Tuesday, March 14, 2023

Banking confidence game

Or should I say “The Banking con game”? Either way, it amounts to the same thing: The belief that money you deposit with a bank will be available to you on demand. As if money was a physical entity deposited in a box in the bank, to be reclaimed at will.

But it doesn’t work that way. The money you deposit in a bank is simply a number entered into the bank’s ledger as a liability for the bank to you. A promise to pay you upon demand.

On the other side of the ledger the bank will create loans to approved applicants and in the process create money numbers in the accounts of said applicants to the value of the approved loan. These repayable-with-interest loans are then classified as assets for the bank.

This way of operating by a bank is enacted in law in the country in which the bank is situated and there is a snag: Neither the money deposited by savers, nor the money lent out to borrowers, belong to the bank.

In order to be allowed to operate, a bank needs to have legal ownership of a sufficient amount of money, like share capital and operating earnings, to cover day to day cheque clearing operations by the central bank as cheques written on customer loan accounts are processed.

In practice, commercial banks will use short term loans from the central bank to facilitate such day to day operations when needed.

Things can go sideways very quickly if a bank is no longer able to meet its obligations to either depositors or loan customers, creating the conditions for a “banking panic”, where people line up to withdraw their monies.

The banking regulator ought to be aware of this kind of situation well before the “shit hits the fan” and take over the failing bank to prevent a market panic.

That evidently did not happen at an early stage in the case of the Silicon Valley Bank, creating jitters in the whole financial system, due to the interdependency of financial institutions.

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