Saturday, October 1, 2016

Money series: how commercial banks create money (part 3) - money creation and destruction

In our last post, we have examined on a very high level the four misconceptions that surrounds the process by which money is created by commercial banks.
Now it is time to dive into more details and provide an example of the way money is created when Mr. Smith goes to a bank and apply for a loan of, let's say, 20 k€.

Money creation
Let's imagine that the initial balance sheet of the bank looks like this.

Shareholder equity: 1000000

For the sake of simplicity, we are assuming that the liabilities are only made by the shareholder equity, that sum up to 1M€. This money has been invested into assets for an equivalent value of 1 M€.

Now Mr. Smith steps into the bank and ask to borrow 20K€ for whatever reasons he may have. Let's suppose he needs to buy a new car for his business. The bank checks the financial situation of Mr Smith and grants him the loan.
Here is how the new balance sheet of the bank looks like:

New loan to Mr. Smith: + 20000
New account for Mr. Smith: +20000
Previous assets: 1000000
Shareholder equity: 1000000

Total Assets: 1020000
Total Liabilities: 1020000

We can see some important things, here:

1. In the immediate term, the bank does not need to find the money from anywhere, therefore...
2  ..there is no "lending" here. There is money creation.
3. The only thing that counts is that the bank considers Mr. Smith trustworthy to pay back the debt.
4. Most important: by increasing both sides of the balance sheets simultaneously, by 20K, the bank has created new money and this money is available to Mr. Smith that can spend it in the real economy, improving the GDP (he asked the money to buy a car for his business).

Let's suppose that the loan is for a duration of 2 years and the payment the interest to be paid is 5% year. Let's suppose that the bank is paying Mr. Smith 1% of interest on the deposit.
The margin for the bank is 5-1 = 4%. This spread is the origin of the profit for the bank. So, this is why banks makes money by creating money and applying a spread between the cost of money for the borrower and the cost of money that the bank has to pay for the depositors.

Money destruction
The very first day after he got 20 K€ from the bank in his account, Mr. Smith goes to a car dealer and buy a 20K€ car. Let's suppose that he makes a bank transfer from his bank to the dealer's bank, which is different from Mr Smith's bank. An intermediate balance sheet would look like this.

Existing loan to Mr. Smith: + 20000
Existing account for Mr. Smith: +20000 – 20000 = 0
New assets: 1020000 - 20000 = 980000
Shareholder equity: 1000000

Total Assets: 1000000
Total Liabilities: 1000000

Since there is no money in Mr Smith's account, the liabilities entry for Mr. Smith goes to zero.
Nevertheless, he has still to pay his debt, so there is no change in the existing loan to Mr Smith row. The new assets lowers by 20000, because Mr. Smith took away his money from the bank, in the form of bank reserves. We will cover better this point in the next post. Since Shareholder equity is the algebraic difference Assets - Liabilities, this means that the shareholder equity goes back to 1M€.

Now, after one year, Jack can pay his debt to the bank, which is 20K, plus the interest: after one year, the bank got 5% of 20K, which makes 1K, and has reinvested this extra 1K in other assets.

Exist. loan to Mr. Smith: + 20000 - 20000 = 0
Exist. account for Mr. Smith:  0
Previous assets: 1000000
Shareholder equity: 1000000 -> 1001000
New assets: +1000 //interest paid by Mr. Smith

Total Assets: 1001000
Total Liabilities: 1001000

After one year, there are 19000 euros less. This money has been destroyed.
The extra shareholder equity, 1K€, is the profit of the bank, coming from the interest on the loan, that can be used to pay staff, taxes and the shareholders in the form of dividends.

So, let's recap: 20 K were created, 20K were destroyed, extra 1 K, the interest over the loan, became the profit for the bank, created elsewhere. During this loop of  creation and destruction, money has been used by Mr. Smith to buy a new car, the new car has been bought from a car dealer that has put the money of the sell in his bank account, in order to buy other goods and services on his turn. The process of how money flows from one bank to another is explained by the principle of endogenous money theory, that we will cover with detail in a future post, dealing also with the study of what bank reserves are and what their use is for.
NOTE: The endogenous money model is a much more accurate description of the process according to which money is increased across the banking system as a whole, than the obsolete and inaccurate fractional reserve model. Don't be scared. Money creation is a complex phenomenon and that's why bankers have so much power. People are ignorant in these topics. We only need patience and time to understand the basics.

The bank has made profits by creating money and giving it to a customer who was believed reliable to pay back his debt. The shareholders of the bank got money thanks to dividends on the interest upon the loan of Mr. Smith.
And the government got money from a percentage of the profits of the bank, that is, again, as a percentage of the interest of the loan paid by Mr. Smith, who works hard in the real economy to pay back the principal and the interest on the principal.

So, in a nut shell, the initial creation of money is, in its essence, a risk management evaluation: is the guy asking for a loan able to repay his debt (principal + interests)?
This risk assessment is done by the commercial bank

Now we can start figuring out one important point: if bankers are skeptical about "lending"money to people and enterprises, you can imagine that on a long run, as long as  interests and capitals are paid back, the overall amount of credit in the economy drops.  This leads to recession. Because of this mechanism of credit creation and destruction, if the rate of credit destruction is higher than credit creation, the bridge between the present and the future (such as credit) is wearing out and we dive into a disaster, since the economy suffocates by the lack of credit. Credit, in the present monetary system for economy, is like what water is for a fish: if there is not enough water for the fish to swim and breathe, the fish slowly dies.

This is the precise reason why Central Banks have started injecting huge amount of easy credit in the economy. Since private banks did not lend, then the Central Banks had to intervene starting from 2008 not to end up into another Great Depression like the one in the Thirties. But this important topic is out of scope of the present post. We will talk about Quantitative Easing and negative interest rate policy in the future.

We conclude this post by saying that lending for productive activities to businesses, like the one of Mr Smith, is only a small fraction of the total lending by banks: on average, they account only for 7% of total lending by banks.

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