How loans create deposits and why we should have public banking…

I thought this post should explain in further detail, the nature of how financial institutions extend credit (by creating it) why I think it should be a public good and how it is possible to create affordable housing and ensure housing for all seeing how I called for 0 per cent home mortgages and the elimination of debt.

First we need to conceptualise two ‘spreadsheets’. One set of spreadsheets are the demand deposits you see in your bank account. The second set of spreadsheets are Authorised Deposit Taking Institutes [ADI] accounts at the central bank. In Australia these are referred to as Exchange Settlement [ES] accounts.

The important distinction to make is that we use the term money to refer to multiple money-things. When I use the term reserves I am referring to ‘money’ in ES Accounts at the central bank and when I use the term demand deposit, that is ‘money’ you see in your bank account and then we have physical notes and coins.

figure 1

In the graph above I have visualised this. Like you can open your online banking app and can view the demand deposits you have in your account, an Authorised Deposit Taking Institute [ADI] can log into the RBAs system and view the reserves they have in their system.

They are called demand deposits because if you go into the bank or use an ATM the bank provides you with the physical notes on demand. When you make an online payment for a bill or you transfer ‘money’ to a business or an individual, at the end of the day ADIs will exchange reserves with each other to settle payments.

When ADIs request physical cash from the RBA, they must have reserves in their ES accounts. If they request $20 million, their reserves are debited by that amount and the physical cash is delivered. The reverse happens when they deposit the physical cash with the RBA and their ES accounts increase.

The Bank of England in its 2014 paper ‘Money Creation in the Modern Economy’ said this:

‘Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.’

When a loan or credit is issued an ADI (the green level in the above figure) uses a computer to mark up the size of the relevant account. More money is added to the demand deposit and both a liability (for the recipient of the loan) and an asset (it is an asset for the issuer of the loan) has been created.

The next step is to ensure there are sufficient reserves in the system so when the recipient of the loan makes a payment to a currency user that banks with a different bank, the ADI can make payment. It is the job of the central bank (which in Australia is the RBA) to ensure there is sufficient liquidity in the system which is a jargon way of saying it is the RBA’s job to ensure banks have sufficient reserves to pay each other.

Financial institutions have an unlimited ability to create credit, They lend to credit worthy customers and satisfy their reserve requirements at the end of each day. Each financial institution has an account with the central bank and these must be positive at the end of each day.  The question arises ‘How are reserves added too?

Reserves are added to in several ways. One way is through Federal Government spending. This is pretty logical and straight forward.

figure 2

When the Treasury spends there is an instruction from an official in that department (after an appropriation bill has passed) and the Australian Office of Financial Management records it and an instruction is given to the RBA to mark up the relevant ES account and the recipient of the new spending. The deficit spending at the end of each day is the new spending that has entered the system. A surplus does the opposite and there are less reserves.

The Governments deficit spending adds net financial assets to the system. There is no corresponding liability to the creation of this money unlike when an ADI issues a new loan.

Because the Federal Government spends and taxes which increases and decreases reserves one of the central banks jobs is to ensure liquidity in the payments system. That is, it is, it’s job to ensure there is enough dollars in ES accounts to ensure the payment system operates and ADIs can pay each other. The RBA website says this:

The Reserve Bank needs to transact in the domestic market almost every day to keep the supply of settlement funds at the right level. This is because transactions between the Reserve Bank’s customers and financial institutions (and their customers) change the supply of ES funds. As the Australian Government is a customer of the Reserve Bank, these gross flows can be very large. Expenditure and payments by the Government adds ES funds to the account of the recipient (or their financial institution), while receipts [taxes] have the opposite effect.– https://www.rba.gov.au/mkt-operations/dom-mkt-oper.html

At the commencement of each day the RBA will estimate the required amount of reserves needed in the payments system and it will conduct securities transactions to ensure all payments clear. ‘Securities transactions’ are jargon for buying and selling treasury bonds. They then have a second round in the late afternoon.

“Securities transactions are conducted almost every day in the ‘open market’ by the Reserve Bank. Each morning, the Reserve Bank announces its dealing intentions, inviting financial institutions to propose transactions that suit the Reserve Bank’s purposes. Counterparties are able to sell highly rated debt securities to the Reserve Bank either under repurchase agreement (repo) or outright sale.

Late each afternoon, the Reserve Bank announces whether an additional round of open market operations is required. Uncertainty in the timing of payments to, and from, clients that hold accounts with the Reserve Bank (mainly the Australian Government) can give rise to unforeseen fluctuations in ES funds during the day. The additional round gives participants the opportunity to either lend excess balances back to the Reserve Bank or borrow the shortfall on a secured basis.” – https://www.rba.gov.au/mkt-operations/dom-mkt-oper.html

When the RBA purchases a bond or another form of security it adds reserves to the system. Think of it as moving dollars from a term deposit (that has money locked away) to now having money you can spend in your transaction account. Selling a bond has the opposite affect. It removes dollars from ES accounts and places them in securities accounts that earn interest. It is similar to placing money into a term deposit account.

If any bank is short of reserves for the day there is an option to secure a loan from the RBA. It is called the ‘penalty window’ because it attracts a 25 basis point premium above the target cash rate (which you can learn about later)


When central bankers say reserves aren’t deposit constrained it is because under license, financial institutions have an unlimited capacity to issue credit that they then charge you the privilege for and a nations central bank will always ensure payments will clear.

It’s here where you need to make a distinction between earned and unearned income. Classical Economist had as a guiding principle that everyone deserved the fruits of their own labour and they developed analytical tools to develop ‘overhead’ costs. There aims where to distinguish between the necessary costs of production and value from the unnecessary and parasitic costs in production. These became economic rents. An efficient economy is about eliminating these economic rents that don’t add value. They are things like monopoly pricing, land rents, interest and forms of income where the earner hasn’t laboured to produce anything. They’ve extracted the value of your labour.

Along with claiming masses of unearned income, financial institutions, by their nature to issue credit hold tremendous power over the rest of the economy.

Giving private banks the ability to create credit gives bank an incomparable power over the rest of the economy. They don’t just control how much money is created but where this money goes. It gives private for-profit banks enormous power to determine the level of composition of investment, demand and production within an economy and the power to engineer credit driven booms (such as the housing market)

Mitchell, W., Fazi, T., 2017, ‘Chapter 10: The Case of Renationalisation’ ‘Reclaiming the State, Monetary Sovereignty: A Primer, Pluto Press, Archway Road, London. pp 255 – 259

By nature of how financial institutes operate they are guaranteed by public money. The RBA states:

Bank deposits become a risk-free asset for households and business in Australia because they have an effective government ‘guarantee’ (up to a limit) and receive the first claim on banks’ assets.

https://www.rba.gov.au/speeches/2019/sp-so-2019-12-16.html

Referencing ‘Reclaiming the State’ again:

Given the crucial and systemically relevant role banks play in the economy, they should be considered public institutions. Bank deposits are guaranteed by governments and financial institutions have access to unlimited government funds as the GFC clearly demonstrated

Mitchell, W., Fazi, T., 2017, ‘Chapter 10: The Case of Renationalisation’ ‘Reclaiming the State, Monetary Sovereignty: A Primer, Pluto Press, Archway Road, London. pp 255 – 259

Conclusion
There is tremendous scope for a progressive agenda to eliminate debts, unearned incomes, nationalise the banks and have them work for a public purpose. This could look like:

1. Forgiving student debt, excessive credit card debt (wages have been low for so many workers many survive off credit)
2. Removing interest paid off all home mortgages and setting the rate at 0
3. Putting in strict rules around loan to income ratios (keeping the cost of housing affordable)
4. Having non-recourse loans in place for investment properties. So if properties are sold for less than what was paid, the bank takes the hit.
5. Instituting a policy of having The Federal Government purchase empty places as well as building what is needed to have Guaranteed Housing accessible to all.
6. Tax changes such as taxing economic rents at a higher rate than wages.

The beginning of this post looked at the intrinsic nature of how credit is created. Using that as a lens brings up a lot of different policy options that under an incorrect frame seem unachievable.

There is no real cost to cancelling debts, you change some numbers in a spreadsheet and people then owe less from their wages. There’s a moral question to ask as to whether a private institution should be allowed to issue credit and have so much control over the control of how and where we allocate real resources, why we allow them to have control over our lives and take a portion of our wage (by being able to charge interest because of a privilege our laws give them).

© Jengis 2020

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