Turner Turns (11) Banks Get the Money Back

Banks are different from other businesses in another way. Most of the money that they lend comes back to them. The bank deposits the money in the account of the person taking out the mortgage. It will not stay there, because the borrower will write a cheque to pay the person they are buying a house from (ignoring the solicitors for simplicity). The house seller will deposit the cheque in their bank account, most likely a different bank. The borrower’s bank will have to transfers reserves to the sellers bank to cover the cheque.

The seller might need to use some of the money to pay for goods and services. They might buy some shares or units in a superannuation fund. The money will end up in the banks of the businesses selling these things.

The big difference is that the money ends up being deposited in a bank account, somewhere. Whereas, when a business gives credit to a customer, they hand over good or services to them. They do not get anything back until the loan is due. The money does not come back to their business.

The credit created by the bank issuing the mortgage would end up in accounts at other banks. However many other loan transactions would be going on at the same time. The home buyer’s bank would most likely have some money paid into the accounts of its depositors relating to these transactions. It would receive Central Bank reserves from other banks to cover these cheques. All the transactions could cancel each other it, so the bank might need to give up any reserves at all. If this happened, the bank would have received back all the money that it has loaned out.

This difference allows a bank to create immense amount of credit, provided all other banks are doing the same.

Turner Turns (10) Banks

Banks create credit. However, the structure of a bank balance sheets means that it is not so constrained as other businesses.

Due to fractional reserve banking laws, only a small part of the bank’s assets are needed for the support of its ongoing business. They do not need to use their currency to make a loan. Reserves at the central bank cannot be lent to private individuals.

When making a loan, the bank simply records a deposit in it’s clients bank account. They record this deposit as a liability on the bank’s balance sheet. The mortgage is recorded on the other side of the balance sheet as an asset.

Banks are not constrained like other businesses. Only a small part of their assets, are needed to support their ongoing business. All they have to do is keep enough reserves of currency or at the central bank to cover potential withdraws of call deposits. Deposit insurance means that their reserves can be kept quite small.

Banks are different from businesses. They do have to give up anything when giving credit to a borrower. Banking laws give them the right to give borrowers something they do not own.

Understanding this is easier, if we think about the situation when banks began as goldsmiths storing gold. People deposited their gold with the goldsmith for safekeeping. Rather than withdrawing gold when they needed to make a payment, they would exchange the goldsmith’s receipts. These receipts acted as money. The goldsmiths realise that only a fraction of the gold was withdrawn at any one time, so they began lending some of it out in return for an interest payment.

All the gold belonged to the people who deposited the gold. The goldsmith bank did not own any the gold (although it would record on its balance sheet). When it loaned gold, it was lending gold did not own. It was cheating because it was lending something that did not belong to it.

Now that we have switched to fiat money, the same situation applies. Banks can lend out money that they do not own, just as a goldsmith bank lent out gold it did not own. The law allows banks to operate in this way. No other person or business has this right. Fractional reserve laws give banks a huge capacity to expand credit. This has been a major cause of instability in economies everywhere.

Peston on Banking

In the last couple of years, I have read at least twenty books on the causes and cures of the Global Financial Crisis. I try to grab every one that turns up in our local library. The last one to arrive is “How do We Fix This Mess” by Robert Peston and Laurence Knight. This is the first one by a British author, so it gives and interesting perspective. Robert Peston is the Business Editor for the BBC.

One interesting fact that he brings out is that during the 1930s, no significant banks failed in the United Kingdom. This is different from the United States, where thousands of banks failed. The reason British banks survived that disaster was that they had more adequate capital and liquidity back then.

Peston notes that the leverage of banks has been increasing for more than a century. In the 1840s, banks in the United States would typically hold capital equivalent to around half of their loans and investments. By 1880, a typical US bank had capital equivalent to around a quarter of its loans and investments, whereas the equivalent ratio for British Banks was not far off twenty percent. However, by mid-2008, Royal Bank of Scotland held capital capable of absorbing losses of around a tenth of that, or only 2.23 percent of gross loans and investments, while Northern Rocks capital-to-assets ratio in 2007 was just 1.7 percent.

Peston explains what this difference means. A century ago, a bank would go bust if a quarter of its loans went bad. In the latest financial crisis, one of the biggest bans in the world, RBS was no longer viable if could not get back 2% of what it was owed. In the case of Northern Rock, if it lost just one in every 60 dollars, it was kaput. By the time of the 2008 banking crisis, British banks had on average capital equivalent to less than 3 percent of their loans and investments, a fall of more than three quarters through the course of the twentieth century. The US banks had only a little bit more.

In the latest crisis most of the large banks in the UK had to be rescued. It is not surprising, given the inadequacy of their capital.

Community Based Banking (3) Auditors

The various record-keepers in a community would be competing with each other to have the most trust. If one lost a bit of trust, people would quickly shift their business to another recorder. To maintain trust, record-keepers would need to allow anyone who wanted to examine their records to do it. Most would not have time to do it, so someone with spare time might regularly go round and check the records of everyone undertaking this business in the community. These record-auditors would regularly add up the net balance on each record keepers books and check that they netted to zero. This would quickly expose any fraud. The auditors would support the community by publishing their findings.

At first, record communicated would be very simple an manual. As the economy expanded, the record keepers would develop electronic systems. They would eventually develop distributed and mobile systems that would record transactions anywhere in the community. The result would be a fully functioning money system.

Foreclosing on Churches

According to Reuters, Banks are foreclosing on churches in record numbers.

Banking on Obama

Barack Obama has announced that he will pass legislation preventing banks from becoming “too big to fail”. There will be limits on their size and risk taking activities. Banks will prevented from owning hedge funds and other special purpose investment vehicles to remove risk from their balance sheets. These are good things, but it will not happen.

Christians should not count on the politicians to fix the banking system. Whenever the bankers and politicians get together, compromise follows right behind. The new legislations will be twisted to protect the banks. They will find ways to make any new laws work for their benefit.

The solution rests with ordinary people. If people withdrew their funds form banks that undertake risky behaviour and deposit their money in safer banks, at least some of the banks would be forced to change.

Power to the People
Depositors should also start asking banks what they will do with their term deposits. They should ask if the money will be loaned for a longer term than the term of the deposit. If the bank says yes, they should ask how the bank will repay their money when the term of the deposit has ended. The bank will say that it will obtain deposits from other people or borrow the money from other institutions. This kind of questioning will expose the dangers in what the banks are doing.

If enough people ask for a different service, an innovative bank will be able to get an advantage by providing that service. If consumers start enquiring about a bank that matches the terms of it loans with the terms of its deposits, a bank should emerge to provide that service. If that is what most depositors really want, then that bank should grow quickly. As more and more depositors choose this service, other banks will have to start providing it, so that they do not lose market share.

The power to change the banking system lies with depositors. If enough people demand a better service, banks will have to change their practices. All that is need is for one bank to provide an alternative service. Depositors can then use the power of their money to reward that bank and punish those that refuse to change. Power rests with those who own the money and the money is owned by the depositors, not the banks (From Bank Deposits and Loans).

The Role of Banks - Money Records

A legal method of recording claims is essential for the functioning of the economy. The most efficient monetary system is for those claims to be recorded by an organisation like a bank. A major function of banks will be to record money valid claims and to execute transactions between clients. It will not really matter whether this is done by paper records or computer records, as long as they are recorded correctly.

Bank accounts are records of those claims. Provided bank records are accepted as legitimate proof of these claims by everyone in society, then records on bank ledgers are a satisfactory way of recording them. Provided they have good back-up systems in place, computer records will be as secure as written records. As they make transactions between people easier and cheaper they are probably better than paper money.

In the modern world most money is a bookkeeping entry in the ledger of a bank. Mostly that ledger entry is a digital record on a computer file. When I am paid my wages, my account is credited and my employers account is debited. When I buy groceries on EFTPOS my account is debited and the supermarket’s account is credited. All these are electronic transactions. A cheque is an instruction to the bank to debit my account and to credit another person’s account. When the cheque is lodged with my bank, it issues an electronic instruction to debit my account. Most money that I hold at any point of time is just an electronic record in a banks computer. This is quite acceptable to me provided it can be used for the purposes which I need money.

The only risk with this electronic bank money is the bank is dishonest: making transactions that are not legitimate or have not been authorised by the owner of the funds. However, this will be largely self-policing. If a bank starts making illegitimate transactions, its accounts will become less acceptable for settling debts or buying goods and services. People will very quickly transfer their money to another bank, and the dishonest bank will go out of business. Dishonest banks will disappear, as they will lose their clients.

Banks will have to remain honest to maintain their business. They will need to subject their accounts and accounting systems to the scrutiny of gatekeeping individuals or organisations to demonstrate that they are honest. The more they can demonstrate their reliability, the more their business is likely to grow.

The money represented by bank records would all be on call (unless otherwise specified), so it would not be possible for it to earn interest. The money is a legal entitlement to goods or services. The banks cannot lend these claims, because they do not own them. They simply record them in the same way that a share registry records the ownership of shares. Therefore banks would need to charge a fee for this service. This is not a problem; they are providing a service so it is reasonable to charge for it.

The banks bookkeeping charges would be based on the length of time that money was in the bank. This would encourage depositors to put money that was not being used into savings accounts where it would earn interest and not be subject to charge.

Disappearing Assets

The balance sheet of an investment bank or hedge funds looks this.

Liabilities
- Loans
- Owners Equity
Total Liabilities

Assets
- Assets
Total Assets

The two sides of the balance sheet must balance. If the value of the assets increases in value, the value of loans is unchanged, so the Owner’s Eequity must increase. This has been happening over last few years as the prices of financial assets and property have increased in rapidly. The property boom has led to huge increases in the value of assets.

These increases show up first on the profit and loss statement in an increase in profit. A substantial part of this profit was paid out to employees in huge bonuses. What was left of the profit came through to the balance sheet as an increase in Owner’s Equity. Increased equity was often paid out to the shareholders in large dividends or share buy back schemes, but to keep the balance sheet in balance, some assets would be sold or loans would be increased.

In the past year, asset prices have fallen dramatically. The value of the assets must be written down, so a change must be made on the liabilities column to keep the balance sheet balanced. The value of loans does not change, so the owner’s equity takes the hit. If the business is fully leveraged, a small decline in assets can wipe out all the owners equity. This is especially true of the previous increase in equity have been paid out to the shareholders.

If the decline in the value of assets is greater than the owners equity, then the business is insolvent and in danger of defaulting on its loans. If the business is a bank and the loans are actually deposits make by clients of the bank, those deposits are at risk. In the current crisis, many financial companies and banks are now in a position where the owners equity has been wiped out and their loans are greater than the value of their assets.

The interesting thing is that previous increase in assets is gone. It has been paid out in bonuses and dividends. The recipients have used their bonuses and dividends to buy new BMWs and holiday homes in Spain. They have no liability to the business that paid them. Once bonuses are paid, the employer cannot ask for them back. The increase in the value of assets has gone, so it not available to compensate for the decline in value that often follows.

Governments are wading in to rescue struggling banks and other financial institutions. By providing capital, they are taking equity that is not there. They are hoping that at some time in the future the assets will increase in value against, restoring their equity in the business. If this does not happen, taxpayers will carry the cost.

Savings and Investment (1)

An interesting aspect of a free market economy is the way that savings are matched with investment. Decisions about saving and investment in capital processes are often made by different actors. Investment decisions are made by entrepreneurs and households. Savings decisions are made often made by people and households.

The link between these independent actors is the interest rate. When interest rates rise, people will save more. When interest rates fall, more potential projects become economic, so businesses and entrepreneurs invest more. In a free market, interest rates rise and fall to clear the market and ensure that savings are matched by equivalent investments.

Banks often act as intermediaries between savers and producers. Savers deposit their spare wealth with the bank and receive interest. Producers borrow from the bank to purchase capital goods to increase the productive capacity of their business. Their increased productivity improves living standards for everyone.

This all goes wrong when governments give their central banks authority to set interest rates. A central banker does not know the future, so he do not have enough information to set the interest rate. Following the dotcom crash in 2000, central banks pushed interest rates down, leading to the housing boom and following credit crunch.

Controlling Assets

Some people think that I should not worry about the bank recording my deposit as an asset on their balance sheet. They do not under the nature of modern banking law. When a person deposits money in a bank, they change from being an owner of an asset into a creditor of the bank. They give up a property right in exchange for a contractual right. They swap the ownership of an asset for a promise to receive repayment on demand.

Owning an asset is generally better than being a creditor. If I get a 3 year loan of $30,000 from General Motors, I can buy a new truck. My balance sheet looks like this.

Liabilities
Loan 30,000
Total 30,000
Assets
Truck 30,000
Total 30,000

Before making the sale, the truck was on the General Motors balance sheet, as part of its inventory. Once they have sold the truck to me, it becomes my asset. I can drive wherever I like in the truck. I can paint it bright blue, if I choose. General Motors have lost control of the truck. They cannot control its use it any more.

General Motors has swapped the truck for a credit contract for the money that I have borrowed. They cannot demand it back until the three years are complete. A contractual right is less certain than a property right. When they owned the truck they knew exactly what they had. The credit contract is more risky, because they cannot be certain that they will get their money back when it is due. I may get into financial trouble and be unable to repay the loan. The bank has the uncertainty of a credit contract, whereas I have a property right in the truck. The one holding the property right is in a better position than the one holding the credit contract.

In the same way, holding cash provides more security than holding a credit contract. Being a creditor of the bank is not the same as being the owner of cash. If I demand repayment and the bank fails to pay me, I cannot charge it with theft. All I can do is sue the bank for breach of contract and demand payment of damages. If the bank defaults, my contract right is converted into a claim in bankruptcy. I have to line up with other creditors and take my chances.

All that a bank depositor “owns” is the right to enforce the bank to keep its promise. I believe that most people want better security for their money. We need banks that offer a different option.