Why do banks need money from savers?

[botanic]

Banks create money 'from thin air'. So why do they need money from savers?

After much thought I think I can answer this question!

The explanation actually applies to all account holders, not just savers. So I will refer to 'account holders' from now on.

Why would banks try to hold onto account holders and their money? Banks cannot do anything with this money as far as I can tell. They cannot lend it to other people for example. However we need to look at the wider picture and ask what happens when account holders switch banks, taking all their money with them.

When account holders move money from one bank to another, the first bank has to pay the second bank with bank reserves (unless money also flows in the opposite direction). However obtaining bank reserves is expensive. For example the bank might have to borrow the necessary reserves from another bank, but then it would have to pay interest for an indefinite period. So a sensible bank would try to hold onto its account holders in order to avoid this expense.

Now we are in a position to answer my original question. Banks do not need money from savers in order to use this money. No, but they do need to hold onto all their account holders if possible because losing them can be expensive.

[peterv]

I agree with your analysis.

In addition to the direct cost of holding reserves, there is also the potential loss of profit.

If I have £100 in, say, a 3-year bond with MyBank, then they know that their liability to me won't be called on for 3 years so they can invest the whole £100 in profitable interest-bearing securities or investments.

But if the £100 is in a current account, then they will hold a percentage (say £5) in reserves on which they have to pay interest, and only £95 on investments, so reducing their profit.

Worse - if I then move that £100 from my current account into a 3-year bond with YourBank, then MyBank has to sell £95 of profitable investments to make up the £100 reserves they need to pay YourBank. On the other hand, YourBank now has £100 of reserves which IT can invest and make a profit.

That is why MyBank is willing to pay me interest on a 3-year bond, to stop me moving the money to a competitor.

[botanic]

Peter

Thanks for agreeing with my analysis!

I think this allows us to make progress in two ways:

(1) We now have a clear basis for calculating what we called 'depositors profit' or 'depositors cost' in an earlier thread.

Banks pay some kind of interest to their customers to persuade them not to go elsewhere. In the case of 'demand' accounts the interest is 'paid' in the form of zero bank charges. With no competition between banks the rate of interest would be zero. With perfect competition the rate would be just below the rate that banks pay one another when they borrow reserves. In principle the rate could even be somewhat higher than this because banks provide collateral when they borrow from one another. Holding onto customers avoids the need for any collateral.

(2) The analysis also allows us to take a snapshot of any bank's situation. Suppose a bank effectively holds onto every pound it creates 'from thin air' when it makes loans - neither losing nor gaining money from other banks through customer actions. And suppose the bank has done this from scratch. In this situation the total money in the bank's customer accounts would equal the total money owing to the bank from its loans to customers.

It follows that if the total money in the customer accounts is x pounds less than the total amount owed by customers then the bank must have lost some money to other banks. In other words it must have paid x pounds reserves to other banks in the past. If the difference is x pounds more, rather than less, then the bank must have received an extra x pounds reserves from other banks in the past.

So 'total owed by customers' minus 'total in customer accounts' equals 'reserves paid to other banks'

I am not sure how useful the latter picture is but it shows me that savers don't necessarily have to come into a bank with new money from outside. Some savers may do so, but others may already be in the bank and their savings may result from the bank's borrowers paying money into their accounts, as wages for example. In this case no new money comes into the bank from outside but the savers are useful to the bank all the same.

[botanic]

Peter

I have done some work on the equation given in my last post and made it more useful I hope. My new version is:

'Money owed by customers' + 'reserves' = 'money in customer accounts' + 'bank profit'

The purpose of this equation is to clarify how banks work. So the equation needs to be kept simple. Therefore the meanings of each variable must be constrained to make it work properly.

I think 'money owed by customers' and 'money in customer accounts' are self explanatory but 'bank profit' needs to be defined. In this equation 'bank profit' consists of the interest paid by customers who have loans, less the interest paid to customers who have money in their accounts, less money paid by the bank when loans default, less administrative costs. This profit accumulates, so the equation is not concerned with paying shareholders dividends for example. The 'reserves' variable corresponds to the reserves that enter or leave the bank because of customer actions. So it doesn't include reserves brought into the bank by shareholders for example.

What use is this equation?

Firstly it confirms what we have already said in this thread. Banks need to hold onto money in their customer accounts. Otherwise they would end up needing extra reserves which is expensive. The equation shows this because a fall in the 'money in customer accounts' would result in a fall in 'reserves' if the other two variables don't alter.

I also find it interesting to clarify what happens when a saver puts money into a bank and the bank lends money to another customer who spends it out of the bank. This scenario is slightly similar to the one you described above when you said

"If I have £100 in, say, a 3-year bond with MyBank, then they know that their liability to me won't be called on for 3 years so they can invest the whole £100 in profitable interest-bearing securities or investments."

Both scenarios seem to imply that the bank can do something with their saver's money.

So here is my scenario:
Step 1: A saver puts £100 in their bank, bringing it in from another bank. This results in the 'money in customer accounts' and the 'reserves' both increasing by £100.
Step 2: The bank lends a customer £95. This results in the 'money owed by customers' and the 'money in customer accounts' both increasing by £95.
Step 3: The borrower spends £95 so that it gets into another bank. This results in the 'money in customer accounts' and the 'reserves' both decreasing by £95.

It's tempting to imagine that the bank has loaned the saver's money to the borrower. However this doesn't happen. In step 1 the saver's money is added to their account and it is impossible for the bank to lend this money in any way. In step 2 some new money is created 'from thin air' and it is put into the borrower's account. There is no obvious connection between these two steps. We may choose to think that the reserves brought into the bank in step 1 are used to back up the money created in step 2 in some way. Indeed these reserves are used in step 3 when the borrower spends the money they borrowed and it leaves the bank.

However any link between what savers do and what the bank lends is very tenuous. What if the saver had accumulated their money from payments made by other customers in the same bank, instead of bringing in fresh money? In that case there wouldn't be any extra reserves to back up the loan. And what if step 1 had occurred after steps 2 and 3? We would have to claim that the extra reserves backed up the loan retrospectively!

I have also found that the equation clarifies what happens in the following kinds of transaction:
(1) A customer increases their overdraft.
(2) A bank pays off a debt that has defaulted.
(3) A customer with a loan pays some interest.
(4) A bank pays interest to its savers.
(5) A bank pays salary to its employees.