people who specialise in hunting down defaulting borrowers).

    A banker has to exercise JUDGEMENT in decideing (for example) who to give a home loan to – it is not just a matter of "looking at the data", it is a matter of looking someone in the eye and deciding whether they are the sort of person who will pay back the debt. What their CHARACTER is like.

    When debts are "sold on" (to people who know nothing about the original borrowers) or mixed up with lots of other debts to form securities (historically "mortgage backed" securities are one of the worst kinds – they are basically a time bomb), the basic knowledge is lost – and everything becames a sea of numbers with no REALITY to it (at least no reality till the bust comes).

    Of course all the above is the banker as money lender (someone lending out real savings – their own, or the savings of others entrusted to them).

    Someone who is "extending credit" (rather than dealing with real saving) is not really a money lender – certainly not an "entrepreneur". Someone who is "extending credit" is actually playing a CONFIDENCE GAME (a con) – a "legal" con, but no less dangerious for being legal.

    When REAL SAVINGS are no longer the main factor, and (instead) it is just about "extending credit" (i.e. creating "money" by book keeping tricks) all sense of reality is lost – it all becomes a GAME.

    Someone who is just into "extending credit" is not a real money lender (let alone an entrepreneur) they are just a BUBBLE BUILDER.

    Kurt Schuler denines that they are guilty of criminal fraud – and I am sure he is CORRECT, after all this sort of banker has had a massive influence on court judgments and legislation for a very long time – so it all legal.

    But that does not alter the fact that BUBBLE BUILDING (extending credit rather than dealing in REAL SAVINGS) has terrible ECONOMIC consequences.

    Historically a banker was BOTH.

    Someone like J.P. Morgan invested real savings – AND he extended credit (i.e. he played the bubble game – and that cost him a lot lost sleep and mental anguish, because he was not "educated" enough to treat it as a numbers game).

    But in those times REAL SAVINGS were still a big factor (they were central to the business) – the "extending credit" (the bubble building) was something one did on top (or on the side). Knowing how deadly dangerious it was – like taking a jar of nitro and waving it round your head. Such a bubble can blow at any time (with little or no warning).

    There was still a real financial system in those days – it was just a financial system that bubbles (terrible bubbles) within it.

    These days real savings are almost a side issue – the MAIN THING is the "extending credit" (is the bubble building).

    It is no longer proper to say that the West has a "financial system with terrible bubbles within it" – now the financial system IS A BUBBLE.

    And there is nothing good and "entrepreneural" in this. It is a monster – and, at base, depends on Federal Reserve subsidies (most of them hidden).

    I repeat that banking has always had bubbles – always had "extending credit" as well as dealing with REAL SAVINGS. But the BALANCE has shifted.

    Once it was the REAL SAVINGS that were central to the business of a bank, now it is the BUBBLE that is central.

    Yes J.P. Morgan (and the others) supported the creation of the Federal Reserve and so on (they were not saints – they had a bubble game, "extending credit", going on and they wanted some cover for their backsides).

    But that does not mean that Morgan and the others would be happy with how things are now.

    In fact I firmly belive that if (by some freak of nature or act of God) J.P. Morgan found himself back in his bank (as it is now) – he would, most likely, start killing people. He would take his pistol from his pocket and start shooting people in the head. He would be that upset.

    He would NOT be a happy camper.

    Especially not with anyone who claimed that playing the credit bubble game (the most dangerious con game there is – BAR NONE) was just "being entrepreneural".

  7. To anyone who thinks that my example of the shade of J.P. Morgan comming back and going all horror movie on people is extreme….

    Well first Morgan had a hot temper (especially with people who had no common sense) – a temper as nasty as that nose of his.

    But there is more to it than that – wait and see.

    Wait till this time next year – and you will understand why people might get really upset with those who treat bubble building as a harmless (indeed "entrepreneural") pass time.

    The entire finanical system of the Western world (once basically about investing REAL SAVINGS – with bubble dealing being on top or on the side) has been turned into a "credit expansion" bubble – and this is not a good thing.

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