In a previous post (Coffee and Banking Clearinghouses), we explained how a clearing house substantially improves efficiency of transactions. Suppose that there are ten banks and there are thousands of checks written on each bank. The clearance of each check requires a transfer of gold from one bank to another. If we sum all of the checks, that will give us a NET figure, which will still require 90 transactions (10 x 9): each bank must clear its accounts with every other bank. The clearinghouse adds efficiency by requiring only 10 transactions. One between the clearinghouse and each of the banks separately. Each check which transfers money from bank X to bank Y can be thought of as a payment from Bank X to the CH and a separate payment from CH to Bank Y. This way, all checks can be converted into transactions between Banks and the CH only. At the end of the day, there will be one net figure between each banks and the clearinghouse. Some banks will receive money from the CH while others have to pay money to the CH. Note that the sum of all transactions MUST be ZERO. The total money coming into the CH must equal the total money leaving. This is because each check creates ZERO liability for the CH – it received from one bank and pays to the other. So the sum of all checks must also create ZERO liability and also ZERO gain for the CH.
Once we understand the transactional efficiency of the clearinghouse, we can see the system would evolve naturally towards creating clearinghouses, just because of these benefits of simplification. Once a clearinghouse is created, there are some natural extensions in its functions, which simplify matters further. Suppose that each of the banks maintains some reserves of gold as deposits at the CH. Then the settlement at the end of the day can be done using these deposits as an in-house operation at the CH. The CH can take gold from the deposits of one bank and transfer its ownership to another bank just by changing book entries, without any movement of gold. This leads naturally to the idea of “reserve” requirements: each bank must place a certain amount of gold, in proportion to its deposits, at the CH, to enable end-of-day (or week) clearing of checks.
After understanding these mechanical details of how clearinghouses work, we are in a much better position to understand the creation of money by private banks. The gold based system is much easier to understand than the modern system based on paper and electronic entries, so we continue to explain workings of a clearinghouse in a gold-based system. First, let us consider the simplest case. This is when everyone has 100% trust in banks ability to pay checks in gold. Also, there is complete financial penetration so that everyone has a checking account. Then it is possible to conduct all business entirely via checks. Gold exists in the banks, but is only used to settle inter-bank accounts and not used by general public.
Now we can discuss the topic of money-creation by banks in this scenario. For this purpose, it is useful to make a mental shift in the way we think of checking accounts. Our standard mental framework thinks of each account as a separate box, where the bank puts our money for safekeeping. When we write a check to someone else, the bank takes money out of my box, and gives it to someone else. This is the wrong way to think. Instead, consider a checking account as a Financial Product which is sold by the bank. The account is just a ledger entry in a book the bank keeps (nowadays, It is an electronic entry). When I open an account, the bank creates an entry which is equal in value to the amount of gold I deposit – the gold does not go into my account. It is better to think of the transaction as a purchase. I pay the bank $1000 in gold, and the bank sells me a checking account with an entry of $1000. Now the bank puts my gold into a kitty which contains all the gold, undifferentiated by owner. The checking account I own allows me to write checks to others. If Mr. X writes a check to Mr. Y, this is handled by changing the ledger entries for both accounts, without any reference to gold.
At this point, if everyone deposits gold and gets a checking account, then the amount in the checking accounts would be exactly equal to the amount of gold that the banks collectively have. However, if people use only checks, then banks have a strong incentive to create money. This is done by making loans. Suppose that Mr Z goes to the bank and asks for a loan of $1000 for one year at 10% interest. The bank responds by opening an account for Mr Z which contains $1000. This account is just like any of the other accounts at the bank. However, unlike the other accounts which were created by deposits and therefore correspond to an equivalent amount of gold, this one was created without any corresponding gold. Suppose Bank A has 10 depositors, each of whom opened an account for $1000 by depositing $1000 worth of gold. Then the bank has $10,000 worth of gold as assets, and $10,000 worth of liabilities in the form of checking accounts. But after it makes a loan of $1000, it has the same $10,000 worth of gold in assets, and $11,000 in liabilities in the form of checking accounts. $1000 of new money has been created by the loan. The depositors collectively own $11,000 in the form accounts, but there is only $10,000 worth of gold with the bank. The reader may wonder what would happen in the event that all depositors come and want to cash out their accounts. This is the problem we study next. This also covers the case where some gold is withdrawn by depositors to use for transactions, as opposed to the simpler case where only checks circulate between the consumers.
Suppose Bank A has 10 depositors with account of $1000 each. This gives the bank $10,000 worth of gold. Now suppose that investor X comes to the bank and asks for a loan of $100,000 – far more than the gold in the possession of the bank. The bank will happily open a checking account in the amount of $100,000 for Mr X, even though it only has $10,000 worth of gold. How can this be? How can the bank create money, when it has NOTHING behind the account? A common misconception is that the bank loans money by TAKING money from other depositors. This point-of-view consider banks as financial intermediaries. This is NOT true. All depositors have equivalent checking accounts – they are entries in the ledger. It is not that some entries are BACKED by gold and other entries are not backed by gold. They are all just entries. So, the bank has just created $100,000 out of nothing, with no gold to back it, and without taking any money from any depositor. What happens next?
To make the problem as severe as possible, suppose that investor X comes into the bank with a check for $100,000 and demands payment in gold. The bank only has $10,000 worth of gold from its earlier depositors. What will it do? The answer is that the bank has an ASSET, which is the PROMISE of the investor to PAY $110,000 one year from now. That is the investor promises to pay back the entire amount plus 10% interest one year from now. This promise is a legal obligation plus it is usually backed by collateral worth significantly more than the amount promised of $110,000. The written form of this promise is called a secured promissory note, and is effectively guaranteed, because of the collateral. Now the bank can SELL this note to raise the amount it needs – $100,000 today, to give gold to the investor X. What happens is that this note is used as collateral by the bank to BORROW in the inter-bank market. The bank sells the note at a DISCOUNT. The note is worth $110,000 a year from now, and the bank sells it for $105,000 in gold on the inter-bank market. It can now pay $100,000 in gold to the investor, and pocket $5000 in cash today.
What really happens is more complicated. Instead of SELLING the secured promissory note, the bank offers the note as a collateral in order to borrow for just one day, the full amount of $100,000 it needs. This short term loan, or overnight loan, is obtained at the inter-bank borrowing rate, which is generally much lower than the commercial rate charged to borrowers. The bank borrows only for one day because it is very possible that much of the gold that left the bank will come back to the bank tomorrow. That is because the investor will take the gold and use it to pay others. These others will take their gold and deposit it into banks. Some part of this gold is likely to come back to the original bank. When the bank used this gold repay the overnight loan, it avoids the overnight interest rate charges on the loan. But consider the worst-case scenario, where none of this gold ever comes back. In this case, the bank will borrow the full amount, $100,000 overnight for every night over the entire year. Thus the bank loans $100,000 for one year at a high commercial interest rate. To finance this loan of money which it does not have, it borrows the full amount every night, repeatedly for the whole year. This is called a “maturity transformation”. The bank converts a one-year loan into a sequence of 365 short term overnight loans. That is, a loan of maturity one year is converted into a sequence of loans of maturity one day. The bank still makes a profit in this worst case scenario as the difference between the low inter-bank rate at which it borrows, and the high commercial interest rate at which it lends.
Finally, within this scenario, we can explain two terms of critical importance since Bagehot. When the investor asks the bank for $100,000 in gold, this creates a LIQUIDITY crisis for the bank. The bank has an asset (the secured promissory note of the investor, which promises to pay $110,000 in the future), but this asset is not liquid. The bank can convert this asset to cash by borrowing from other banks, offering this note as collateral – only if other banks are willing to lend. The bank is SOLVENT because it does have enough assets to cover its liabilities in the long run, but it is not LIQUID – it does have the cash required to cover its short term needs. Consider however a different scenario where the investor at some later stage in the game declares bankruptcy. The bank seizes the collateral assets of the investor – maybe a house originally worth $200,000 when the loan was initiated. Now suppose that a housing crisis led to the collapse of the investor leading him into bankruptcy and ALSO reducing the value of the house to only $50,000. Now the bank does not have LIQUIDITY and ALSO does not have SOLVENCY. That is, now it cannot meet its liabilities either in the short run or in the long run. The famous Bagehot rule says that we should support SOLVENT banks generously, providing them with liquidity to meet current needs. But we should not support banks which are not solvent. Instead, these banks should be allowed to go into bankruptcy, and taken over and managed by the state (or by other suitable management) for an orderly liquidation. This rule was NOT followed in the Global Financial Crisis. Not liquidating banks when they become insolvent creates the problem of excessive risk taking by banks – they know they will be bailed out if they fail.