Debit, credit, banco!
by Rudo de Ruijter,
Independent researcher,
Netherlands
In “Secrets of money, interest
and inflation” [1] I have exposed many things about banks.
There were many readers who still had questions about the
way banks make money. That is not so surprising, for it is
really something that is astonishing. Some people cannot
believe it. That cannot be, can it?
In this
article we wil explain this money creation in detail. To
avoid misunderstandings: banks make money, but they don’t
make bank notes. Only the central bank is allowed to print
banknotes. Ordinary banks do it simpler. They make money by
inscribing numbers on their balance sheet and lend that out.
And on the lent out money they collect interest. That is how
the bank grows rich.
So, banking is a nice game. But, as with all games, there
are rules. These are imposed by the central bank. That does
not mean that everything always goes perfectly then. Things
can become a mess, like we know from today’s credit crisis.
We come back to that later.
Let us see
how banking works. Banking is mainly a question of
bookkeeping. I find bookkeeping boring, so I will only show
the interesting parts. Here you can first have a look at the
bookkeeping of a bank, to be more precise, of its balance
sheet. To keep it simple, I didn’t put everything on it. On
the left hand side, the debit or assets side, you find what
the bank has. It is also called the Activa. On the right
hand side, the credit or liabilities side, you find what the
bank owes to others, like the Current accounts, also called
Transaction deposits. They are often called passiva. On this
side you also find what the bank owes to its owners, the
capital. When you substract all the passiva from the total
of the activa, you find the capital.
(At a bank
the numbers are that high, that on the balance sheet the
last three figures are generally omitted. Then you have to
multiply all amounts by 1000.)
Now let’s
set the banker to work and see how he does things. It is not
necessary to see the complete balance all the time. At each
stage we will have a look at the part that changes. To keep
it simple we’ll work with small amounts. In reality they are
much bigger. We will also mention the principal rules. We
start easily.
Bank takes notes in deposit
John has
1000 euros in banknotes and brings them to the bank. The
banker says “thank you” and inscribes the 1000 euros on the
balance sheet as an asset of the bank. “Banknotes in cash: +
1000 euros. But the bank will also have to give the 1000
euros back to John one day. So the bank has also a debt to
John. The banker writes at the liabilities side: Checking
account John: +1000 euros.
This way
many customers bring their money at the bank. By experience
the banker knows that a lot of customers will leave most of
their money for a long time. Daily some money goes, but
other money comes. So the bank has more bank notes than for
its daily needs.
Now the
bank is going to lend out the bank notes that it does not need
for its daily use. On that money it can collect interest.
And the more the bank lends out, the more interest it can
collect. But it has to take care, that it keeps
suffisciently in cash, in case John comes in to collect
money. And if John doesn’t come, other customers will surely
come. How much money the bank should keep in its pay-desk?
Well, in most countries the central bank dictates the rule.
We will take the US as example [2]: “For all the money in
transaction deposits the bank has to keep at least 10% cash
reserves.” So, of the 100 euros of John, the bank may
lend out 900 euros. (In Europe the liquidity varies per
country from 2% to 25%. [3] )
Bank lends out banknotes
Peter
wants to buy a laptop and asks for a loan of 850 euros. The
bank lends him 850 euros in banknotes. Customers who owe
money to the bank are inscribed under Debtors (they owe to
the bank = the bank has a claim on them.)
Hey,
how is that possible? At first there were only 1000 euros
and now John has 1000 euros and Peter has 850 euros! Yes, we
have been fooled. The banker simply juggles the 850 euros
from his hat. John still has 1000 euros in his account and
Peter now has 850 euros for which he has to pay interest.
Debit, credit, banco!
So that is
the secret of the banker. You lend out the money and
pretend you still have it!
Now, don’t
be angry with your banker. This way of banking has grown
historically. In fact is comes from the time of the
goldsmith. There weren’t any banknotes at that time yet, but
receipts for coins of gold that the goldsmith kept in his
vault. The goldsmith lent out money in the form of such
receipts. The secret of the goldsmith was, that he lent out
more receipts than he had gold.
The goldsmith
In the
days that people were still paying with golden coins, many
gave them in deposit at the goldsmith’ and paid him a small
compensation for it. At that time he was the only one with a
safe vault. The customers got a receipt, with which they
could collect their coins later. But the customers started
to use these receipts to pay for their purchases. This way
they did not have to go on the street with their gold. And
whoever received the note could go and collect the gold at
the goldsmith, if he wished. By storing other people’s gold,
the goldmith got rich while sleeping.
More
and more often there were also people who wanted to borrow
money from him. But in stead of taking gold coins home, they
rather left the borrowed coins in the vault and asked for a
receipt. On the loans the goldsmith collected interest. At
the beginning he only lent out his own gold. (That is to
say, he lent out notes with his own gold as collateral.) But
when more and more people wanted to borrow money, he started
to cheat. He started to lend out notes that were backed by
the gold of his depositors. And those customers already had
received a note for the same gold! This way the goldsmith
lent out more and more notes and collected more and more
interest. And as long as not too many people came in at the
same time to exchange their notes for gold, nobody would
find out.
Empty vault
This is
still the way it goes today. Everyone has amounts in his
checking accounts and as long as not too many claim their
money at the same time, nobody notices, that the vault is
nearly empty. Nearly all money is lent out. Many people
still think, that the bank is rich and lends out its own
money. Not so. The bank itself has no money for that. The
bank always lends out other people’s money.
Because of
that nearly empty vault, there is always a risk the bank has
not enough money to fulfill the necessary payments. In such
cases, like in today’s credit crisis, they say poetically: the
bank has a liquidity problem. More about that later.
Multiply money
with the trick with the hat
Our Example Bank, thanks to the deposit of 1,000
euros of John, has created an additional 850
euros to lend out to Peter. Let’s see, what
happens to these 850 euros. Peter buys a laptop
and the shopkeeper brings the 850 euros to his
bank, Bank B. The banker says “thank you” and
inscribes the 850 euros on the balance sheet as
an asset of the bank. “Banknotes in cash: + 850
euros. But the bank will also have to give the
850 euros back to the shopkeeper one day. So the
bank has also a debt to him. The banker writes
at the liabilities side: Checking account
Computerstore: +850 euros.
Bank B.
must keep a cash reserve of at least 10% for the 850 euros
that have been added in the checking accounts. That makes 85
euros. So Bank B. can lend out 765 euros. Bank B. lends out
750 euros to William, who buys a bicycle with it. The
bicycle seller brings the 750 euros to his bank, Bank C. Of
the 750 euros Bank C. can lend out 675 euros. And so the
story goes on with each time a bit smaller amounts.
This way John’s banknotes travel consecutively to the
Example Bank, to the computer store, to Bank B, to the
seller of the bicycle, to Bank C. and so on. And each time a
banker gets his fingers on these notes, he can create new
loans with them. And finally the 1000 euro’s of john can
lead to many loans, spread over many banks, that collect
lots of interest with it.
All banks together
If all
banks would lend out the maximum allowed, then our Example
bank would have lent out 900 euros, the next bank 90% of 900
= 810 euros, the next bank 90% of 810 = 729 euros etc. and
all banks together could lend out 9,000 euros with the 1,000
euros of John. Fortunately, until now, banks do not succeed
to reach that amount. That would take a lot of time and the
average loan does not exist that long. And when a loan is
paid back, it disappears from the balance. But even if they
succeed in adding only two, three or four times 1,000 euros,
they collect two, three or four times as much interest. John
himself has a checking account and does not get anything. He
even pays costs for checking books and bank cards.
(Note,
that the maximum of 9.000 goes for a 10% cash reserve. With
a 2% cash reserve the maximum is 49.000!)
Juggling with
payments
But if the
banks haven’t got the money in the checking accounts, they
cannot pay with it, can’t they? Then it isn’t money, is it?
That is right. Of the 1,000 euros of John, our Example bank
has only 150 euros left and Bank B. has 100 euros left. A
bank would never be able to pay the total of all amounts in
the checking accounts at once, if the accountholders would
order to pay it to accounts at other banks or to hand it out
in cash. If the money would really exist, the bank, of
course, would be able to. For all the amounts in the
checking accounts, the bank has only a little bit of real
money, with which it can execute the payment orders of their
customers. That is the little bit it did not lend out, the
cash reserve.
And when
the bank has used that little bit of real money to execute
payments for its account holders to account holders at other
banks, what happens then?
By that
time payments will arrive from account holders from other
banks to account holders of our bank. And our bank can use
that bit again to execute following payment orders.
So, when
John wants to pay 30 euros to someone at another bank, our
bank transfers 30 euros from its cash reserve. And then,
some other payment will arive from another bank that will
increase the cash reserve of our bank again. And this way
banks can transfer continuously relatively small amounts to
each other. And when they do so quickly enough, a big number
of payments can be executed with it.
In fact, it
looks as if bankers have an awful lot of money, but in
reality it is the little bit from their cashreserves that
goes forward and backward between them and with which the
payments can be done. But at real banks with thousands of
customers that little bit of cashreserve is still a fair
amount. With that, substantial amounts can generally be
transferred from one bank to another without problems.
Clearing money
Until now
we have done all bookings with bank notes. But when banks
have to pay each other each time in bank notes, that is not
practical. The notes would have to be transported all the
time from one bank to another in armoured lorries.
That goes in a simpler manner nowadays. Banks can exchange
their bank notes for a balance at the central bank. The
central bank has accounts of each bank with their balances.
And when one bank wants to make a payment to another bank,
the central bank transfers it from the balance of that bank
to the balance of the other bank.
Because
most payments are made through clearing today, banks hold
few banknotes and most of their cash reserve consists of a
balance at the central bank. And when our
Example Bank borrows 50 euros from another bank, these are
also added to the cash reserve. (120 + 50 = 170)
And when
you borrow money from the bank nowadays, you won’t get bank
notes to take home with you, but it is added to your
checking account. And as long as you don’t spend that money,
it does not lower the bank’s cash reserve. (That only
happens at the moment you transfer money to someone who has
an account at another bank, or if you withdraw cash money.)
Loans
When banks
lend out money, they take a risk, that the loan will not be
(entirely) paid back. That is why the banks usually ask for
a security. When you borrow money for a car, and you don’t
pay back, the bank will confiscate the car, sell it and with
the product the outstanding loan is paid back. And if that
is not suffiscient, you keep a debt towards the bank. But if
you cannot pay, the bank has to write off the outstanding
amount. And if that happens too often, not only the bank,
but also the people who deposited their money, will be in
trouble.
Now we
come to the second important rule: Banks must have a
capital which, at least, equals 8% of the outstanding loans.
[4] To put it otherwise: for each 8 euros of capital, the
bank may lend out 100 euros. But for some loans, such as
loans with mortgages, they may lend out twice as much with
the same capital and thus collect twice as much interest. So
it is not very surprising that banks like to offer these
types of loans. (Although, at the moment, by the end
of 2008, loans are a bit problematic.) For loans to the
state, the 8% rule does not apply. The state can always
raise taxes to pay back the bank.
So, for the loan to Peter,
our Example bank has to meet that solvency requirement too. For the loan of 850 euros the bank has to have
a capital of 8% of 850 = 68 euros. In our example the bank
has 110 euros, so that is suffiscient.
When Peter
pays back 100 euros each month, 100 euros are added in the
pay-desk (cash) and the amount in Debtors decreases by 100
euros.
But if
Peter doesn’t pay back the last 50 euros, then the bank must
write them off. Nothing arrives in the
pay-desk, but the amount in Debtors will still decrease by
50 euros. And that means, that the total (here 1,130 euros)
decreases by 50 euros, and consequently that means that, on
the other side, the capital decreases by 50 euros. And if
the bank would have had other outstanding loans, then it can
easily happen that the bank becomes insuffisciently solvent.
Debit, credit,
crisis
That
happened in the United States, when especially poorer people
had got mortgages at a very low interest, but could not pay
anymore when the interest rate went up again. Many bankers
had forseen these problems and had insured themselves
against defaults of payment. But what these bankers had not
count with, is that there would be so many defaulters, that
the insurers could not pay anymore and went bankrupt. And so
they still had to write off many loans at the assets-side,
which decreased their capital at the liabilities side. Their
solvency was at stake. Other bankers had sold the risky
mortgages in packets to other banks inside and outside the
US. The buyers had been fooled and now were stuck with
contaminated packets of mortgages, that nobody wanted to buy
from them anymore. And this way, world wide, many banks got
into troubles and a number of them failed. And because banks
did not know of each other who had bought these packets and
who might fail the following day, they did not want to lend
money to each other anymore. Normally they do so each day,
when at the end of the day some have an excess of cash
reserve and other are a bit short of it. And when banks do
not trust each other, each one has to take care of itself.
And that means, take care for suffiscient cash reserve, so,
lend out as little as possible. And because most enterprsies
depend on loans, the enterprises too get in trouble. In the
beginning one by one, and then in increasing numbers. Crisis.
[1]
Secrets of money, interest and inflation:
http://www.courtfool.info/en_Secrets_of_Money_Interest_and_Inflation.htm
[2]
Liquidity requirement Federal Reserve: (since 1992)
http://www.federalreserve.gov/monetarypolicy/0693lead.pdf
[3]
Liquidity in Europe
http://www.bportugal.pt/euro/emudocs/bce/eubankingsectorstability2005en.pdf
, tabel 16
[4] The 8% solvency
requirement has been decided by big international banks in
the Basel I accords of 1988. Since then it has been reshaped
a lot. Since 2006 the Basel II accords are in force, with
more requirements for the composition of the capital, but
also more choice for bankers to determine the methods of
calculating their risks.
The Basel
Capital Accords:
http://www.parl.gc.ca/information/library/PRBpubs/prb0596-e.htm
Example of
calculation of solvency percentage:
http://www.rbnz.govt.nz/finstab/banking/regulation/0091769.html#navstart
European
proposal to lower the solvency in 2004:
http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/04/178&format=HTML&aged=1&language=EN&guiLanguage=en
More
documentation:
Bank
balance:
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=bank
balance sheet
Geld,
Financiële Markten & Financiële Instellingen, C. van Ewijk &
L.J.R. Scholtens (Wolters Noordhoff) (in Dutch.)
December 2008
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