Sunday, June 9, 2013

Banking for Blasphemers

      This little essay is reproduced here as a response to an on-line discussion launched elsewhere.

  Contrary to popular belief, most bank loans come neither from the banks’ own cash nor from customer deposits, but from money created at the moment of the loan. When you borrow funds from your bank, the bank deposits the money in your account and simultaneously increases its assets by the same amount. And since assets represent a claim on goods and services, the bank thereby enriches itself at everyone else’s expense. Of course, it also charges interest on the loan, which brings in  a little extra profit.  Throughout the explanation given below - which is greatly simplified for reasons of space - it is important to bear in mind that every bank loan creates as deposit.
        Here is an example. Let’s suppose an official at the central bank issues John Fastbuck with a banking licence which he uses to set up Fraudulent Bank Ltd. (We will assume, for  the sake of simplicity, that the banking system has only one bank in addition to the Central Bank (which may also be privately-owned as is the Federal Reserve in the U.S.).  John has no money, so the initial balance sheet is as follows:

        Assets                   Liabilities & Equity
           0                                    0
   
        Ms Angel inherits 1000 euros in cash which she deposits in a savings  account with Fraudulent Bank. Now the bank’s balance sheet looks like this:

        Assets                  Liabilities & Equity
        1000                           1000
   
        So as to meet reserve requirements and in preparation for making serious profits, Fraudulent Bank buys a 1000-euro bond at the central bank. It does this by registering the purchase and crediting the government account (in this example we are using a reserve requirement of ten percent - though average bank reserves world-wide are significantly lower and, in some instances and countries - including the United States - the reserve requirement has been waived or sidestepped).:


             Assets                              Liabilities & Equity
    Current    1000
    Deposits    0                                      1000
    Bonds     1000                                   1000
    Total       2000                                    2000
        Where did the extra 1,000 come from? Thin air. It was just a bookkeeping entry: effectively a promise to pay the central bank.
        Let’s return to the initial deposit.  Ms Angel chose to deposit the money with Fraudulent Bank because the interest-rate offered seemed attractive at 10 per cent.  Now Fraudulent Bank needs to generate income to cover the interest liability. The best way of doing that is to start lending - fast. Along comes Mr Honest who needs a 9000-euro loan for his daughter’s university fees. In view of Mr Honest’s good name, Fraudulent Bank readily approves the loan (though it takes collateral lien against his house as security):

            Assets                              Liabilities & Equity
Current     1000
Deposits                                               1000
Bonds       1000                                    1000
Loans       9000                                     9000
Total      11000                                   11000
   
        Clearly the depositor’s money was used to meet a reserve requirement of ten percent.  The loan to Mr Honest came from funds created by the bank. These funds are not, of course, in the form of gold nuggets. They are, once again, “promises to pay”. They allow Mr Honest to use his loan - and cause the “money” to circulate - solely because everyone accepts  cheques (or electronic transfers) of Fraudulent Bank as “good”.
        What about interest payments? At the end of the year, the bank has to pay Ms Angel 10% on her deposit of 1000 euros = 100 euros. In order to attract loan business, the bank feels it can only charge borrowers 5%. Five per cent of Mr Honest’s 9000 = 450 euros. So at the end of year one of operation, Fraudulent Bank’s balance sheet looks like this:

             Assets                              Liabilities & Equity
    Current              1000
    Deposits                                              1100
    Bonds                1000                          1000
    Loans                9000                           8550
    Ret. Earnings                                         450
    Total                11000                         11000
   
    In reality the banks charge borrowers a higher rate of interest than they concede to depositors so they make even more profit than Fraudulent Bank.
    Note that the amount of money in circulation is increased by the bank’s  payment of interest to Ms Angel. Where has this money come from? The answer is that it comes from the ether just like Mr Honest’s loan.  On the other hand, the amount of money in circulation is reduced by Mr Honest’s payment of interest to the bank.  Where does that money come from? It doesn’t. The bank only created money for the loan, not for the interest. So in order to ensure that money is available for paying interest, the banks have to issue - and therefore lend - still more money. And since these new loans also attract interest, it follows that outstanding debts can never be repaid because there will never be enough money in circulation.  Moreover, because countries as well as individuals borrow money (money that didn’t exist before the loan was made), it follows that every citizen - that includes you and me - is in hock to the banks. In fact, our collective debt to them exceeds the  value of all humanity’s assets.
    By the way, provided Mr Honest continues paying interest, Fraudulent Bank doesn’t want his loan repaid because that would have the effect of reducing its equity.
         What if Mr Honest goes bankrupt and misses his interest payments? The bank has an answer for that too: it’ll take his house instead. Those 9,000 euros are not just a bookkeeping entry, they’re real.
        Now you know why banks have been so keen to lend money. Fractional reserve banking gives them a licence to print it - and to commit fraud also since they are lending funds which - a second before the loan -  they didn’t possess. If we could all do that we’d have as much money as we wanted - though admittedly it wouldn’t be worth very much.
    There is, of course, a very large fly in this  comfy banking emollient - of which the current crisis offers an excellent example. When banks make too many sub-prime loans (loans to people who are at high risk of default - and then do default) the collateral - usually real property - tends to lose its market value. When supply exceeds demand (in this case for repossessed houses in the US) prices plummet - which meant that the banks left holding the collateral turned out to be worth much less than their balance sheets indicated. They were also not bringing in the expected cash flows. The rest, as they say, is history.
        If you’ve followed this account, you might be wondering why any reserve is required at all, why banks can’t simply create as much money as they can find people to lend it to. The same thought has occurred  both to them and to many legislators. Before the 2008 crisis politicians - with Tories at the forefront - were banging on about the negative effective of “over-regulation” of the banking industry, while banks were sidestepping reserve requirements anyway through the use of Collateral Debt Obligations and Credit Default Swaps. In many of the countries that matter, the banks had - and for that matter still have - a completely free hand to ruin us.
    Moral? Next time you take a bank loan, don’t worry about paying interest and don’t even think of paying it off. The money wasn’t the bank’s anyway and if the loan officer tries to claim the opposite, ask her to prove it.

Note: This little piece was initially inspired by Canadian Economist John Kutyn; but there are many other sources. See, for example, Michael Rowbotham: ‘The Grip of Death’ and ‘Goodbye America’, Oxford 1998 and 2000;  Huber & Robertson: ‘Creating New Money’, London 2002;  Sir Harry Page:’ The Lending of Money at Interest, London 1985.