A key observation of the endogenous money theory is that banks create deposits (money)
by lending. This means that banks apparently face soft budget constraint in responding
to demand for credit. However, there are several limiting factors, which can make
the banks' money creation somewhat constrained, and can thus harden their budget constraint.
Such factors include the need to preserve banks' profitability and the bank regulations
(the capital and liquidity requirements). Previous literature on soft budget constraint
(SBC) in banking mentioned government bailouts, central banks lender-of-last-resort
policies, or the poorly informed depositors who over-finance banks, as reasons for
the SBC for banks. Taking the 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 purpose. Our analysis, as well as lessons
from several recent bank crisis episodes suggest, that under current banking regulation
SBC is an inherent feature of banking.
