In the previous post “Fixing Oz Banks: Why is “taking deposits” so important to bank “lending”?” we considered the features of banks that make them “special” and different to non-banks.
Those features include:
- A key difference between a bank and a non-bank is the authorisation to “take” deposits.
- Another difference is that a bank calls the obligation or “accounts payable” that arises when a loan contract is executed a ‘deposit’. Non banks do not and are 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 at all has been deposited but the inference that something has, by calling it a deposit, is very important to concealing the ‘out of nothing’ character of the accounting record made by a bank.
- Accordingly, the authorisation for a bank to take deposits is also an implicit authorisation to ‘make’ deposits. We can see that in the accounting entries made when recording the execution of a bank loan contract. The loan entries (Dr Loan Cr Deposit) creates the deposit but also implies that a deposit was taken.
- 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 loan contracts with nothing more than accounting entries.
- The overall process of bank lending is designed to create an obligation on the part of the person obtaining a loan to pay interest to the bank. An obligation created out of nothing.
- The accounting entries involved in the process of lending (creating deposits) or the taking of deposits do not create the interest that the loan contract demands be paid.
- Although the interest obligation is created out of nothing it drives very real economic activity as the ‘created’ deposits are transferred between people seeking deposits that will allow them to pay back loans and interest obligations.
- The authority to create deposits out of thin air and to decide the purposes for which a loan is created is a serious and powerful economic power that if abused or not used productively misallocates scarce resources and costs every member of the community.
- Bank extraction of interest from the process of creating loans/deposits is not a victim less crime. It is a dissipation of productive economic activity.
However, at this point we must give credit where credit is due (pun intended) and acknowledge the brilliant and subtle nature of what is not much more than a confidence trick.
But yet we are left asking the question,
“So how do the banks get away with it?”
Leaning on the public
Although the private banking system is a very clever confidence trick constructed around accounting entries recording obligations, that are more often than not only honoured with accounting entries recording the movement of the obligations between account holders of the same bank, it still relies heavily on the support of the public to make it work.
Creating mountains of obligations out of thin air in the form of the ‘deposits that correspond to loans is a risky business as the risk of being required to honour the obligations grows as the volume of deposit obligations gets larger and larger.
As we know from history it only takes a few twitches in the herd and the demand for “deposit” obligations to be honoured can become a stampede. As most of the ‘deposits’ were created from thin air the herd is always bound to be disappointed.
In the absence of panics, bankers try hard to encourage people to not demand that the bankers honour their obligations. They do this by sharing some of the spoils of the confidence trick. They offer some of the proceeds of the loan, part of the interest paid by the borrow, on the condition that people do not demand the banker’s obligations be honoured. The banker’s profit is therefore the difference between the interest charged to the borrower and the ‘slice of the action’ paid as interest on the ‘deposit’. Naturally the banker public relations / propaganda teams work hard to conceal what is going on and insist that the interest is being paid on a ‘deposit’ saved by the thrifty rather than an unwitting party to the banker’s double entry / confidence trick.
But sometimes the offer of a “slice of the action” is not enough and the Banker must honour some of the obligations created out of thin air. The assistance and support of the public provides the system of private bank accounting with the one thing it prizes more than anything. Ready access to a convenient means of honouring obligations in the unfortunate event that the need arises. That convenient means are the various forms of deposits or liabilities of the sovereign, public or central bank.
When the public want a “banking” system deposit fully honoured they want it fully honoured in exactly the thing that the banks claim their deposits represent.
A 100% safe and risk free liability of the state.
It is worth keeping in mind that before the rise of central banks and the availability of “public deposits” to oil the wheels of private banking, banks accepted deposits of valuable items such as gold and silver. Once sufficient deposits of gold and silver had been taken, to cover the unfortunate demands of difficult customers for deposits to be actually honoured, the real business of the bank could get under way and that was the entering of loan contracts and the creation of “accounts payable” or deposits out of thin air.
Most of the time the obligations of the created deposit would not need gold or silver to be produced, and could be honoured by a few accounting entries transferring the created obligation between customers, with the banker free to collect the interest that accrued pursuant to the original loan contract.
To see this in action read the discussion of banking transactions within a single bank and between two banks.
The only real change with the rise of Central Banking is that Central Bank or Public Deposits have replaced the role of gold and silver as providing the means by which deposits created out of thin air might be ‘honoured’ if the need to do so arises.
One important thing to keep in mind is that the profits of banking are derived from the interest payments that arise from the deposits created “out of thin air” and thus leaning on the public is not about profiting from the relationship with the Central Bank directly. Rather the “leaning” we are talking about is concerned with public support for the private banking model or more accurately the private bank “confidence trick”.
It is the “Too Big Too Fail” and “lender of last resort” support of the public for private banking that now makes private banking such a richly profitable and largely risk free business model.
So how does the private banking system lean on the public to keep its confidence trick from imploding?
The answer is quite straightforward and involves allowing private banks to “take”
- deposits created by the Central bank and mix them in their accounts with the ‘deposits’ the private banks create from thin air when entering loan contracts or
- to acquire large quantities of Central Bank deposits by selling ‘assets’ specific bits of paper to the Central Bank.
This process means that if a customer of a bank obtaining a loan demands that the bank honours the “deposit” corresponding to the loan with cash, which is a liability and thus deposit of the central bank, the bank can do so provided it has ‘taken’ sufficient of those ‘public’ deposits from other customers and stored them in the vault.
Thus keeping the private bank “deposit creation from thin air” business model operating only requires that sufficient Central Bank public deposits find their way into the accounts of private banks to allow them to meet the occasional demand that some deposits be honoured with a liability of the state. In the absence of a panic that is not a difficult exercise.
But encouraging cash to find its way from mattresses, wallets and drug dealers into the vaults of the private banks is a messy and inefficient business and handling all that ‘cash’ is expensive.
What the bold “bankers of the future” (Ken Rogoff take a bow) would much prefer is that cash (notes and coins) are abolished completely as that would make it impossible for a customer to be so rude as to demand that a banker honour a deposit “created from thin air” with a physical liability / deposit of the state.
But the future is not yet here so how does the public support the confidence trick business model of the bankers on an industrial scale?
The first is to provide the bankers with a very efficient method of accessing Central Bank deposits that they can use to “honour” deposit obligations when transfers between banks take place.
The two bank example in the previous post used a very stylised example to show how two banks with two customers could “honour” their obligations arising from loans to those two customers with nothing more than an agreement to set off their respective accounts payable and accounts receivable entries.
The problem with that example is that life is never so neat and some way of honouring obligations between multiple banks for many transactions is required.
The RBA kindly explains how this took place before Central Banks were invented (for the most part to provide public support and convenience to the bankers business model).
“..Banknotes are one possible settlement medium. This was once common and high-value notes were issued specifically for the purpose. Banks owing funds to the system would pay their total obligations in and those due funds would take out the same total amount. One can envisage bankers sitting around a table with some (A, C & D in the example shown) putting their notes on the table and others (B in the example) picking them up. Before central banks were established, banknotes were used for settlement because the issuing banks had sufficient standing to make their liabilities a settlement medium of “acceptably low” risk…”
The RBA goes on to explain how a Central Bank like the RBA made this honouring of inter-bank obligations risk free
“…Once central banks were established, their liabilities – in the form of currency notes – generally became a more attractive settlement medium, especially when large values were involved. These liabilities are free of the default risk inherent in banknotes issued by private banks. By settling their clearing obligations using central bank-issued money, banks replaced claims on other commercial banks with risk-free claims on the central bank.
In this process, importantly, the central bank is not a counterparty in clearing and settlement. It has not accumulated claims on or liabilities to the banks involved. The banks have merely used central bank-issued money to settle the obligations between themselves…”
Just as Central Bank money / liabilities / deposits in the form of notes and coins provide banks with the ability to acquire a stock of the stuff that unruly customers, demanding a banker honour their credit “out of thin air” obligations, are likely to require, the banks were now also given access to Central Bank deposits in the form of their own “Exchange Settlement” deposit account at the Central Bank.
Exchange Settlement Accounts (ESA)
The Central Bank (RBA) maintains on its balance sheet a group of deposit accounts called exchange settlement accounts (ESA) and each of the authorised deposit taking institutions (ADIs) has one. These accounts are liabilities of the Central Bank and they are deposit accounts. Currently the banks have about $28 billion dollars worth of Central Bank money in those deposit accounts. They buy those deposits by selling certain ‘assets’ to the Central Bank. More about those ‘assets’ the banks sell to the Central Bank later.
In other words the exchange settlement accounts contain public deposits created by the Central Bank. And yes those deposits are created by the Central Bank “out of thin air”
Access to these accounts means that banks can “honour” if required to do so their obligations using 100% rock sold risk free public money. The process is very simple the banks involved in the transfer signal the RBA to adjust the balance of their respective ES accounts.
How very nice for them.
You may wonder why only banks and not the general public are able to maintain a deposit account at the RBA. After all if they are by definition 100% safe and risk free and private bank accounts are NOT, why is the general public not allowed to maintain a deposit account at the Central Bank.
Why is the general public forced to deposit their 100% safe public money notes and cash in private bank deposit accounts where they are forced to slum it with bank “created from thin air” deposits. Remember the law prohibits anyone other than banks “taking deposits” so you don’t get a say in the matter.
It is very good question and one to which there is no good answer. Another example of the bankers receiving privileges that the general public are denied. In truth the reason is because Central Bank were not created to serve the public but instead were created so that the full faith and credit of the public could serve the business model and interests of the banks.
Fortunately fixing Central Banks so they serve the public is not difficult but more on that later. Suffice to say at this point that respect an urgent and long over due reform that is required is to allow the general public the right to open a deposit account at the Central Bank. Fixing Oz Banks: The critical Bank Royal Commission reform
To make matters worse the Central Bank will from time to time borrow, lend, buy and sell (or various complicated variations on the theme) bits of paper ‘assets’ to and from the private banks in exchange for adding or removing deposits from a banks ES account. The reason for doing this is so that the Central Bank can manage the interest rate that banks charge each other for making ‘loans’ between each other of their Central Bank deposits.
Naturally banks don’t do anything for nothing, so every transaction undertaken by the Central Bank to induce a private bank to enter one of these ES account balance altering transactions involves a little clip of the ticket on the way through.
Certainly those little clips of the ticket are not much to a banker and we are not suggesting they are. The point of the exercise is not make a buck or two from ES account transactions but to support the real game which is cranking out as many interest accruing loans as possible and creating “deposits” out of thin air that “Praise Be” only need to be honoured by internal bank accounting entries.
Attempting to drive real productive economic activity using the ancient ‘confidence’ trick business model of private banks is nothing more than mutating a barbaric relic of history into a bizarre Public Private Partnership whereby the public Central Bank allows private banks to ‘lean’ on the full faith and credit of the public in support of its private and disreputable business model.
Even worse as the constant booms and busts demonstrate and the ongoing failed attempts to regulate private banking demonstrate – it simply does not work and carries a heavy price tag in terms of:
- unproductive allocations of resource
- corruption of public policy and the political process with massive donations and ‘rotating door’ appointment with politicians and public servants
- a massive black hole sucking in society’s best and brightest intellectual talen
- corrupt and criminal behaviour
So if it wasn’t bad enough that:
- the private bank business model is about entering interest accruing loan contracts and creating deposits “out of thin” air, by labeling an obligation or accounts payable a ‘deposit’ thus falsely implying that something had been deposited when it had not.
- that private banks always prefer to “honour” the obligations they create by transferring them to another customer who hopefully will not be in a hurry to demand an actual honouring of the obligation (by transferring it to someone who does not have an account at the bank or by demanding payment in cash)
- that only private banks have access to 100% safe and risk free Central Bank deposit accounts
- that private banks have a monopoly on taking deposits of Central Bank money in the form of notes and coins and thus the general public are forced to use risky banking services (having the government extend a guarantee for $250,000 to private bank deposits is no substitute for the 100% risk free deposit accounts on offer at the RBA)
We find that the Central Bank, owned by the public, spends most of its time and effort doing little more than making sure that the private bank ‘confidence trick’ business model of creating deposits out of thin air is given full the “bells and whistles” support of the full faith and credit of the public.
A shameful scam of the highest order.
Especially when there is a very simple and superior alternative that can be introduced without difficulty or risk (except perhaps to the current “deposits out of thin air” business model of private banks)
I think you should next discuss what, exactly the assets are on the central bank (RBA) balance sheet. ie. they are either physical gold, or, other central bank (foreign) liabilities, other forms of debt/paper.
Also, I would like to see an explanation of how and where the loan contracts are moved to (off the commercial banks balance sheet) and how this explanation can be reconciled with the often used phrases “overseas” or “wholesale” funding….
But I otherwise agree with everything you have written. There are two independent money circuits…as per Joseph Huber @ sovereignmoney.eu
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That is a good idea and I will address those issues in the following posts. Thanks for the note about Joseph Huber. There are lots of people working hard to explain how and why the current model of banking in most western countries does not work. The more the merrier as reform requires a lot of people understanding the need for reform.
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