personal views of a former fed trader

The Primary and Secondary Market for Money

Domestic businesses have steadily increased their borrowings even though overall bank business lending appears to be declining. In general, businesses seeking to borrow money (bank deposits) have two main sources: banks or the debt capital markets. A bank loan leads to the creation of new bank deposits and increases the overall money supply, while issuing a corporate bond changes the ownership of existing bank deposits. These two markets for money operate under different constraints and serve different but overlapping borrower segments. In the past year, larger businesses rotated away from from banks to the capital markets while smaller businesses continued to borrow from banks. In this post we describe the two markets for money and show that together they show significant strength in the demand for money from domestic businesses.

On the surface it looks like business loans are declining. Note: includes loans to foreign corporations

Primary Market: Commercial Banks

Bank loans can be thought of as a primary market for money because loans result in the creation of newly issued money. This new money can boost asset prices and economic growth as it circulates throughout the economy. It is extinguished when the loan is paid back.

Banks lend when they can earn a return that meets their requirements. Lending returns are most obviously related to the steepness of the interest rate curve, but are also impacted by various costs. A steepening curve implies increasing loan interest income relative to interest paid on deposit liabilities. (One of the mechanisms Fed cuts stimulate the economy is by steepening the curve and encouraging bank credit creation). Bank lending also has to cover a range of operating costs (e.g. office leases, salaries, advertising) and balance sheet costs (i.e. larger and higher credit risk loans have higher capital costs).

These costs make their way into the interest rates banks can offer borrowers, even when benchmark yields are low. Banks loans are thus a relatively expensive form of financing despite having high seniority. Bank loans tend to be more popular among smaller businesses who have limited alternative sources of financing. Smaller businesses have steadily increased their borrowing from banks over the past two decades and especially the past year.

The recent jump in borrowing by smaller businesses is largely due to the PPP loan program, which offered them forgivable loans at rock bottom rates. Around $800b in loans were made and half have been forgiven. The chart above understates the loans to smaller businesses because forgiven PPP loans do not show up on a bank’s balance sheet. Note that this surge in lending mirrors the surge in bank deposits held by small bank accounts.

Secondary Market: Debt Capital Markets

The debt capital markets can be thought of as a secondary market for money because the borrower is receiving existing bank deposits. No new money is created and the money supply is unchanged (unless a bank is investing, but they are not major investors). In a sense, existing money is being more efficiently used. Almost all classes of investors are active in the corporate bond market, from individuals to pension funds to foreign investors. They usually evaluate bond offerings relative to Treasury yields and demand a spread as compensation for credit risk. Bond investors are concerned with beating their benchmark or absolute returns, but don’t have the high regulatory capital costs or overhead of banks.

Corporate bonds outstanding began rapidly climbing when QE started

Borrowers in the debt capital markets tend to be larger business that are often publicly traded and well known. These borrowers can easily borrow from a bank as well, but it is cheaper for them to borrow from the market. Larger businesses overall have not significantly changed their level of bank loans over the past two decades, despite a brief spike last March when market turmoil closed the capital markets and forced them to temporarily borrow from banks. In contrast, they have significantly increased their bond issuance.

Corporate bond issuance began to skyrocket after the GFC. This is the result of both low Treasury yields from the Fed’s zero interest rate policy as well as the enormous growth of bank deposits from QE. When the Fed conducts QE it is adding reserve assets on the balance sheet of banks, but also deposit liabilities. QE significantly increased the supply of bank deposits in the secondary market for money. This surge in supply can be seen in narrow credit spreads and steady growth in corporate bonds outstanding.

Although the growth in corporate issuance disintermediates banks, it also strengthens the transmission of monetary policy. Larger businesses can borrow at rates that more closely follow the expected path of policy, which can be directly impacted by forward guidance.

Businesses Have a Lot of Money

Increasing demand for money by businesses is usually a risk positive indicator, as more money usually leads to more spending on goods and services (and stock buybacks). The decline in overall bank business lending obscures the underlying strength in business credit growth. Borrowing from smaller businesses have surged from PPP loans, while larger businesses have borrowed record amounts from the corporate bond market. A lot of the money borrowed appears to be hoarded, but that may change with improving sentiment. At the very least there is potential for a significant reflationary move.

Corporate/Non-corporate used as a proxy for larger/smaller businesses


  1. Robert Pearson

    “Lending returns are most obviously related to the steepness of the interest rate curve”

    Is that really true any more? In my experience banks go to great lengths to match assets with liabilities and try to run very little interest rate delta – ie very little risk to short term interest rates either rising or falling.

    Even with a steep interest rate curve, longer term fixed rate assets tend to be swapped back to floating rate, or matched against similar duration fixed rate liabilities (such as bonds and quasi-equity bonds subject to bail-in). I recall having lengthy conversations regarding whether common equity should be treated as variable rate or fixed rate liabilities for the purposes of matching it against assets.

    • kb

      I think lending returns and interest delta are two different things. Lending returns depend on the steepness of the yield curve while interest delta depends on the changes of interest rate. You can hedge interest delta and still have good lending returns on the steepness of yield curve.

      • Robert Pearson

        I would say lending returns depend on the steepness of the credit spread curve, not the steeples of the ‘interest rate curve’. If you’re hedging out interest rate risk (or put another way, matching assets with liabilities), the shape of the interest rate curve is immaterial.

        You do make more money by lending longer to a customer if the spread over the risk free rate is wider at longer maturities than shorter maturities (which it usually is), but, of course, this is really just compensation for the extra credit risk the lender is taking on. Whether the underlying risk free interest rate curve is positive, flat or negatively sloping doesn’t really affect this.

        • Prateek

          Great insight Robert. Appreciate it. I was curious about net interest margins under different term structures. I have observed that the spread between return on Bank Assets (Say a 5 year loan) and a Bank Liability (Say a 5 year Fixed rate Deposit) tend to be greater when the yield curve is steeper. So what I mean suppose I match duration and credit-risk of asset and liablity, and then look at the net spread earned by the bank, it appears that this spread is greater in high interest rate regimes thean in low interest rate regimes. I might be missing something, would appreciate your views. Thanks

  2. Fernando Ulrich

    Hi Joseph,
    I’d like to understand better when you say “When the Fed conducts QE it is adding reserve assets on the balance sheet of banks, but also deposit liabilities.”
    As I understand, from the point of view of commercial banks balance sheets, QE is simply a change on the assets side (more reserves, less Treasuries/MBS). There’s no liabilities impact, no commercial bank deposit creation.
    From the PoV of the Fed’s balance sheet, it’s an increase in liabilities (reserves) and in assets (Treasuries/MBS).
    Am I missing something?
    Thanks, I greatly appreciate your work.

    • Joseph Wang

      You’re right in the case where banks are selling Treasuries, but it’s different when non-banks are selling Treasuries. In the latter case commercial bank balance sheets grow – see this post for more details.

      • Fernando Ulrich

        Got it now! Thanks!

  3. Vx

    Is PPP lending really that accretive to the economy? Were they not targeted as a transfer payment to keep people employed, which served its purpose but really did not create capital demand? also (share buybacks) as a secondary thought with regard to bond market driven BS re-engineering misses that alot of that funding is probably for equity investor friendly purposes, again, not really representing true lona demand and economic activity. I am clearly not convinced that business demand for economy supportive lending is as great as presented here.

    • Joseph Wang

      You may be correct – I would just note there is potential for a very positive outcome. Smaller businesses/their employees received $800b in free money. Free money may not be spent on capital goods, but even if its spent on consumption that is a lot of spending. Larger businesses borrowed a lot from the market and in the past would spend that on stock buy backs, which is risk positive.

  4. Richard Weisberger

    Can you go over 1) how Fed QE increases bank liabilities? 2) Impact of QE when yield curve doesn’t increase?

    • Joseph Wang

      For 1) see this, which includes an example. 2) QE is intended to put downward pressure on longer dated rates by buying a lot of Treasuries. It’s supposed to flatten the curve.

  5. Dave

    Does the Fed primarily purchase from primary dealers or institutional investors when aiming to increase deposits through asset purchases?

    How do banks interact with money funds? Does each money fund have a bank account that receives reserves for it on its behalf before it invests and transfers it out via Fedwire Funds? Does that imply if there was no RRP facility to extinguish reserves, that the reserves a bank tried to get rid of by buying a money fund would just be moved to another bank that banked the money fund and then onto a borrower, and may even come back to the same bank by a depositor that obtained funding from the money fund since reserves cannot leave the system unless the Fed wants it to?

    In other words, there is a hot potato effect where no matter how much banks try to deploy reserves into securities, other banks must be receiving reserves and no one can get rid of them completely, so there continues to be an elevated amount on average across the whole system and asset prices increase ever higher since the same reserves come back eventually in form of deposits and need to he deployed again?

  6. Darrell

    Hi Joseph

    Just curious on the following narratives on QE. I was reading this on the internet but wish to find out more on detail:

    1) Banks cannot lend reserves;
    2) But the Fed can buy Treasuries in the secondary market (incl. banks, hedge funds, asset management funds) & create a cash deposit in the account from which Treasury was sold. This cash can then be redeployed into risky assets.

    Is this true or false? Any readings on the internet that you can share with me on this?



    • Dave


      1) Banks do not lend reserves to the general public. They lend them overnight to each other in what is known as the Fed Funds market. At least, this was mostly true when we were in a scare reserve environment. These days, there’s excess reserves in the system, most banks have enough reserves to meet their reserve requirements, and thus the Fed Funds market is a shadow of its former self and most action has moved to the repo market.

      2) The second statement is true. The Treasury that was held by a non-bank investor was swapped out for cash, which can then be re-deployed into a risky asset.

  7. Steve Roth

    Hey great posts, great to find your blog and tweetstream. Here’s a Q I’ve been struggling with:

    Commercial banks are chartered with a special privilege: they’re allowed to create (print) new M assets* for lending. (In return for that privilege, they accept tight monitoring and regulation.) It’s like legal counterfeiting! Of course they can’t print money for spending on goods and services. Just for (new) lending.

    But my question: are they allowed to print money to buy existing bonds? I don’t think so. (New bond issuances? Ditto, I think.) This is why “(new) lending creates deposits” was pretty exactly true until 2008; it was the only thing that created deposits, M assets held by non-banks.

    Now QE: it seems to have created a new (incentive?) mechanism whereby banks can print new money/deposits to buy existing bonds (then swap them with the Fed, for reserves). That solved a problem: the Fed can’t buy bonds from non-banks; they can only pay in reserves, which only exist in Fed accounts. Non-banks don’t have Fed accounts. So if the Fed wants to buy bonds from non-banks, the banks have to intermediate that: buy, then sell to the Fed.

    Takeaway: this pretty byzantine mechanism (see Choulet’s explanation, involving eg foreign subsidiaries of domestic banks and vice versa) means that the Fed can, effectively, create bank deposits/M assets. Bank lending is no longer the only thing that creates those special fixed-price assets held by non-banks.

    Thanks for listening, love to hear any thoughts. Thanks.

    * a.k.a “bank deposits” or more broadly checking/saving/MM holdings. The defining characteristic of these special M assets/instruments: their price is institutionally hard-pegged to the unit of account, by multiple institutions. So synonym would be “fixed-price instruments/assets.)

    Reserves are also (the ultimate) fixed-price assets, of course. But since non-banks can’t hold them, they’re utterly different in their mechanisms and effects from M assets held by non-banks. MB has very complicated relationships with M2. The two measures only overlap in that both include a fairly trivial amount of physical cash. Gesturing vaguely to “the money supply” without specifying which is just…incoherent. (Though that blithe usage does nicely perpetuate the childishly simplistic S/D beliefs about “demand for ‘money’.”)

    • Joseph Wang

      I’ve moved this comment to the Forum and responded there. Apologies for the late reply.

  8. Dave

    One important point is that QE also introduces primary money.
    QE results in replacement of natural demand by borrowers for primary money because it introduces new deposits to non-bank investors which can lend in capital markets to those borrowers now and will do so at a lower rate. QE is generating primary money, bypassing the bank lending process, and thus cannibalizing bank loans, as obligors hunt for borrowing (cost of money) at the cheapest rate (they are indifferent to whether money is primary or secondary), and once introduced, secondary money (from prior bank lending and QE and other bank purchases) competes with demand for new primary bank money creation and there is now plenty in the secondary market. As non-banks flush with cash from QE, increased supply of excess liquidity results in investor acceptance of lower yields from obligors, and obligors replacing higher cost bank loans with bonds. Since the borrowers repay loans only and that does not eliminate reserves from Fed QE, bank loan growth will face headwinds and non-bank lending will grow on investor balance sheets. Hence, explosion in direct lending & other non-bank replacements. To compete, banks also need to reduce their interest rates, and so QE leads to decreased borrowing costs across all markets (although non-banks lead the way).

    No reg capital costs of markets-based finance makes it cheaper (and especially large companies able to obtain public ratings and in less cyclical / business risk industries).

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