Almost have it

I always welcome it when someone tries to learn or understand something new, especially if I’ve been a source of that inspiration. Previously I responded to another blogger when they “thought out loud” regarding how banking works, taking some inspiration from my article on fractional reserve banking. The author in question rewrote part of their original article, adding some details and correcting others. So how did he do?

Let’s just say some additional study is needed. And the place I’d ask him to start is with double-entry accounting. I think having a pretty good understanding of that will aid him quite well in better understanding how banking largely works.

For now, let’s get into his revisions, and poke at some other parts of the article I may have overlooked last time.

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.

I should really have made this clear in my previous article: there is no such thing as “normal banking” and “mortgage banking”. There is just banking and lending. In actuality, there is just accounting, and what you do with the money in question and how it is accounted on the books.

The loan is an asset to the lender. Unless the agreement prevents such, the loan can be assigned to someone else by selling off the asset. Exceptions to this include payday lending and pawnbroking, but I’m not going to delve into that here.

[Central banks] 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 central bank deals with all banks that participate in the banking system. In the United States, that means all banks participate in the Federal Reserve System. It’s pretty much a basic requirement of being a competitive financial institution. Even the United States Treasury is a member, as are the individual State Departments of Revenue.

As I pointed out in my previous article, this also includes credit unions, as well as the small banks and the largest banks like Wells Fargo and Bank of America. But smaller banks don’t “deal mostly with the big banks”. My bank doesn’t hold accounts with Wells Fargo, for example. They again deal directly with the Federal Reserve.

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.

Not quite. As I mentioned previously, if a lender sells a loan to another party, they relinquish all right to it. With secured loans, such as mortgages, they relinquish the lien as well. In other words, they completely wash their hands of the loan and all their rights to it.

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.

Because that this happens is largely behind the scenes. But banks do this all the time. They sell securities, such as certificates of deposit, to get more cash on hand to cover their banking practices. Paying an agreed-upon interest rate to their creditors. Whether that is to shore up reserves or write more loans, so long as they don’t get over-extended.

Rich people buying CDs and having their own bank accounts is why banks have money to write mortgages. The whole business regarding “collateralized debt obligations” and “mortgage backed securities” also came about because of this.

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.

Central banking isn’t about controlling “unregulated banks”, but more establishing a central means of regulating the monetary system. In the United States, banks are generally a member of the Federal Reserve System, so must agree to a certain degree of regulation as part of their membership.

Prior to central banking, and even for a time thereafter, banks issued their own bank notes. In the United States, State legislatures authorized chartered banks to issue bank notes in the State’s name. In 1863 the United States passed the National Banking Act, which authorized nationally chartered banks to issue a national currency, with oversight by the Comptroller of the Currency. This continued until the 1930s when the United States transferred issuing authority of the currency to the Federal Reserve, thereby centralizing the regulation and management of the currency of the United States. The Comptroller of the Currency still has oversight authority.

Paper money was initially backed by a bank’s reserves in gold or silver, be it bars or coins. In the United States and much of the world, this is no longer the case. Instead of being backed by physical assets, it’s backed by the full faith and credit of the controlling government.

The single most important role of a central bank is as “lender of last resort”.

Basically if there is a crisis in the banking system such that banks are no longer able to meet the demands of their customers, the banks can appeal to the central bank for liquidity. In the United States, the Federal Reserve is empowered to provide short-term loans to banks secured by allowable collateral as defined by the Federal Reserve Act. This along with the overnight lending market allows a bank to get through any higher-than-typical demand.

Additionally the Federal Reserve will periodically buy bonds from its member banks at the “prime rate”, allowing banks to obtain additional liquidity, whether for new loans, covering other expenses, or shoring up reserves.

There’s a lot involved here, but I’m not going to delve any deeper at this time.

No one likes “reserves” because they just sit there and don’t do anything.

Banks don’t like reserves sitting idle for the same reason businesses don’t like their employees sitting idle. Idle money, just like idle employees, means you’re not making money. So banks loan out the money to get it moving in the economy. The interest they charge on the loans is then used to cover expenses, and some of that interest is paid back to customers.

Early bankers realized that loaning out their deposits allowed the economy around them to prosper more than if the money sat idle. And a prosperous community, in turn, means a prosperous bank. At least that’s how it used to be.

Banks also didn’t just loan out the deposits. Sometimes they’d invest them in various securities exchanges as well, earning money for the bank and its customers.  Whatever got the money moving rather than just sitting idle. Though this largely won’t happen today unless you put the money into a “money market” account.

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.

Nice to see the author re-checked their information and corrected it accordingly. He’s right on how this works as well, but let’s show this visually, starting with an initial $100 deposit, a reserve requirement of 10%, and assume the bank loans out up to that reserve requirement.

Create a spreadsheet (Google Docs or Office Online will work) with two columns. In cell A1, put 100. In cell B1, put the formula =A1*.9. In cell A2 put the formula =B1. In cell B2, repeat the formula from cell B1. Then copy and paste the second row down to row 3 onward.

What you’ll notice is the amount that is loaned out gets steadily smaller. And if you were to continue the progression far enough, you’d find that the amount of money loaned out in total approaches $900 from the original $100 deposit. This means that original $100 deposit was able to “create” about $1,000 in deposits through fractional reserve banking.

It did not, however, create $900 in new liquidity that didn’t previously exist. What was created is an additional $900 in liabilities against the original $100 deposit. And the bank that took the original deposit has $100 in liabilities attached to $10 in reserves. This is what makes fractional reserve banking problematic, which is why it’s a delicate balancing act between the bank’s lending activities and the demands of the depositors for their money.

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?

Much of the same could be said about the move away from hard money like gold and silver toward paper money. It’s a matter of convenience more than anything else. Paper is much easier to lug around than gold and silver. And a card linked to an electronic database is much easier than cash.

This doesn’t then mean that lenders can just “pump out loans”.

The author mentioned early in the article about “balancing the books”. What balances the books is the double-entry accounting that has been the governor of accounting practices for the last couple centuries. Double-entry accounting provides for a lot of checks and balances and instance audits of the system by requiring that every debit be balanced by one or more credits meeting the sum total, and every credit be balanced by one or more debits meeting the sum total, thereby keeping everything in “balance”.

Combine that with the accounting equation, and you largely have a pretty good check on everything out of the gate. It’s why I use double-entry accounting for my personal financial management.

Electronic systems remove a lot of the guesswork in managing the books, thereby also lowering significantly the chance of error, especially the chance of costly errors. Add on internal and external audits, and the chance of error is all but eliminated.

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.

Depositors have always had the way of enforcing that idea by moving their money to another bank. The reason interest rates on saving accounts are pitiful right now is due to the extremely low interest rates on loans. When the bank is charging only 4% interest on a 30-year mortgage, they’re not going to give their depositors much in the way of interest on their savings, especially in demand deposit accounts like a saving account.

The interest the bank pays you is a cost of banking. Their revenue comes from the interest on loans and fees on services. So if they’re not making much revenue from interest, they’re not going to offer good interest rates to depositors.

If you want interest rates on saving accounts to go up, the cost of borrowing — the interest rates on loans — also need to go up, and borrowers need to be borrowing at those higher rates.

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.

Regulating inflation is one of the roles of the Federal Reserve. And it does this through the “prime rate”, which is the rate at which the Federal Reserve lends money to its member banks. Since the prime rate plays heavily into the interest rates for lending by banks to customers, a low prime rate typically means low interest rates on loans.

Lower interest rates on loans also means more liquidity flowing through the system, and a higher chance of inflation. The Federal Reserve monitors this and will raise interest rates to curb inflation if they think it’ll escape what they feel is reasonable. Currently the Federal Reserve aims for an inflation rate of around 2%.