Saturday, July 9, 2016

What do banks do?

We normally define a bank as an institution that takes deposits and lends them out. While this definition might seem adequate in most of the circumstances, it is not exact.

The problem is, however, not of the definition only. Most of the existing writings, from daily business news to books on the business of banking, do use this rather simplified definition, what sometimes leads to wrong conclusions.

What follows, is my attempt to sketch a precise definition for banks. The attempt itself is a result of a half a year inquiry into liquidity risk in the banking business which led me to believe that problem of definition is the reason behind many common misconceptions.

My working definitions: a bank is a money-creating institution with fixed exchange rate. While it might also be too simplistic and not exact, it aims to deconstruct common belief that bank takes money from depositors and then lends it to the borrowers.

How banks create money out of nothing?

The common definition of banking says that banks take deposits from customers and lend those funds to the borrowers in need for financing. The key problem in this process being a mismatch of terms between deposits sourced and loans granted (maturity transformation).

This definition, however, is nothing more than a simplification of the more complex process, and as always in such cases, some meaning is lost. To understand the problem one has to go back to accounting and look at the balance sheet during the lending process.

When a bank grants a loan it becomes an asset to the bank. The bank asset is matched by a deposit in the name of the borrower on the other side of the balance sheet. Signing a loan agreement (before any other transactions are done) is an exchange of "I owe you" (IOU) contracts between the customer and the bank. The exchange does not require any additional funding and creates assets and liabilities for both, the bank and the borrower. The key difference between the two IOUs is that the one issued by the bank (liability of the bank) is what we call money.

Creation of credit, therefore, is the creation of money in the form of deposits. While it does not require additional funds, as loan and deposit are created out of nothing by the act of borrowing, money creation is limited by the key characteristics of money.

On kinds of money

Before moving on to talk what are the key characteristics of money (deposits ) created by the bank, it is essential to sort out few details about what money overall is. I will skip the overall introduction and concentrate on key aspects related to the business of banking.

In the modern world, we typically view money as a currency issued by a central bank or equivalent governmental institution. While all major currencies are either in the form of "fiat" money (has no defined value in terms of any objective standard) or have their value fixed to one of the fiat currencies, we tend to consider that dollars, euros or any other currencies in our accounts are IOUs of the government institutions. That is not the case.

In advanced economies, the government issued currencies are (or at least were before the spree of QEs) only approximately 15% percent of all money supply. The only way for individuals and common businesses to get access to the government issued money is to deal in actual paper money (less than 5% of all money in most of the advanced economies. The other part of government issued money is only accessible to a few special institutions who are allowed to have accounts with the central banks - mostly banks and some other financial institutions.

So who issued the other 85% of the money? Banks. The money we keep in our bank accounts is not government issued. What we deal with on a daily basis are not Dollars of the United States or Euros of European Union, but dollars of the Citi Bank or pounds of Deutsche Bank. Referring to all money as a liability of the government is once again a simplification.

What restricts money creation in the banks?

To qualify as money, the IOUs of the banks have to have certain qualities, particularly, to be convertible into government issued currency at short/no notice, at marginal/no cost and at a fixed value (normally one for one).

Let's consider a loan granted to an individual. The bank can create the loan and a matching deposit out of nothing but the difference in their future behavior imposes limitations. The loan is likely to stick with the bank for a while, and the deposit will likely be converted to government issued currency.

Let's say the borrower pays for goods in a shop with the borrowed money and the shop has their account with the other bank. In order to process the payment, the bank of the borrower needs to pay to the bank of the shop in government money. To go back to the balance sheet of the bank, deposit disappears and the drop in liabilities is matched by the drop in government money holdings of the bank.

As banks tend to have less government money than they have deposits, to ensure convertibility of the bank money into the government money requires a bank to be able to replenish lost government money stock. The risk related to a failure of doing it over short run is typically called liquidity risk, while the risk of failure to do it over a long term is referred to as a solvency risk and depends on the quality of bank assets.

Wrap-up

Banks created approximately 85% of money supply in most of the advanced economies. This percentage is unfortunately exceeded only by a number of experts who rush with policy advice without understanding how money works.

Each individual bank creates their own money (in all currencies they allow accounts in). This creation is only restricted by a need to maintain convertibility of the bank money into government money. Fundamentally, this restriction is no different from the self-imposed restriction on the government money creation during the years of Gold Standard.

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