The Financial Jigsaw – Issue No. 13

My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author

Last week saw the last of the “Money Chapter” so now we move on to look at the banks, starting with commercial banks.  See here for last week’s: Issue 12 the last on money  In this Issue we start off by understanding debit and credit, which is an area that causes most confusion for those not trained in bookkeeping or accountancy.  Once the principles are understood, it will be easier to figure out why our bank statements appear to be back-to-front with credits appearing as money in the bank; hopefully this short explanation will make it all clear.

COMMERCIAL BANKS

 “Give me control of a nation’s money and I care not who makes its laws”

Mayer Amschel Bauer Rothschild, Banker

We have already met commercial banks in the foregoing Issues and how they earn profits by making loans and creating money.  Here is another piece of the jigsaw which will link to our understanding of money.

But first we need to look at a brief history of banking before discovering more about the way banks are organised today.  All financial institutions and commercial entities need to record their transactions in books of account using the double-entry system: ‘debit’ and ‘credit’.

We have already encountered these terms in recent Issues.  Before we explore the banking system it is worth taking a brief look at how debit and credit works because unless you are a trained accountant it is likely that these terms will add further confusion to an already complicated subject.

There are two main documents used in financial reporting:

1. The Profit & Loss account, which lists total income and by deducting total expenses  reveals net income: ‘profit’ or ‘loss’
2. The Balance Sheet upon which first, are listed all the ‘assets’ – such as: equipment, land, and money owned or owed to the business (debtors), plus cash at bank, stock-in-trade and placed investments; and second, listing all the ‘liabilities’ – such as: loans made to the enterprise, money owed to suppliers (creditors), any overdraft/loans at the bank, and investments made into the business such as ordinary shares otherwiae known as equity.

From the balance sheet we see total liabilities (they are all the creditors added up) and we take them away from the total assets (these are all the debtors) and arrive at a positive result (a solvent business) or a negative figure indicating that it might be in trouble because it owes more that it owns.

The balance sheet is but a snap-shot of the health of an enterprise at any one time.  A simple way to remember debits and credits is to think of them as:

• Debits are either assets on the balance sheet or expenses in the P&L account
• Credits are either liabilities on the balance sheet or income in the P&L account

Double entry bookkeeping works by making two entries for each single transaction, which always equal each other, and gives rise to the expression: “balancing the books”.  Banks use the same system, but to add confusion, your bank statement shows the reverse.

For further information have a look at this article:   https://www.wikihow.com/Understand-Debits-and-Credits

We are said to be in ‘credit’ when we have money in the bank, however at first sight, we would expect this to be an ‘asset’ (a debit) as it is our money in the bank!  Quite so, and you can be forgiven for thinking this, as most people do.  There is an answer.

Your bank statement is a copy of your account but in the bank’s books, it is telling you that your money is a liability (creditor) on the bank’s balance sheet, (see above) – and therefore it is not your money anymore, it is owed to you by the bank; the bank has become your debtor.

So where is the equivalent debit?  Put simply, it is in your books, it is a debit, and therefore it is your asset, being your money in the bank. In pure accounting terms cash in the bank should strictly be shown in your books as a debtor, the bank owe you the money; as we have discovered you can’t always rely on getting it back!

The beginning of banks and fractional reserve banking

Banking as we know it today began many centuries ago when money started to be used in the form of paper notes.  At first it was a very local affair with small banks issuing their bank notes to be used by merchants and others in their locality.  For example, we still have Scottish bank notes which are a hangover from these earlier times.

It soon became clear that competing local banks were becoming unmanageable as some went bankrupt because of too many bad debts and their depositors lost money.  This reduced the public’s confidence in banks and encouraged cash trading and bartering, which of course is not easily traceable and the government suffered loss of tax; this situation persists in business and alternative markets to this day!

Every economy needs money to invest for the future and develop new products and services; the more the economy grows, the more money is provided but not simply by printing extra pieces of paper.  The clever bankers devised a cunning system to multiply the amount of money in circulation, without cost, by expanding the money supply.

They created a system which is known as ‘fractional reserve banking’.  You may remember, from foregoing Issues, that banks take in deposits from their customers as savings and current account balances and we also know that this legally belongs to the bank so they have every reason to lend it out, for profit.

In theory and put simply, but not necessarily precisely, the banks are restricted, by regulations, in lending up to 90% of their deposit amounts; keeping 10% as a ‘reserve’ to meet repayments as and when required.  However the banking community has developed various ways around these regulations by borrowing money on their own account from other financial institutions which is just one of the many causes of past financial crises.

 Fractional reserve banking simply explained

Somebody will borrow money from their bank which they will spend or invest and which will eventually arrive back at another bank to become a deposit.  Thus for example, say: £1,000 deposited into one bank allows £900 to be loaned by this bank and which is eventually re-deposited back into another bank at some point.

This allows 90% of the £900 to be lent out again, and so on until the balance is approximately zero, ten times later, (you do the math).  By the magic of fractional reserve banking we have created £10,000 worth of loans, out of nothing, for only a single £1,000 deposit.

For more information see this: https://www.investopedia.com/terms/f/fractionalreservebanking.asp

This system of banking is used by countries worldwide and the central bank (or other monetary authority) controls the level of money creation that can occur in the commercial banking system and helps ensure that banks have enough funds to meet demand for withdrawals during normal times.

A problem arises for bankers in that money is loaned out often over a period of several years, but the deposits are only short term, which creates an imbalance between deposits and loans; the bank makes its profit through the interest rate differences (net interest margin, or NIM) and fees.  However, if confidence in the banking system fails, and many of the depositors demand their money back all at the same time, we say that a bank-run has occurred because the bank is unable to repay its depositors; it would have to declare bankruptcy.

One of the central bank’s functions is to allow a commercial bank to borrow funds to fill this gap; this is known as ‘liquidity support’, the central bank acting as lender of last resort.  Bank runs can occur for many reasons but are mainly due to a lack of confidence for one reason or another.  In the classic example of Northern Rock, which was the first bank in 150 years in the UK to suffer this fate, the bank run was caused by lending out much more than just 90% of its deposits using a range of complex financial instruments.

The Northern Rock example of failure

Northern Rock had borrowed heavily on its own account in the international money markets, extending mortgages (which many failed to repay due to a recession) to customers, based on this borrowed money and then re-selling these mortgages on international capital markets, in a process known as securitisation.  In August 2007, when global demand from investors to buy these ‘securitised mortgages’ fell away it meant that Northern Rock was unable to repay their loans from the money markets which had originally provided the funds.

This problem had been anticipated by the financial markets to which it drew greater attention. On 14 September 2007, the bank sought and received loans from the Bank of England (the central bank acting as lender of last resort) to repay the money markets. The widespread publicity and general nervousness led to panic among individual depositors, who feared that their savings might not be available should Northern Rock become bankrupt.

The depositors lined up outside the bank to withdraw their savings as quickly as possible but by this time it was too late to rescue the bank which had failed to find a commercial buyer for the business.  It was taken into public ownership in 2008, and was then bought by Virgin Money in 2012.  This later became the first of several ‘bailouts‘ in the UK and around the world using taxpayers’ money.  Here is an article explaining the detail:

https://www.telegraph.co.uk/finance/markets/2815859/Why-Northern-Rock-was-doomed-to-fail.html

The Northern Rock case is also interesting because it was first a building society, a mutual society bank, where the depositors are actually the owners of the bank and was not involved in the risks of fractional reserve banking.

During the 1980s, when Margaret Thatcher’s government embarked on its policy of ‘general privatisation,’ Northern Rock, in common with many other mutual societies decided to become demutualised.  In the 1990s, along with many other UK building societies, Northern Rock chose to list their shares on the London stock exchange.

Throughout this period a concern against demutualisation was that the assets of a mutual or building society were built up by its members throughout its history, not just by current members, and that demutualisation was a betrayal of the community that these societies had been created to serve.  Debate still rages today as to the whether these policies have contributed to the continuing financial crises and that perhaps the sound banking principles of yesteryear should have remained a preferred option.

More about the Cyprus crisis

Cyprus would also have been an example of a bank run which in this case didn’t happen. It would have happened if the Troika had not stepped in to ensure that severe restrictions were placed on taking money out of the banks (capital controls) as discussed in earlier Issues.

There is considerable disagreement over the significance of the Cyprus crisis. Some people say that it was just temporary and will not affect the rest of the financial system.  Others speculate that it is indeed significant and illustrates what is really going on in the EU and the financial world in general and why our money in the bank is at so much more risk than ever before.

However, Cyprus could be a spark that ignites a keg of dynamite under the financial system.  Banks around the world are potentially bankrupt and have been so for years. This is because all the world’s financial systems use fractional reserve banking which, through regulation and backed by government guarantees, only have to keep a tiny fraction of the money deposits on hand.

They make loans which create these deposits (known variously as ‘book money’ or ‘sight deposits’), also known as the banks’ assets, so that even in good times they are unable to return on demand all the depositors’ money. These loans cannot be called in instantaneously as they are contracted over periods of years and most borrowers would default anyway if the loans were suddenly called in.  In bad times this ill effect of this process is even greater because so many more loans that the banks have made are likely to become distressed or ‘bad’, never to be repaid.

Cyprus has demonstrated that governments and bankers are quite willing and able to confiscate our money in their banks in order to preserve their banking system.  Cyprus was said to be particularly vulnerable because of its strong financial connections to Greece; Cypriot banks had bought large amounts of Greek government debt.

All banks are beholden to the state because they own so many government bonds, which are considered to be the most secure, but which are quite the opposite in reality. Many governments themselves are bankrupt and the Greek government is among one of the worst of them all.

To be continued next Saturday

Author: Austrian Peter

Peter J. Underwood is a retired international accountant and qualified humanistic counsellor living in Bruton, UK, with his wife, Yvonne. He pursued a career as an entrepreneur and business consultant, having founded several successful businesses in the UK and South Africa His latest Substack blog describes the African concept of Ubuntu - a system of localised community support using a gift economy model. View all posts by Austrian Peter