The Financial Jigsaw – Issue No. 14

My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author

Last week we opened with a look at the banks, starting with commercial banks.  See here for last week’s: Issue 13   In this Issue we look at how commercial banks operate to keep the money-go-round working in a modern bank-centric economy.  How they create new money by making loans and how they manage the accounts they have created.

COMMERCIAL BANKS

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

Mayer Amschel Bauer Rothschild, Banker

The historical role of commercial banks

Historically, commercial banks offered two types of accounts: demand deposits and time deposits. Demand deposits are what we now call current accounts, but the original idea was that you would pay your bank to store your money securely, and you had the right to “demand” your deposit back immediately and/or transfer funds by writing cheques or drawing cash to pay bills.

Time deposits, which have become known as savings accounts, pay interest when you deposit your money for a specific period of time. This is why they are called “time” deposits; you lend the bank money for a given time period and banks then know how much money they have to lend out at higher interest rates and make their profit.

In the past there was no need for government guarantees on deposits because bankers backed their businesses with their own funds, and if they miscalculated, they became personally liable and often went bankrupt. Depositors would naturally avoid banks which were known to make risky loans and banks competed to be the most prudent and solvent lenders.

Both lenders and depositors were cautious in those days.  It could be said that the idea of governments guaranteeing everyone’s deposits is just another unaffordable, un-backed social promise of the 21st century.  The fact that a government guarantee is now required must say something about the unstable nature of our 21st century banking systems.  Unfortunately the real nature of banking is not something taught in schools and colleges but which actually should be high on the curriculum of any secondary educational institution.

Part of the problem is that banks are no longer financed by the individuals who founded them by risking their own personal net worth.  Now all banks are public corporations of immense proportions as are most connected financial institutions.  This means that they have ‘limited liability’ and are therefore risking, not their own money, but other people’s money – your money – (shareholders’ and creditors’ money) without having to account personally for the consequences of failure.

In this event they can just pack up, take their bonuses, cash in their share options and move on.  Government guarantees create what is known today as ‘moral hazard’ where risk is not borne by the risk-taker but is passed from the banks to their shareholders and creditors (depositors), without recourse, and thus the taxpayer has to pick up the final bill.

Modern banking methods

Just imagine that you are a smart, young trader working for Barclays, Goldman Sachs, Deutsche Bank or any one of these mammoth financial institutions in the City of London. It’s actually in your best interest to make irresponsible bets.  You could win millions of pounds on this financial roulette wheel if you win and get a multimillion bonus.

One really cannot blame these people; it is the financial system itself that is failing, as there is little incentive for banks, governments or politicians to change because they are the ultimate beneficiaries.  Only a cataclysmic failure will initiate the needed changes but unfortunately we will all have to pay the price when this happens.

Nevertheless, you can be sure that the financial elite will be long gone when the crunch arrives, as has already happened in Cyprus.  Yet again the wealthy had flown the banks with their money well in advance and, as was reported on 13th April 2013, the Cyprus government found out they lacked the funds to continue with the bail-in process.  They estimated that their banks would now need €23 billion, and not the €17 billion originally planned for because of shortfalls in the projected amount of deposit money left available.  This is an example of how difficult it is to prevent the smart money moving before emergency controls can be implemented.

How a commercial bank creates money by making loans

Contrary to popular belief, the legal status of a bank determines that it does not take deposits and it does not lend money. Various legal judgements have made it clear that when you think you have deposited your money into a bank, in law, you have made it a loan. Banks are in the business of purchasing securities.

When you think that you are asking for a loan, and you think you have signed for it, your offer letter makes it clear in law that you have issued a security; a ‘promissory note’, and the bank buys this; thus the bank is doing something very different from our perception of its actions.  If it is a secured loan like a mortgage a separate document is created to enable the bank to claim the asset in the event of a default of the promissory note.  There are always two documents in this case.

When you want the money the bank has ‘loaned’ you the bank will say that it is in your account but the bank has not transferred any money into your account from anywhere inside or outside of the bank.  It owes you money against the promissory note, so what appears in your account is simply a record of that which it owes you, nothing more.

What you think is money is only a record. The Bank has just created money out of nothing. The banks can do this is by ‘creating’ sight deposits by referring  to what is actually an accounts payable liability, having arisen from a ‘loan contract’ through purchasing your promissory note, but no money has actually been deposited. From the bank’s balance sheet position a deposit is a liability because it owes the customer the money and a loan contract (a promissory note) is an asset in the bank’s books.

When we pay money into a bank, which we call a deposit, this is appears as a record of the bank’s debt to you, the customer. The money supply in an economy consists of 97% of these deposits. This short video explains this process: https://www.rt.com/shows/renegade-inc/379579-uk-finance-curse-suffer/

 Book money (sight deposits) created only by transactions between banks and non-banks

In terms of volume, the majority of the money supply is made up of book money, which is created through transactions between banks and domestic customers.

Sight deposits are an example of book money: sight deposits are created when a bank settles transactions with a customer, that is, it grants a loan by buying a promissory note and credits the corresponding amount to the customer’s bank account in return. This means that banks can create book money just by making an accounting entry; according to the Bundesbank’s economists: “this refutes a popular misconception that banks act simply as intermediaries at the time of lending; that banks can only grant credit using funds placed with them previously as deposits by other customers“. By the same token, excess central bank reserves are not a necessary precondition for a bank to grant credit and thus create money.

Commercial banks’ ways of creating money are not infinite, however. According to the Bundesbank Monthly Report, they are constrained by the banking system’s interaction with non-banks and the central bank, by regulatory policy and, not least, by banks’ own inherent interest in maximising their profits.

Despite its ability to create money, a bank still has to fund the loans it has created since it needs central bank reserves for the cashless settlement of payments when sight deposits created by lending are transferred to other banks. These are balances which only the central bank can create.

A bank decides on the structure of its funding depending on relative costs as well as on interest rate risk and liquidity risk. In order to be able to grant additional loans, a bank can offer more favourable credit conditions. However, if funding costs remain static, the returns on lending will be lower, and, all other things being equal, additional lending will be less attractive.

Complex interactions

The banking system’s ability to create money is additionally constrained by the behaviour of enterprises and households, especially by their demand for credit and their investment decisions.

In turn, the central bank shapes monetary and credit growth indirectly by adjusting target interest rates (base rates), which influence the funding and portfolio decisions of banks and non-banks through a variety of channels. According to the Monthly Report, monetary growth is, overall, “the result of complex interactions between banks, non-banks and the central bank.” In a conventional monetary policy implemented by manipulating the policy rate, the ups and downs of central bank reserves are shaped by banks demand.

The Bundesbank’s economists also describe how monetary policy asset purchase programmes fundamentally impact on central bank reserves and the money supply. Whereas such programmes necessarily increase central bank reserves, this does not apply to the same extent to the broad monetary aggregate. The only way asset purchases can have a direct positive impact on the money supply is if the end sellers are domestic non-banks, with the report adding that; “….in this case, the transaction leads to an increase in the central bank holdings of government bonds and an increase in sight deposits held by the seller“.

However, the ultimate sellers of the instruments could also be commercial banks or non-residents. In addition, the money supply could also be indirectly influenced by, in particular, the transmission of the asset purchase programme to asset prices and yields or lending. This is why there is no mechanistic relationship between the increase in central bank reserves and the broader monetary aggregate.

Benefits of full backing of deposits with central bank money is questionable

The authors of the Monthly Report also comment on proposals for banks to hold central bank money against 100% of their sight deposits. These proposals are designed to constrain banks’ money creation and thereby improve the stability of the banking sector.

However, it is not evident, the Bundesbank’s economists argue, that this constraint would indeed make for a financial system that is more stable overall than could be achieved through targeted regulatory action. At the same time, that kind of transition to a new system would risk impairing important functions which the banking system performs for the economy and are crucial for keeping real economic growth on a steady path, they write. The Monthly Report says further on that “given the economic costs a change of system would entail, the question arises as to whether the benefits could outweigh the drawbacks“.

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