Banking primer

(I did publish this two years ago but came across it again today, so copied and pasted)

The dawning of a new financial paradigm?

Those are fancy words, but it may be what we are looking at down the road. Those of us who went to school for some time, and those who went to school for less time in order to be able to get our hands on cash, sooner, rather than later, missed out on some very important knowledge about the nature of money in a modern society:

Where does that stuff come from? We all know that it is circulating around as we go about buying and selling goods and services, but how does it come into existence?

I made it a point to find out after my property development locally came to an abrupt halt in November 2007. That was just before the financial crash in 2008-9. Having successfully completed phase one of my acreage development, and looking to finance phase two, I walked into my bankers office to extend my line of credit.

Having already sold all the lots in phase 1, I was confident that there would be no problems. Oops!!

My banker had decided to terminate the line of credit and demand repayment of the outstanding balance instead. The bank knew of the coming crisis already and was taking self protective action.

And, as it turned out, that bank saved my financial skin as well, for I would have gone broke if the development had proceeded.

Anyway, this prompted me to ask “What the heck is going on here?” So I made it my business to find out. And have been doing so for the last 12 years or so. The result? The banking system is a fascinating animal, to say the least.

The system has changed and evolved over aeons of time, but has always been based on the idea that if I get something from you, I will have to give something back in return, whatever that may be. Banking evolved into a third player in this process: In return for getting something from you, I will give you a note from my bank, authorizing you to pick up whatever you want from somebody else at an equivalent value.

In order for this to work, people generally have to believe that the bank will keep its promise to those carrying its promissory notes. That’s why, in most dusty old western towns, the bank building might be the only one constructed from bricks, rather than a canvas tent. The message is pretty clear: ”Trust us”. And in big cities, they are generally some of the most fancy buildings around. Located at the heart of the business district.

But how is money created? Banks just lend it out, right? This is where things get interesting. Most people (including me 12 years ago) believe that banks lend out deposits placed in them by their customers (us). And make their profit from the difference in the amount of interest charged against loans, as compared to the interest paid to depositors. “Simple, my dear Watson”, as Sherlock Hemlock would say.

When I was 16 years old, I took to performing magic tricks as I had read somewhere that magicians were popular with girls. I didn’t have much luck in that department, but it taught me a lot about creating illusions. And that is exactly what has been done to us in regards to how banks operate. They do not lend out our deposits at all. Rather, they are authorized by law to create money on their books when they give loans to us, their customers.

And, what I discovered is that they have a very sneaky way of covering up their tricks of the trade by the way they set up their books: OK, You make a deposit in a bank and the number of dollars you put in is recorded as such in your account with the bank. Now, this is where the magic of book keeping kicks in: Using the double entry way of tracking money, the amount of your loan is entered as an Asset to the bank called a Loan, (because you have to pay it back to the bank) and also at the same time, as a Liability to the bank (because it is a deposit in your account becoming a promissory note from the bank to the person you give a cheque, or equivalent, to).

So now, if you look at a bank’s balance sheet at the end of the year, there are literally millions of dollars of loans outstanding and roughly the same amount of money recorded as customers’ deposits. But those deposits were put there by the bank into our accounts when we borrow money. Very clever. It looks as if money in is roughly equivalent to money out of the bank’s doors, reinforcing the illusion that banks are just intermediaries between depositors and borrowers.

Now you know why we believe that banks lend out their customers’ deposits. In reality the bank created that money out of nothing and recorded the amount in accounts as if people had brought that amount into the bank and deposited it in their accounts.

You gotta hand it to them, they really know how to pull the wool over our eyes and get away with it.

In summary, banks create money on their books mostly based on demands for loans and as authorized to do so by Canada’s Bank Act.

Banking is not a simple money tree for bank owners because of the financial risks involved in issuing loans to customers: In my case, walking into the bank and asking for an extended line of credit proved unsuccessful because my credit officer judged the market for properties to be about to collapse based on inside information and refused the request for more money. As it happened, that was the right call.

Most of the money in circulation is created by commercial banks in the process of issuing loans, etc. When those loans are paid back over time, that money effectively disappears just the way it appeared, as if by magic. All the while new loans are issued and the wheels keeps turning.

Sitting in the background, tracking all interbank transactions and keeping an eye on things, is the central bank, in our case, the Bank of Canada. Of which we the people are the owners. That is important. The Federal Reserve plays a similar role in the U.S.

A nationally owned central bank is very special because it can literally create money on its books on the authority of the national parliament. Or Congress in the United States. It also operates a clearing system for money transactions between banks as is needed when you write a cheque to somebody on your account with one bank and that person deposits the cheque in his/her account with another bank.

All these banks have accounts with the central bank which are credited and debited as transactions between banks take place. And if one bank’s account goes into the red during this process, it has to borrow money, quick smart, to cover the shortfall. Failing to do so will cause the bank regulator to shut down the bank.

This is where the central bank is different: It cannot go broke and can only be shut down by Parliament.

And Parliament can direct the bank, using various mechanisms, such as the issuance of bonds (I Owe Yous) for the bank to purchase, with money created out of thin air by the central bank. The government can then turn around and distribute that money where it is needed in the overall economy.

During the present COVID crisis this is now happening on a grand scale with some $250 billion having been created in Canada and in the process of being distributed at this time (May 2020).

Postscript, April 2022: Partly, as a result of massive injections of central bank created money money all across the world during the pandemic, inflation has now taken hold world wide with unpredictable consequences.