The house of money
A bank is an entity that specializes in the provision of money. The product is money (in the form of loans), and the price of this product is called interest rate. Yes, the price of money is the interest rate at which said money is lent. Consider this your first lesson in finance.
A bank is also a place where people deposit money, and where they can effect transactions with other people, e.g. by writing a check instructing their bank to move money from their account to another person’s account (which may well be held with another bank).
People can also withdraw their money in cash and use it for daily transactions, or they can deposit it at another bank, at which point it becomes virtual again, while the physical cash gets recycled. That means two things are worth noting:
- All cash is a collective liability of all the banks, since each of them is required to accept it1.
- All money in the economy (a measure called M1 by economists) is the collection of all deposits plus all the cash circulating around.
While M1 is important (and we will see how later when we discuss the concept of inflation), the breakdown between cash and deposits is not. The two numbers fluctuate a lot, particularly around certain holidays when grandparents withdraw cash to gift to their grandkids, but that has no bearing on the total money supply. So it is very wrong to think of cash as the entire money supply, all the more in developed economies cash is a mere fraction of M1, considering most transactions are entirely electronic.
Now we know that a bank is an entity that disburses loans, holds deposits, and effects transactions on behalf of its clients, but the reverse is not true: an entity that offers loans and deposits and effects transactions must not necessarily be a bank. Your auto dealer may extend you a loan to purchase a car from them; or a payment services provider can allow you to deposit cash and make electronic payments with your stored value card. What makes a bank special is the unique privilege to create money out of nothing. All others must have money in the first place before they can lend it, but not a bank. Many people wrongly believe that a bank lends you money that others have previously deposited, but that is simply not true. A bank can lend many times over what was previously deposited by simply creating the money. The mechanism is as follows: Mrs. Jones goes to her local bank branch and asks for a $10,000 renovation loan. The clerk approves the loan and presses a button in his computer, which creates two transactions in two distinct accounts:
- A new loan account is created in Mrs. Jones’s name which will serve as the servicing account for her loan. Initially the amount in the account stands at $10,000 — a number that will decrease gradually over time as she pays off the loan.
- At the same time, $10,000 is credited into her deposit account, from where she can go on to withdraw the money and pay her renovation contractors.
Where did the $10,000 come from? It came from the void. It came out of thin air. It was created in the memory of the computer when the clerk pressed 1,0,0,0,0,<enter>. This is the miracle of birth, the genesis, the Big Bang — the creation of money and the manifestation of a God-like power vested with one single type of entity: the Bank.
Such great power obviously requires certain checks and rules. For example, a bank cannot simply create money and give it to itself in the form of revenue and pass it to its shareholders as dividends. Remember that cash, and by extension all money, is a collective liability of all banks, so other banks won’t like it if one of them started minting money and gifting it to itself arbitrarily2.
But what if a bank stuck to the rules of lending but still went overboard issuing risky loans? Any losses must be borne by the bank’s own capital, which, as our reader might have guessed by now, is only a small fraction of the entire loan book (and the reason today’s banking is sometimes called fractional reserve banking). That would jeopardize not just that particular bank but also the trust in the entire banking system, possibly precipitating bank runs at other banking institutions and causing a cascade of defaults3. A regulator was needed.
The Central Bank
Over time, as banks mushroomed and went bust, leaving many people high and dry, the industry gathered and decided to impose some self-discipline on its members — for the good of the members and the industry as a whole (and we may add for their clients too). A body was formed in the face of a Central Bank (CB) that would regulate the bank’s activities and decide on common policies. The English CB is the oldest recognized institution as such, but today all CB look alike.
One requirement that the CB imposes on all banks is to place reserves with it, where what qualifies as reserves are basically loans issued to the government. Another regulatory requirement is that the risk associated with the loan book of each bank (risk being calculated by a certain formula) must not exceed its reserves held with the CB multiplied by a number called reserve ratio and decided by the CB. When banks wish to do more business and issue more loans, which they do all the time, they must either purchase and deposit more reserves with the CB or borrow (at interest) reserves already held with the CB from other banks. The supply and demand of such reserves naturally dictate the interest rates that banks charge one another and, in turn, the interest rates that banks lend at to their customers.
This is no small power! For instance, by simply reducing the reserve ratio, the CB can indirectly (but very quickly) increase the demand for reserves, thus raising interest rates, tapering the issuance of loans and reducing M1. With just one number, the CB can inflate or deflate the amount of money in the entire banking system. There are many other levers at CB’s disposal to inject (or mop) liquidity in the banking system, i.e. to increase (decrease) lending and simultaneously decrease (increase) interest rates.
At first glance, it all looks legitimate, as the purported goal of the CB is a noble one — stability of the banking system, which underpins the entire economy. For good measure, there are other “acquired” objectives that the CB pursues for the public benefit, namely pricing stability in the economy and unemployment.
Under a deeper investigation, though, things begin to appear shoddier, since what the CB essentially does — coordinating the actions of members of the same industry and effectively setting the pricing (interest rates) of their product (money) would be called a cartel in any other industry. That is why many conspirators talk about a banking cartel. Furthermore, most CB have their own balance sheets (holding government bonds and foreign exchange reserves) thus incurring profits and losses like any other private company. The US CB, called the Federal Reserve, is a private company incorporated in the state of Delaware and its shareholders are some familiar names like JP Morgan, Goldman Sachs, Bank of New York Mellon etc. The Swiss CB is even listed on the Swiss stock exchange, which is mind-bending.
But things are less sinister in reality. CBs are not really run like for-profit companies for the benefit of their shareholders. For example, the FED transfers all its profits and losses at the end of each fiscal year to the US Treasury (their ministry of finance, essentially). And furthermore, the head of the FED is appointed by the president and approved by congress, not by the shareholders, so it is fair to say that the CB serves the people rather than its shareholders, while at the same time not being beholden to the (executive branch of the) government, since the president cannot fire and hire the head of the FED at will4. The FED has its own mandate, as discussed above, and while that hasn’t really stopped it from acting politically and with favoritism5 at times, its loyalty is clearly to the public and not to the banking industry.
The larger economy
It is fair to say that money powers the economy by flowing through the financial system the way oxygen powers a body by flowing through its arteries. Corporations borrow money at interest to invest in projects and assets, earn a return on them (hopefully above the level of interest), and finally repay the loans. Without borrowing, most companies would not be able to function. It is true that less capital-intensive industries can get by without external capital (lending), like an art studio or a small IT company, but most companies require external financing. Financial markets also allow capital seekers (e.g. a mining company) to raise money from capital providers (insurance companies, pension funds, mutual funds), or from public markets via securitization (issuance of bonds), though the most important source of funding remains bank lending.
One commodities trader once shared with me: “We traders never keep any money on hand; on the contrary, we borrow as much as we can, we buy goods that we sell for a profit, and then we return our loans with the interest. Any money we can get our hands on is invested to earn a return. We never enter a bank to deposit money — we only ever step into a bank to borrow money.” That is when I realized that rich people borrow, while poor save.
Bank lending dictates supply of capital. Given the demand, which is determined by the state of the economy, the supply of money determines the price of money, i.e. the interest rates at which companies borrow, which further impact the interest that other non-banking players may expect to earn on their loans. By lowering or raising interest rates, or the cost of capital as economists prefer to say in this context, the CB could render certain projects either viable and investable or non-viable and non-investable, in turn expanding or contracting the economy. When money is tight and expensive, projects become out of reach, companies wilt and lay off people, and the economy shrinks while unemployment rises. When money is plentiful and cheap, any project becomes enticing and companies invest in anything that moves, increasing employment and expanding the economy in the short run.
One might wonder why not make capital practically free and expand credit ad infinitum. Well, because there are many downsides to doing that. First, cheap capital creates froth and zombie companies that would not be able to continue operation if it were not for the cheap capital. It detracts from good projects by making all projects — good or bad — seem equally investable. That is bad for the economy, and for a company it is like cocaine which keeps a weak body going for a while before destroying it in the long run. Sooner or later the capital dries up, investments in the bad projects are written off, losses are incurred, and companies fire people leading to economic contraction and high unemployment6.
Furthermore, cheap capital inflates the demand for assets, raising the prices of properties and causing an old/young divide, where young people cannot afford to purchase their first property at sky-high prices and delay marrying and having children. In other words, ultra-cheap capital for too long creates market distortions with high economic and socioeconomic cost to be paid down the road, and should be reserved for when the economy really needs a boost. When the economy is running fine, e.g. due to the discovery of oil or the invention of a new technology, interest rates should be left to the market forces to naturally rise and balance the demand for capital. This is why the CB has a balancing act to play between pricing stability, economic activity, and socioeconomic objectives like unemployment and demographics (yes, like it or not, the cost of money impacts how many babies are born).
Monetary policy does not, in itself, create economic activity — it only shifts capital from one place to another. An indirect and temporary effect of that may be an increase of economic activity, e.g. by creating a wealth effect where companies and individuals feel richer and invest/buy more things, thus boosting the economy. But again, such effect is indirect and temporary and should be reserved for when the economy needs a jab, not for powering the economy. The medium-term effect of monetary policy is always flat, i.e. what you gain today you will have to pay back in the future. It is only good for smoothing the economy over, not for increasing it.
Lessons
A bank is a place where the poor go to deposit their cash and where the rich go to borrow money.
Counterintuitive as that may sound, if you understand and remember this definition, you will have a much happier financial life than most people. I wish I knew this when I was twenty rather than now. When I shared this with some of my less privileged friends, they looked at me in dismay: “Are you telling me that I am now richer because I’m now drowning in debt?” Well, I didn’t elaborate back then as it might have offended them further, but this point will become self-evident when we understand how inflation works.
Accounting
Notice that the money held on deposit at a bank is actually a liability of the bank, as it owes such money (and interest on the money) to its depositors. Conversely, the loans that a bank issues are assets of the bank: assets which generate revenue for their owner (the bank) in the form of interest rates. For all other (non-bank) entities and individuals, their bank loans are liabilities and their bank deposits are assets. That means that the balance sheet of a bank looks exactly the opposite (and thus quite confusing) from the balance sheet of anyone else who is not a bank. It also means that a bank earns revenue from the difference of the interest it collects on its loans and the interest it pays on its deposits.
Footnotes
- There is a peculiar legacy on display in Hong Kong’s dollar bills, where until today different banks continue to issue different notes, e.g. a $10 could be issued by either Standard Chartered or HSBC with the respective bank’s logo on the bill; yet that is nothing but a relic,and of course all HK banks accept any notes regardless of the issuer. ↩︎
- Though giving sham loans without the hope of repayment to related entities is still technically accepted and widely practiced in murky jurisdictions. An example is KTB bank in Bulgaria that went down in flames and opened a $4b whole in the deposit insurance fund, which had to be topped up by the government. Essentially, the public was robbed at the expense of a few lucky “debtors”. ↩︎
- Case in point are the failures of First Republic Bank and Silicon Valley Bank, which went down in 2023 owing to mismanagement of their loan book, which endangered the entire banking industry and required emergency funding by the CB. ↩︎
- It must be acknowledged that president Trump is trying really hard to do precisely that as of the time of this writing. ↩︎
- Remember the bailout of Citigroup in 2008 and the refusal to bail out Lehman Brothers. ↩︎
- Europe is discovering that right now after years of low interest rates and accommodative monetary policy. ↩︎