Firstly a bank creates a loan. So the loan is to person A, and firstly the deposit is to person A as well. At that point the bank is still fine and still fully funded.
What happens then though is that person A wants to pay person B.
If person B is at the same bank, then there is NO problem. The deposit is switched to person B and the bank is still fully funded.
The fun starts when person B is at another bank :o
What has to happen that is that bank 2 has to take over the deposit in bank 1 from person A. That increases the assets of bank 2 which then creates a new deposit for person B.
That’s how payment works. Somebody has to take the place of the original depositor in the source bank before you can create anything in the target bank.
Of course at that point bank 2 is taking a risk on bank 1 and will expect to be paid by bank 1 an interest rate to compensate for that risk.
And it also means that if bank 2 isn’t prepared to take a risk on bank 1, that nobody in bank 1 can pay anybody in bank 2.
It’s this latter point that caused the creation of central banks – to make sure that the payment system clears. The theory being that all the banks trust the central bank ‘in the last resort’ and therefore the central bank can ensure payments always clear.
So the cost of funding is really the payments bank make so they can be part of a payment clearing system.
It is the same with cash. Reserves are debited and a deposit no longer exists.
Central banks can then add regulations and drains, reserve ratios, capital ratios, discount windows and all sorts of other things to increase the cost of funding. This is ‘discipline on the liability side’ to try and limit what banks lend for. It doesn’t really work as we saw in 2008 – because the first thing that fails is the payment system.
MMT suggests that this is counterproductive and that the central bank should just provide the liabilities necessary at no cost to ensure the payment system clear. Instead banks should be ‘disciplined on the asset side’, i.e. specific regulations as to what sort of loans a bank can make. If the loan isn't up to standards it becomes a bad debt. Too many of those and the bank goes bust.
This description is somewhat simplified (no equity and capital), but I hope it gets over the essence of what is going on. BoE doesn’t provide reserves when commercial loans are made. They provide reserves as loans to the commercial banks at a high price with quite a lot of restrictions to encourage banks to borrow from each other, as described above, first.
And banks don’t need deposits. But they tend to be cheaper overall and more sticky than the alternative forms of funding – capital bonds and equity.
And if the bank is big enough, it can make a few bob charging for customer transactions within its own balance sheet.
If a Barclays customer pays another Barclays customer, then all that happens is a few numbers change position on the Barclays computer. But Barclays can charge for that and earn income literally from doing nothing.
Full MMT Banking reform proposal here