Economics 14: money and banking

by George Hatjoullis

The relationship between central banks and deposit taking banks has been touched upon in the Economics series but needs a more detailed discussion. The central bank creates fiat money. It is fiat because it has no intrinsic value and is money because the state gives it the status of money. However, it will only function as money if everybody accepts it as a medium of exchange. In periods of hyperinflation fiat money might not be acceptable, legal tender or not. Fiat money is simply a liability of the central bank. To create fiat money the central bank need only print notes and coins. The CB can only also make available an account with itself that it credits with some amount of currency. However, it only makes such accounts available to deposit taking banks and the state.

Deposit taking banks are corporations formed with shareholder equity or capital just like any other corporation. They accept deposits of fiat money and make loans. They are (or should be) closely regulated and are restricted in the size of their balance sheet relative to the capital base. The balance sheet has liabilities on one side, mainly deposits, and assets on the other, mainly loans. They make profits by charging more for loans than they pay on deposits and pay some of the profit out to shareholders in dividends. They make losses when borrowers default on loans. This is a simplified version of the banking model but captures the essentials.

An individual bank can make more loans than it takes in deposits. In this way it creates money. Let us call this bank money to distinguish from CB money (it is all fiat money). It does this by borrowing from the CB and using the assets on its balance sheet as collateral. The CB regulates this activity but the form of the regulation varies from jurisdiction to jurisdiction. The essential point is that if the bank has sufficient capital (and a banking license) it can borrow from the CB to make loans to individuals and corporations and use the loans as collateral. The CB will apply a ‘haircut’ to the loan collateral so the bank may not be able to borrow quite as much as it lends, also limiting the absolute amount of money the bank can create. The CB will charge a rate of interest for the loan to the bank and this will set the basic interest rate for all other interest rates. This is a simplified and somewhat unusual description of how the process works and not one found in textbooks. It does however capture the essential relationship. A more detailed discussion is left until Economics 15.

The CB makes available fiat money to the banking system, at a price. The banking system creates the bank money that we use on a day-to-day basis. The only direct contact we have with CB money is through notes and coin. The banking system creates the money by making loans. It uses our deposits to make loans but also borrows from the CB using the loans as collateral. In this way it creates bank money. The CB will not necessarily accept all loans as collateral so the banking system needs to keep some assets in the form of loans acceptable as collateral (e.g. short term loans to the state). The CB influences the structure of interest rates by the charge on loans it makes to the system. It can also limit the capacity of banks to make loans by restricting the loans it makes to the system. Note the asymmetry in the power of the CB. It can restrict the capacity of the system to make loans and create money but it can only encourage the system to make loans and expand money. This is an important asymmetry.

A deposit with a bank is a loan to the bank. The bank has a liability to you equal to the amount of the deposit. If you acquired the deposit via a bank loan you also have a liability to the bank (or system as you need not keep your deposit with the loan issuing bank). You are a creditor of the bank and as such have claim on the assets of the bank in the event that the bank is resolved (or wound up). You have a form ownership of the bank. The state forces the system to guarantee a portion of all deposits (up to £85k per person per deposit taking license in the UK). The guarantee is exercised via a state body (FSCS in the UK) that funds itself via a levy on all banks. This works well if only one bank fails but if many banks fail the fund is likely to be insufficient. The insured deposit base is thus in effect an unfunded liability of the state. This may be explicit or implicit. It is always at least implicit because if insured depositors lose their funds the stability of the system would be jeopardized. Note the state is just the taxpayer so it is the taxpayer that is funding this implicit guarantee. What about deposits above £85K?

Uninsured deposits (over £85k in the UK) are not, as the name implies, so insured. If the bank fails these funds could be lost if the liquidation of assets does not raise sufficient funds. This would also involve systemic risks if enough banks were failing. The state typically steps in to cover the uninsured depositors by bailing out the banks. This is what happened in the UK in 2008. It bailed out the uninsured depositors (and senior bond holders) by bailing out RBS and Lloyds. No uninsured depositor lost money. Junior bondholders and shareholders lost money but no uninsured depositors. Many bankers lost their jobs but no uninsured depositors lost money. The great banker bailout was actually the great-uninsured depositor bail out for Lloyds and RBS (and many other institutions that failed). The taxpayer bailed herself out. However, neither the press nor politicians were going to allow the facts get in the way of an expedient story.

Uninsured depositors in the two largest Cyprus banks, Bank of Cyprus and Laiki bank, were less fortunate. The losses were so great that the state could not bail them out. The state was forced to ask for help from its eurozone partners. One striking feature was the size of the outstanding loans to these two banks from the central bank, the ECB. One wonders how this could have been allowed to arise in a well-regulated system. Yet no criticism of the ECB was ever voiced. Those offering aid to the Republic of Cyprus (the ‘troika’) decided that uninsured depositors would need to be ‘bailed-in’ as a condition for assistance. Uninsured depositors were not reimbursed by anyone and received only equity in the new resolved banks as compensation. This unprecedented action set a new precedent that is now a part of the evolving eurozone banking structure. This precedent, however, need not apply outside of the EU.

One of the big fears being voiced at the moment is of deflation. A distinctive aspect of deflation is that people want to hold money. Indeed deflation may develop and persist because the demand for money balances exceeds the ability of the system to supply the desired level of balances. The CBs have done everything that they can to encourage the banking system to create the required money balances through lending. However, the banks do not want to lend as much as is needed. They have been beaten up by politicians and the public and told to be less cavalier in their lending. They have been told to hold more capital in relation to their assets. They have fulfilled this need by reducing their asset base; they have lent less. They are more prudent and seek only loans with high reward/risk characteristics. There seem to be less available so they have lent less. The feared deflation is in part a direct result of the treatment of the banks by the state, politicians, regulators and the public in the aftermath of the 2008 crisis. Beating up the main money creating mechanism was not such a good idea unless an alternative was available.

The only other effective way for the CB to expand the stock of fiat money is to deal directly with the non-deposit taking part of the system. It has tried to do this by buying debt (mainly government issued) directly from the public. This has reduced long-term interest rates and encouraged the public to hold riskier debt and other assets. However, much of this debt is held by deposit taking banks so the CB has not been dealing with the public. Moreover, to the extent that government debt is regarded as ‘near money’ it has not really met the demand to hold money and near money assets. It has substituted one form of ‘near money’ for money. The evidence is in the growth of money aggregates or rather the lack of growth, globally. The liabilities of the CBs have grown but the liabilities of banks not so much. Hence deflation remains a concern.

The only other conceptual tool, direct monetary financing, is taboo. The central bank gives the state an unlimited, zero interest, overdraft with which to fund expenditure. The state deals directly with the non-bank sector providing this money in exchange for goods and services. The receivers’ put the money in the bank and bank money (or deposits) grow in line with this overdraft. The supply of bank money expands to meet supply. Deflation becomes less of concern and inflation re-enters the dialogue. At this point the CB needs to withdraw the overdraft but it is fear that it may not that has made such action taboo and illegal in most jurisdictions. Still, there it is.

It may take a while for the state and monetary authorities to grasp that the deflation is entrenched and only taboo action may be capable of breaking it. Unfortunately, by the time it is obvious the damage has already been done. The second aspect of this deflation has to do with technology and globalization. The global capacity to produce GDP is expanding rapidly. Potential global output is expanding rapidly. However, it is not expanding by employing people or putting purchasing power in enough pockets. Who will buy if not a CB enabled state?