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The Banking System

The Banking System

As you remember, any banks had the right to issue bank notes during the times of the gold standard. Like bank accounts, such bank notes signified a client’s right to withdraw the gold from storage and thus simplified monetary circulation. A buyer could give the bank note to the seller or write him a check, thus transferring ownership of the gold in the vault.

Since some amount of gold always remained in the vaults unclaimed, bankers had the opportunity to invest it. By doing so, they were able to generate additional income for bank—providing that all of their clients would not claim their gold from the bank at once. As a result of this manipulation, the amount of money in the economy grew since the already-circulating bank notes, acknowledged ownership of the gold in the vaults, were complemented by a portion of the actual gold from the vaults.

This system was referred to as a fractional-reserve banking system. After the developments in the banking world in which central banks emerged and the gold standard ended, the fractional-reserve system evolved further, strengthening its money-increasing capability. The modern commercial bank system has a unique ability to create money not by earning profits, but by creating it—literally out of thin air.

Here is how it works:

Money deposited by bank clients is recorded in the bank’s books as liabilities, following the same method as the Central Bank. With regular commercial banks, it is not, as a rule, gold or foreign currency that is deposited in their vaults, but rather money created by the Central Bank. These deposits are recorded in the bank books in the same way as created money is recorded by the Central Bank.

Cash in vault Customer accounts

100 units

100 units

 

From the viewpoint of commercial banks’ clients, their banks’ liabilities are regular money. This is another form of cash and not something conceptually new. Balances on client accounts can be used to make wire transfers or withdraw if an account owner wants to get his or her cash back. Therefore, unlike the Central Bank that actually owes nothing under its “liabilities”—after the gold standard was canceled— commercial banks have to give back to their clients the “real” money they have received: the money from the Central Bank.

In order to warrant fulfillment of their obligations in this situation, banks have to keep the received money in their vaults and serve clients, charging them for their cash-management services. In this case, client accounts would be fully covered by the CB money that would simply be stored at commercial banks for improved safety and convenience of management.

However, because modern banking is a fractional-reserve system, commercial banks have the right to use the attracted money for investment—and they actively use the right.

This is what a bank book looks like in the fractional-reserve system:

Bank A grants loans by giving away cash received from its clients to third parties, that is, borrowers who can be individuals, companies, the Treasury, etc.

Bank A

Cash in vault Customer accounts

80 units

100 units

Loans

20 units

 

The borrowers can spend this cash on goods or services, and sellers of the goods or services can then deposit the received cash with another bank that will make the following record in its book:

Bank B

Cash in vault Customer accounts

20 units

20 units

 

Because people and companies believe that the funds in their bank accounts are money, without even asking whether the money is fully covered by the CB’s money, the two above-mentioned transactions result in the emergence of new money in the economy. The amount of funds in the bank accounts totals 120 units, while the amount of “real” money issued by the CB is only 100 units. Therefore, the banking system has created 20 money units. This process can go on; for example, Bank B may, in turn, invest part of the money, and its borrowers may deposit it in their accounts with Bank B, and so on. Please note that the money created by the banking system is not equal to the total amount of balances in its accounts (120). It is only equal to the difference between this amount on the accounts (120) and the amount of CB money that the banks have (100). Money created by the fractional-reserve banking system is the difference between the balances in the accounts within such a banking system and the amount of real government money that is part of the banking system’s assets.

This example can be made even more dramatic since the existing rules allow for making money out of thin air not only to the banking system as a whole, but also to individual banks:

Bank A

Cash in vault Customer accounts

100 units

100 units

Loans Customer account

20 units

20 units

 

In this case, the bank simply records on the left-hand side the loan granted to a borrower and on the right-hand side, the money credited to a client’s account (i.e., to the account of the person to whom the loan is being granted). By doing so, a regular commercial bank creates money out of thin air.

As you might have noticed, the commercial banks’ method of creating money through the fractional-reserve mechanism is similar to the Central Bank’s method of creating money through loans granted to banks. The only difference is that by doing so, the CB issues its own money and consequently cannot turn out to be insolvent as a matter of principle. Should the borrowing bank decide to withdraw the money from its account, the CB will simply print banknotes, decreasing in its books the balance on this bank’s account and increasing the amount of issued cash. If a borrower does not repay the loan, the CB will have to write off this loan, but in any case, it cannot become insolvent since the cash created by it, is in fact irredeemable.

Similar to the CB, banks have an opportunity to create money using the credit emission method. However, ability of banks to create money is limited because they don’t have the right to issue cash in the form of banknotes i.e. the ultimate money. At their clients’ demand, banks have to give them cash that is issued by another entity – the Central Bank.

Two questions naturally arise:

  1. What happens if any investment made by a bank is depreciated, partially or fully, and the bank does not get its invested money back?
  2. What happens if the amount of money that the clients want to withdraw exceeds the cash amount currently available at the bank?

The first problem is an issue of bad debts and adequate banking capital. The second one is a liquidity issue.

These two issues of the banking system are at the core of the bank crisis. Being part of the system, they always accompany the banking business. A crisis is only the time when these problems aggravate, becoming too obvious not to be noticed.

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