Recent Glass Pyramids posts “MyRBA: Banking without the banks” and “Fixing Oz Banks: The critical Bank Royal Commission reform” have discussed some major reforms to Australian banking including the introduction of MyRBA deposit accounts for any Australian who wants one at the Reserve Bank of Australia.

However, a number of eager readers of the Glass Pyramid have requested a simple explanation of what banks currently do and why that is a problem anyway.

This is important because there are many myths and misconceptions about what it is that banks actually do.

The following is as an outline of the beating heart of what banks do.   Getting this clear is important for understanding the posts above and future posts on why it is problem and why we need to be talking about reforms that will address those problems.

Banks do two things – taking deposits and making loans.

Both taking deposits and making loans are critical to what makes a bank a bank.  In fact they are inextricably connected.    However, what is over looked is that bank lending is unique (and very different to non-bank lending) because banking lending involves the creation of ‘deposits’ out of thin air and that process depends on the ability to take deposits.

Taking deposits

Most people understand that banks accept deposits.  As the word suggests depositing means transferring something to a bank or “depositing” something with a bank.  A straight forward and natural application of the word deposit.

If Scott Morrison takes his coin jar containing $15 to the bank teller they will take his coins down to the vault and make the following accounting entries.

Debit      Cash (coins in vault)     $15.00

Credit     Deposit – Scott     $15.00

Debit means the cash is now an asset of the bank and the Credit means the bank has a liability to Scott to transfer $15.00 back to him when he wants it.  In a sense the bank has an account payable or obligation to Scott.

What a lot of people don’t realise is that by law ONLY a bank may hold or maintain a “deposit”.    This is why Australia banks are described as Authorised Deposit Taking Institutions or “ADIs” (when referring to banks in this post I am referring to an ADI).    If you are not a licensed as an ADI you simply cannot take a deposit.

These laws about “taking deposits” may seems a little strange as, after all, surely there cannot be any real harm in allowing anyone to accept a transfer to them and agreeing to return it on demand.

The reason why the taking of deposits is taken so seriously has to do with the other side of what a bank does and it is how this works that most people don’t understand.

Making loans

When Scott goes to a bank to obtain a loan the bank will ask him to sign a loan contract.

The loan contract simply says that Scott agrees to pay the bank an amount of money and an amount of interest over a period of time.

Bank loan contracts are basically identical to loan contracts created by non banks so the loan contract itself is not very important. What is important is how a bank accounts for the loan contract.

The bank makes the following accounting entries:

Debit   Loan to Scott      $100

Credit  Deposit – Scott    $100

The debit represents that the banks has acquired an asset.  The agreement from Scott to pay them $100.    The credit represents the banks promise to transfer $100 to Scott.

That the bank calls its promise to transfer $100 to Scott a ‘deposit’ is critical as clearly nothing has been transferred to the bank or deposited by Scott.   All Scott did was sign a loan contact.

The ‘deposit’ has simply been created out of thin air.    As nothing has been transferred to the bank by Scott the bank cannot transfer anything back to Scott.

What the bank is calling a “deposit” in the context of a loan would be called an “account payable to Scott” by a non-bank (i.e. a non-ADI).

For example, if the Glass Pyramid entered into a loan contract with Scott the accounting entries made by the Glass Pyramid would be:

Debit   Loan to Scott      $100

Credit  Account payable – Scott    $100

This is really, really important because an “account payable” clearly does not imply, like the word ‘deposit’ does, that anything has been transferred to the Glass Pyramid. Accounts payable clearly conveys that the Glass Pyramid has an obligation to pay Scott $100 that it has not yet honoured.

Blurring the distinction between a deposit that involves something being transferred to a bank and a deposit that is nothing more than an inappropriate label given to what is an “accounts payable” is central to how banks operate.

Two types of deposits

So we can see from the above examples that banks use the word ‘deposit’ to refer to two very different things.

On the saving side it represents something transferred to the bank which can be transferred back.

On the loan side it represents an obligation of the bank to transfer something that has been created entirely out of thin air.

So how can a bank honour the account payable (deposit) arising from the loan?

Now it is one thing to create an accounting entry to record a loan and decide to call the credit (account payable to Scott) a ‘deposit’ but a completely different thing to honour that account payable/ deposit.

How on earth does a bank honour a ‘deposit’ in favour of Scott that it has just created out of thin air by making an accounting entry.

This is where the authorisation to take deposits becomes critical.   It is the authorisation to take deposits that connects the two sides of a bank – taking deposits and lending.

To illustrate the process we will look at two examples:

Single Bank

In the single bank example Scott signs a loan contract with Bank A and Bank A creates accounting entries to record the loan.

Bank A

Debit   Loan to Scott      $100

Credit  Deposit (Account payable) – Scott    $100

Scott wants Malcolm to do 5 hours of work in his garden at $20 per hour and promises to pay him $100. Malcolm agrees and tells Scott he banks at Bank A too.    It is critical to appreciate that the process of loan creation by the bank is driving real economic activity – assuming you accept that doing Scott Morrison’s garden is real economic activity.

Malcolm does the gardening work and asks Scott to pay him.    Scott rings the bank and tells them that he wants to use the loan ‘deposit’ created when he signed the loan contract  to pay Malcolm.

Bank A says fine and makes the following accounting entries.

Debit     Deposit (account payable) – Scott    $100

Credit   Deposit – Malcolm $100

Because the Debit to the deposit in favour of Scott cancels out the existing credit in that account the accounts of the bank at the end of the transaction look like this:

Debit     Loan to Scott – $100

Credit   Deposit  – Malcolm   $100.

The bank has effectively honoured/discharged the account payable that arose from entering the loan contract with Scott by taking a deposit from Malcolm.  Without the legal ability to take a deposit the bank could not honour the account payable ‘deposit’ to Scott by simply making a few accounting entries.    It would have to actually honour the account payable with ‘something’ so that Scott could pay Malcolm and as we know the account payable (called a deposit) was created out of thin air so there is no ‘something’ in the vaults of the bank.

So what is in it for the bank?

Clearly the deposit (liability of the bank) now in Malcolm’s name matches the amount of the loan (asset of the bank) so if Malcolm decides to transfer $100 back to Scott (say for doing a service on Malcolm’s car), Scott could pay off his loan and the Bank could make the following entries

Debit     Deposit  – Malcolm   $100.

Credit   Loan to Scott – $100

Those entries would then cancel out the existing entries and we back to where we started before the original loan was made to Scott.  The Banks balance sheet would be blank.

The reason the bank is motivated to make the loan and operate the ‘deposit’ accounts is simple.  To charge Scott interest on the loan.

But where does the interest come from because the creating of the loan only created a deposit that equals the loan amount not the loan amount plus the interest that Scott must pay?

That is a very good question and we will discuss it later.

But now the bank has an obligation to Malcolm.   How does the banker avoid honouring that obligation (say by Malcolm demanding the Banker give him cash).

They do this by sharing some of the spoils of the loan to Scott.  Once the Bank makes the accounting entries and transferred the ‘deposit’ from Scott to Malcolm, Scott was obliged to start paying interest.   They offer some of the interest, to be paid by Scott, to Malcolm.  All that Malcolm has to do is not demand that the Bank honour the deposit now in his name.    The bank’s profit is therefore the interest charged to Scott minus the ‘slice of the action’ paid as interest to Malcolm on the condition he leaves the deposit exactly where it is – in the accounts of the bank.

The interest that Malcolm is earning on the deposit transferred from Scott to Malcolm is nothing more than Malcolm’s reward for not asking the Banker to honour an obligation that the banker cannot honour because the deposit was created ‘out of thin air’.

Two Banks

The two bank example is critical because we need to understand how a bank can honour an obligation if Malcolm does not have a deposit account at the same Bank as Scott.

In this example Scott is a customer of Bank A and Malcolm is a customer of Bank B.  Scott and Malcolm enter into a loan contract with their respective banks.

Bank A – Scott’s Bank

Debit   Loan to Scott      $100

Credit  Deposit (account payable) – Scott    $100

Bank B – Malcolm’s Bank

Debit   Loan to Malcolm      $100

Credit  Deposit (account payable) – Malcolm    $100

Now Scott asks Malcolm to doing a $100 worth of gardening work and Malcolm asks Scott do $100 worth of servicing on his car.    They both tell their banks to get ready to make the agreed payment. Again it is critical to appreciate that the process of granting loans by the two banks is driving real economic activity.

Let’s slow down the ‘in theory’ accounting steps that result step by step.

Step 1       

Each Bank debits the deposits resulting from each of the loans and makes a credit in an account payable in favour of the bank who will ‘receive’ the required transfer.   In practice these entries would not be made but they help illustrate how the “honouring” of loan ‘deposits’ takes place when two banks are involved.

Bank A      Scott’s Bank

Debit     Deposit (account Payable) Scott    $100

Credit    Account payable to Bank B   $100

Bank B      Malcolm’s Bank

Debit     Deposit (account Payable) Malcolm     $100

Credit    Account payable to Bank A  $100

Step 2

Scott wants to deposit the $100 he is being paid and Malcolm wants to deposit the $100 Scott is paying him.    The debit to “accounts receivable” represents that each Bank is now expecting to receive a transfer from the other Bank.

Bank A      Scott’s Bank

Debit      Account receivable from Bank B  $100

Credit    Deposit (account Payable) Scott     $100

Bank B      Malcolm’s Bank

Debit     Account receivable from Bank A  $100

Credit    Deposit (account Payable) Malcolm     $100

Step 3      Settlement between Bank A and Bank B

As a result of Step 1 and Step 2 both Bank A and Bank B have account receivable and account payable entries.

Bank A   

Debit      Account receivable from Bank B  $100

Credit    Account payable to Bank B   $100

Bank B

Debit      Account receivable from Bank A  $100

Credit    Account payable to Bank A   $100

Bank A rings Bank B and says “lets forget about transferring anything why not just set off your accounts payable against your accounts receivables and we will do the same”  Bank B agrees to this splendid plan.

After completing the set-off the accounts of Bank A and Bank B will appear as follows

Bank A   

Debit      Loan to Scott  $100

Credit    Deposit (resulting from transfer from Malcolm) Scott   $100

Bank B

Debit      Loan to Malcolm  $100

Credit    Deposit (resulting from transfer from Scott) Malcolm   $100

Now both banks have honoured the “deposit/account payable” arising from their loans to Scott and Malcolm.     Furthermore the deposit in favour of Scott at Bank A and Malcolm at Bank B are the result of ‘transfers’ between the Banks so in that sense something has been deposited.  However, without the legal ability to take a deposit  neither bank could honour, by making a few accounting entries, the account payable ‘deposits’ they created when they entered the loan contract.

And again we are in the position where the deposits balance the loans so if Scott and Malcolm chose to they could repay their loans and after the relevant accounting entries the bank’s accounts will be blank.

That is how a system of banks that can ‘take deposits’ can work together to both create loan ‘deposits’ and honour those obligations.

So what is in it for the bank A and B?

Again the answer is simple.

The reward for the Banks is the interest that Scott and Malcolm have agreed to pay pursuant to their loan contracts minus the interest they agree to pay Scott and Malcolm on the deposits that have been transferred to them by each other providing they don’t ask the banks to honour those deposits (i.e. by asking to withdraw the deposit in cash or transfer them to someone with an account at another bank)

Where does the interest come from when both loans only created the principal?

That is a very good question.

Where does the interest come from?

The interest that Scott and Malcolm need to find to pay to the bankers clearly is not created by the accounting entries recording the loans.

However,   if there are new loans being created on a continuing basis with the corresponding  ‘deposits – account payables’ accounting entries some of those new ‘deposits’ can be transferred into the deposit accounts of people trying to gather interest they have agreed to pay on older loans.

In other words Scott and Malcolm can do some gardening and car maintenance for other people who have entered loan contacts and ask for some of the loan ‘deposits’ of those other people to be transferred to their respective deposit accounts so they can pay the interest.

In short the new loans are creating deposits that help pay the interest on older loans.

Of course this creates a problem because those other people now don’t have part of the deposit that matches their loan principle so they have to work to obtain transfers of deposits to meet the shortfall in loan principle and the interest owing.

This is why ever expanding ‘deposit’ creation (granting of new loans by banks) is important to a deposit taking banking system.   It makes it easier to pay the interest on earlier loans and reduce the risk of default and potentially banking system collapse.  It is also the reason why ‘credit crunches’ when banks stop lending are dangerous to an economy built around our banking model.  If the amount of outstanding loans decreases so too do the corresponding deposits.  A reduction in the amount of deposits makes everything a bit harder, a bit harder to gather the deposits required to repay a loan, a bit harder to gather the deposits to pay the interest obligation.

It is the pursuit of deposits to repay deposits and to pay the interest due on past loans that is a real driver of the unsustainable growth that is at the core of financial capitalism.

Note: “Alfonso” at MB noted a good article by Steve Keen on the interest issue and the post has been updated to reflect the points made in the article.

https://www.forbes.com/sites/stevekeen/2015/03/30/the-principal-and-interest-on-debt-myth-2/#1ec998bd1c76

Steve makes a fair and important point in that article, the created deposits may flow around around the economy , between deposit accounts, many times before repayment of the principal or payment of the interest, so it is not as straightforward as simply saying the loan does not create the interest when it comes to meeting the interest obligations arising from the loan associated with deposit creation.  The pressure involved in gathering the deposits required to pay interest obligations is reduced the faster is the velocity of money in the economy.

But by the same token he is not saying that interest is completely irrelevant either (it would become an issue with sufficiently slow velocities of money) and does not create pressure to gather deposits additional to the pressure to gather the deposits required to repay the loan amount. Nor is he saying that a monetary model where most deposits, if not all, are created with an interest charge attached does not have significance compared to an alternative model where ALL deposits are created by the public sector without an interest obligation attached.

However his point is important.  It is a matter of degree and not overstating the case.

CONCLUSION

What are the key points after all those accounting entries:

• A difference between a bank and a non-bank is the authorisation to take deposits.
• Another difference is that a bank calls the accounts payable that arise when a loan is made a ‘deposit’.  Non banks do not and are probably prohibited from calling the account payable arising from a loan a ‘deposit’
• A ‘deposit’ arising from a loan contract is created out of thin air and is nothing more than an accounting entry.  Nothing has been deposited.
• The authorisation to take deposits is also an implicit authorisation to ‘make’ deposits.
• The ability to take deposits is critical to how a single bank or two or more banks are able to settle the accounts payable ‘deposit’ obligations that arise from or were created by loan contracts
• The purpose of the overall process is to create an obligation on the part of the person receiving the loan to pay interest to the bank
• The accounting entries involved in the process of lending or the taking of deposits does not create the interest that the loan contract demands.

Further important points

• Real economic activity is being driven by the loan / deposit creation process.
• The more loans a bank creates the more deposits are created. Conversely when loans are repaid with deposits the volume of deposits in the banking system contracts
• Because the process of creating a ‘deposit’ through bank lending does not create the interest demanded by the loan contact, the pressure to gather deposits to pay the interest obligation is additional to the pressure to gather the deposits to repay the loan principal.  Ongoing new bank lending reduces that pressure and helps prevent banking system collapse.
• It is the pursuit of deposits to repay the deposits created by the loan contract and to pay the interest due on past loans that is a real driver of the unsustainable growth that is at the core of financial capitalism.