Banking

I wanted to write something about this subject because I have been studying about how home loans work, and it helped me realize some things that others have been pointing out for a long time.

Note that on 19 May I rewrote this post to try to make it more accurate; see more about that below.

Financial people tend to speak in terms that are not easily understood, and to assume you know about something that you don’t actually know about. However, most people have heard of the term “balancing the books” and this is a basic concept worth going over.

I suppose the idea that the books have to “stay in balance” is similar to the idea that “for every action, there is an equal and opposite reaction.” In the physical universe, this is true by observation. However, money and finance are conceptual universes, or you could say a kind of mathematical model of the physical universe. If a car exists, it is assumed that someone was paid to make it, whether that’s really what happened or not. So if I buy a car, I basically convert some of my cash into a vehicle. In my books (if I kept books), the price paid moves out of the Cash asset category and into the Vehicles asset category, and they stay balanced. What if someone gave me the car? I basically have to create a special category for gifts, which in a commercial business would be similar to something called “retained earnings”.

Debt

Now, say I’m a bank, and I have some deposits from my customers, and loan a portion of these to someone. This decreases my cash – the pool I make loans from. How do I replenish that pool (other than by getting more deposits)? In normal banking I would have to use part of my income (payments on loans I had already made to other people) and put that back into my cash. In mortgage banking I could do something called “selling the loan.” Basically, the loan turns into a security (essentially a document that can be bought and sold) that I can sell to a company that buys those types of securities.

Where do those companies get their money? They also create and sell securities – stock, basically – to investors. The investors include a lot of firms that help people save for retirement, as well as other investment firms. Those firms buy all sorts of stocks and other securities with that money.

The ultimate source of money for buying debt (making loans) in the U.S. is the Federal Reserve. The “Fed” is part of a network of “Central Banks.” Central Banks get charters from governments to control the money supply for them. They regulate banks, and they buy debt (or make loans, however you want to look at it). The Central Banks deal mostly with the large commercial banks, which are all international corporations. Smaller local institutions deal mostly with the big banks. The chain of purchasing debt works its way down until you get to the borrowers, who are expected to keep up their flow of payments. Governments are also large borrowers. To borrow money, they issue “bonds,” which come with a promise to pay dividends, and the full amount borrowed at the time of maturity. So in the case of government borrowing, the taxpayers, have to pay all that through their taxes. That’s why “bond initiatives” have to be approved by voters. In the end, a lot of what we make at our jobs goes to make profits for the owners of “debt.”

Making Money

Before my recent studies, I hadn’t really heard about this practice of “selling debt.” But debt is a receivable on the bank’s books, so it is worth something. It never occurred to me that you could somehow sell that to another company to get more cash (stay liquid, as the financial people call it). But this is really just another way of saying that the bank borrowed some cash. I’ve heard of companies borrowing to make payrolls, or buy new equipment. I’d just never heard of banks borrowing so they could make more loans. Of course, assuming they continue to service (collect payments) on the loans they sell, they have to forward most of those payments to the new owners of the loans, so that portion of their income is no longer available for lending.

As I wrote this, I came to see that “selling debt” could also be given another meaning. It could also be seen as selling people – governments in particular – on the idea that they should borrow money in order to do things. They shouldn’t save, they should borrow. You shouldn’t “wait until you can afford it,” you should buy it right now, do it right now. With governments, this is particularly pushed as a way to finance wars. Every major war I am aware of was financed with debt – the taxpayers (via the government) borrowed money from banks, then had to pay it all back afterwards. It is a potent way to “make money” in a short amount of time. I don’t know, however, if it really accomplishes anything over longer periods, especially if it involves making war.

Fractional Reserve Banking

Some people believe that this is a new idea. But it is really just a newer term for an old idea. According to Google’s Ngram viewer, the phrase first appeared in literature around the turn of the last century.
As long as banks have been loaning money, they have been using deposited funds (or other assets) to do so. The idea of “Central Banks” was pushed into place after it seemed that unregulated banks had an inclination to dig too deep into their cash. Now Central Banks police what fraction of a bank’s deposits (or cash, to use a simpler term) must be held in reserve so that their depositors will be happy with the illusion that their full deposited balance could be withdrawn at any time. Depositors get to account for their full deposited amounts as “cash,” when in reality only a fraction of that amount is actually available to be paid out from the bank’s reserves.

No one likes “reserves” because they just sit there and don’t do anything. It’s kind of like a having a Fire Department in your town. In a perfect world, they would never have a fire to fight, or even a cat to get out of a tree. In this real world, you need to have one because “stuff happens.” Same goes for reserves.

Some would argue that amounts held is reserve should be quite substantial. It gives stability to an economy, and breeds a certain level of confidence, even a certain willingness to take risks. I think there is validity to those arguments. But that does not mean banks need to keep 100% of their “on demand” cash deposits as reserves. This is discussed more below.

The beauty of a cashless system (in the eye of the banker)

In the “old days” money meant gold coins, or ingots of silver, or other precious metals, or gems. Today it can be reduced to a code in a bank’s database. Money (currency, really) had to be manufactured, transported and stored when not in use. Meanwhile, businessmen had grown used to account books, and moving larger sums around using bank drafts instead of currency. This began the move away from “hard” money. The “softer” the money, the easier it was to handle and move about. Banks and their major customers really liked these benefits. And so, national currencies were pushed into place, the use of paper money was greatly expanded, and finally computer systems were developed that just require an ID card to access account records.

Global-scale electronic funds transfer systems now exist, and are very widely used. All accounts at all modern banks are computerized. Banks are now relieved of the problem of having to store precious metals in their vaults, though “modern” money can still be stolen. To the extent that the world goes cashless, banks and stores are relieved of the problem of securing their on-hand currency, and only have to worry about their computers, which can be locked away in their now-empty vaults.

So, what’s so good about cash?

However, the credit or debit card holder now has to worry about the security of his electronic transactions. I once had a bank make a $2,500 error in my favor. They never bothered to correct it, though I told them about it more than once. For them it was insignificant, but that’s a huge amount for me. What if my account suddenly one day had $2,500 less in it? They better be able to correct that!

In a secure and honest world, using a card instead of cash (currency) would be a great way to go. In the world as it really exists, I want to be able to fall back on coins and paper money. If a store’s electronic payment system goes down, I want them to accept my cash. If I need some water out of an old-style vending machine, I need some coins or I go thirsty. If I want to tip a waiter, it’s easier for me to think with using a couple of extra bills.

When money is a commodity, then you can’t have some unless you earn it or physically steal it from somebody. When money is only a number in a database, what happens if I can’t get access to that database? And what happens if someone can get illegal access to it? Or in some other way fiddle with accounts just by making some entries in a computer program? It gives the tech-savvy an advantage I’m not sure they’ve earned. The cashless ideal includes a reliance on technology that is not necessarily as reliable as I need it to be. At the business level, if a transaction gets fouled up, it can be fixed later. At a personal level, it could mean the difference between staying fed or going hungry.

I’m not advocating a return to cash necessarily, though we might be forced into it should the electronic funds transfer systems stop working. But I am pointing out that our turn away from cash did not handle the most important problems we have always had: dishonesty, thievery and avoidance of real productive work.

Reality Check

My original concept of how this scam works was simple, but incorrect:

The bank has my $100. I thought this meant it could loan out $1000. That’s not exactly right. It is only allowed to loan, maybe, $90. Except, that loaned money is going to end up in another bank account, and then about $80 of that could be loaned back out. That whole cycle can be imagined to repeat maybe 5 or ten times. Now a lot more than my $100 has been loaned – deposited – and re-loaned. That’s what people call “creating money.” I discuss this more below.

The other part of my perception of what was wrong with this system was the cashless nature of modern transactions. This possibly provides more opportunity to “fiddle” the system. If you have to provide a borrower with real currency to complete a loan, then if you run out of currency, you can’t make any more loans. If you only have to credit an account on a computer, then you don’t need the currency. So, who’s to stop you from just pumping out loans? Your accountant, if he’s honest. Or a regulator, the next time you get audited. So the real point here is that the removal of hard currency from the system, reducing it all to numbers in databases, has a tendency to degrade the underlying concepts of what money is and represents. It should represent real value, real productive work. You should not be able to “fiddle” it into existence when you have done nothing to earn it.

Interest

I originally linked this trend towards a cashless system to the decline of interest rates, close to their total disappearance. I have a problem with interest because I don’t think most of the explanations for it are correct. It is often described as a payment to the lender based on the risk he takes by loaning money. But what about the risk the borrower takes in borrowing money? And what about loans between friends or relatives? I think the banks just decided to shift the paradigm because they had the power to do so. Look at interest rates on savings accounts, for instance. It used to be recognized that the depositor was actually making the bank a loan, and should earn interest on his unused balance. But depositors had no way to enforce that idea on bankers, so gradually interest payments on savings accounts have reduced to almost nothing.

The abandonment of the use of interest rates to control inflation in certain markets, and the subsequent increase in the supply of money in those markets, are bits of history not totally explained by the factors discussed above. Though the smaller banks that overextended themselves before the Great Depression could be blamed for what happened, I think that blame would be misplaced. They, however, felt the brunt of new banking regulations, while at the same time, what was to become a huge boom in the mortgage markets can be traced back to those times. I think there remains an untold story (at least it hasn’t been told to me) about how that all came about and about what is unfolding today. My concern is that we will strike out at the wrong targets (called misidentifying root cause where I work) and simply prolong our agony as a result. Benefiting from the suffering of others has never been an honorable way to gain status in a society. Yet suffering continues while a few grow unbelievably rich. Until we begin to apply more effective solutions to problems of finance, the economy, and politics, we will continue on our slide towards a non-sustainable system that will eventually totally break down.

Credit:

I relied heavily on an article written my Kenneth Ballard here:

Accounting for Fractional Reserve Banking

to get an explanation of how banks account for the loans they make.
I don’t know much about this guy, but he seems to know what he’s talking about…I wish the subject were easier to understand. I have had a terrible time trying to do so…
Wow! Mr. Ballard has responded with corrections here:

And that is not banking

Follow-up notes for those interested

According to the Federal Reserve’s own website:
“Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. … Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks.”

Notice that this says nothing about loaning money. The “reserve requirement” is a fraction of total monies on deposit. So, that means the rest of the monies on deposit are available to loan out. I think the first stumbling block here is the term “deposit liabilities.” Who, who isn’t accounting trained, knows what this really refers to? It’s like two conflicting ideas in the same term. This goes back to the fact that there are two balancing sides to every transaction. When a bank receives money from a depositor, it’s not a gift, but on the other hand, the depositor gets nothing in return, except a receipt. As the reference I cited at the beginning states, in the “old days” that receipt acted as money. Nowadays, the fact that a person has money “on account” gives them the right – or ability – to buy things with it.

The depositor counts his bank balance as cash – as a liquid asset. He can do this because there is an implied promise (perhaps written somewhere) that the bank will pay him back “on demand.” More realistically, the depositor has loaned the bank some money for its use. But there is no formal loan contract, as would be the case if the depositor had purchased a CD or a bond. So the depositor is encouraged to not think of his deposits as “on loan” to the bank. However, that is closer to the actual situation. I think this difference between perception and reality is what some people object to. Yet, if the banks do a good job, no one will ever know the difference.

It could be argued that banks should be more honest about what they are doing. It would probably better reflect how they actually operate if they sold bonds or CDs to anyone who wanted to maintain a significant balance with them. Or to make them a “member” like the Credit Unions do.

Private individuals are never going to fully realize that a portion of their deposited funds is being loaned to others unless the way their account at the bank works actually makes that clear. In the past it has been a workable system in spite of this. But since interest rates collapsed, more and more people are questioning it. The “multiplier effect” would still work, but perhaps the banks should be made more responsible for both the positive and negative aspects of it. Having to “insure” bank accounts is not something that should be necessary. If the banking system were more honest with the public about how it actually operates, I think the public would support it – especially if it resulted in real economic growth at the local level. Right now something is suppressing that growth. Questionable ethics levels in the banking community does not help matters any. The banking system has a lot of power to do good in society. Or harm. It is not currently demonstrating the good side of that power.

Tags: banking, economics, money, politics