Endogenous money, bank regulation and the soft budget constraint (SBC)

István Ábel, Katalin Mérő

Keywords: soft budget constraint, endogenous money, bank regulation

TL;DR: Within the framework of endogenous money theory, we examine whether current banking regulation is appropriate to impose a hard budget constraint on banks.

Abstract: Most of the money in circulation is created by commercial bank lending. The state also creates money by printing cash, but this represents only a small fraction of the money in circulation. A key observation of endogenous money theory is that banks create deposits (money) by lending. They apparently face soft budget constrain in responding to demand for credit. Nevertheless, there are several limiting factors, which are able to make the banks’ money creation somewhat constrained, i.e. make their budget constrain hard. Such factors include bank regulations (the capital and liquidity requirements) and the need to preserve bank profitability. Previous literature on SBC in banking see the government bailouts, central banks LoLR policies, or the poorly informed depositors who over-finance banks, as reasons for SBC for banks. Taking endogenous money theory as a starting point, we use a different approach. We analyze whether the tools that aimed to keep the bank’s budget constrain hard are appropriate for this task or not. Our analysis, as well as lessons from several recent bank crisis episodes suggests, that under current banking regulation the SBC is an inherent feature of banking.