Non-banks versus Banks

Banks play a key role in the monetary system, yet their lending now accounts for less than 20% of the total credit market debt in the U.S.  Most of the lending is done by non-bank financial institutions such as finance companies, mortgage companies, insurance companies, pension funds, and investment banks.  Non-banks cannot accept demand deposits, and therefore play no direct role in the payment system.  But they provide a variety of financial products and compete with banks and each other for lending opportunities. 

Non-Bank Lending

Non-banks are ordinary intermediaries.  They act as a conduit between those with funds to lend and those in need of funds.  By pooling the funds of investors from whom they borrow, they can then lend in various amounts and periods.  For their service they charge a fee, usually in the form of periodic interest payments.  Their borrowing and lending increases the total credit market debt but has no direct effect on the money supply.  Non-banks simply intermediate the transfer of funds from the bank accounts of the original investors to the bank accounts of the ultimate borrowers.  

Non-banks usually borrow short-term at lower rates to lend longer term at higher rates.  That means a non-bank must be able to roll over its short-term debt at favorable rates.  It must also be able to borrow on short notice to manage any cash flow problem.  For that reason it must maintain an excellent credit rating, or it may not be able to borrow at all.  

Bank Lending

Banks are not ordinary intermediaries. Like non-banks, they also borrow, but they do not lend the deposits they acquire.  They lend by crediting the borrower's account with a new deposit, and then if necessary borrowing the funds needed to meet the reserve ratio requirement.  The accounts of other depositors remain intact and their deposits fully available for withdrawal.  Thus a bank loan increases the total of bank deposits,  which means an increase in the money supply.  When the loan is paid off, the money supply decreases.

A net increase in bank lending results in a shortage of reserves needed by the banking system, which only the Fed can supply.  In order to maintain control of the Fed funds rate, i.e. the interest rate on overnight loans between banks, the Fed must provide the funds as required.  It does so by purchasing Treasury securities from the public. 

Bank lending has no effect on a bank's own capital.  But bank lending is limited by the capital ratio requirement set by the Fed.  If a bank has sufficient capital, it can expand its balance sheet by issuing more loans.  However if it is not holding excess reserves, it will have to acquire more in order to meet the reserve ratio requirement.  Banks therefore actively seek new deposits.  Of course they prefer deposits on which they pay no interest, like ordinary checking accounts.  They also borrow from savers who open savings accounts and investors who buy their CDs.