Possibilities and limits of banking regulation in the endogenous money theory framework

The banks’ soft budget constraint

Abstract

he article questions whether the current system of bank regulation can guarantee that banks are subject to a hard budget constraint. We use the framework of post-­Keynesian endogenous money theory. Banks deposit loans in companies’ bank accounts, and no external source is needed for the transaction, so banks can in principle create an unlimited amount of money if there is a demand for credit. However, banks’ ability to create money is limited by a number of factors. Using János Kornai’s concept of a soft budget constraint we analyze the factors that cause inherently soft budget constraints for banks. We point out that neither monetary policy, nor the profit goals of banks, nor the banks’ internal risk management practices would guarantee that banks face a hard budget constraint. This must be imposed on them by an external factor, the banking regulation. However, the current system of banking regulation is not well suited to do this, so the soft budget constraint is inherent to banking. This contributes to the fact that banking crises are natural part of the financial system.