Thursday, 11 October 2018

What do banks do? An accounting perspective




This paper was given to a U3A Group. It's a look at settlement services and borrowing/lending practices. It is not intended to be a blueprint, rather an accounting explanation of what banks do and to question whether there's another way.



The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry is appropriately named. There’s been plenty of misconduct revealed. The aim of this seminar is not to trawl through all the misconduct, but to have a closer look at what banks do. Do we need them? If we were designing a new banking system would we come up with the current model?



Intro

The Reserve Bank of Australia (RBA) is Australia’s central bank. It provides banking services to the Federal government, issues notes and currency, conducts monetary policy and oversees the banking system (together with APRA)

Money creation and settlement services are outsourced to private banks. The RBA supervises the settlement system. If the government needs to, it borrows money created by private banks. It does not borrow from its own bank.

Private banks are engaged in three principal activities.

·       Settlement services

·       Borrowing

·       Lending

Settlement services

Settlement services involve receiving and making payments on behalf of customers. To understand how settlement services work it’s best to introduce a bit of accounting.

Imagine there’s only one bank, the Bank of One. This is what its balance sheet would look like.

Table 1: A one bank economy
BANK OF ONE
ASSETS
LIABILITIES
Cash
5
Deposits
135
Bonds, investments
10
Equity
15
Loans
135
150
150



Assets consist mainly of loans (to borrowers). There’s a little cash on hand and some investments which offer a little more liquidity than loans, should liquidity be needed.

The liabilities are principally deposits from customers, both retail and large wholesale lenders. The balance of the liability side is equity, essentially its share capital and retained earnings. Equity=net assets.

Now let’s imagine the bank has two depositors A and B. A has a deposit of $45 and B $90. Now A needs to pay B $2. The bank debits A’s a/c and credits B’s a/c.



Table 2: One bank/2 depositors

BANK OF ONE
Before
ASSETS
LIABILITIES
Cash
5
Deposit from A
45
Bonds, investments
10
Deposit from B
90
Loans
135
Equity
15
150
150

After A pays B $2
ASSETS
LIABILITIES
Cash
5
Deposit from A
43
Bonds, investments
10
Deposit from B
92
Loans
135
Equity
15
150
150



A’s deposit reduces by $2 and B’s increases by $2. Simple as one would expect. The bank’s overall position doesn’t change.

But suppose there are two banks. A banks with Bank One and B banks with Bank Two. How does A pay B $2 in this instance?

This is the ‘before’ situation:

Table 3: Two banks/two depositors before payment

ASSETS
LIABILITIES
BANK ONE
Cash & investments
4
Deposit from A
90
Exchange settlement a/c
6
Equity
10
Loans
90
100
100
BANK TWO
Cash & investments
2
Deposit from B
45
Exchange settlement a/c
3
Equity
5
Loans
45
50
50
Total ES a/cs
9
Total deposits
135



The asset side for each bank has been reclassified to show each with an exchange settlement a/c. This is an a/c each bank has with the Reserve Bank (RBA). The RBA is the central bank and it supervises settlement services for the financial system. Large banks have a/cs with the RBA.

In this instance total deposits across the two banks is $135 and total exchange settlement (ES) a/cs $9. Now let’s assume A pays B $2. This is what happens:

Table 4: Two banks/two depositors after payment
ASSETS
LIABILITIES
BANK ONE
Cash  & investments
4
Deposit from A
88
Exchange settlement a/c
4
Equity
10
Loans
90
98
98
BANK TWO
Cash  & investments
2
Deposit from B
47
Exchange settlement a/c
5
Equity
5
Loans
45
52
52
Total ES a/cs
9
Total deposits
135



The highlighted bits indicate where changes have occurred. Bank One debits A’s a/c for $2 (reducing it to $88) and arranges for the RBA to transfer $2 from its ES a/c (reducing it to $4) to Bank Two’s ES a/c (increasing it to $5. Bank Two then credits B’s a/c with $2 (increasing it to $47). This all happens in cyber space in an instant.

Overall total deposits and total ES a/cs don’t change. There’s just a shuffle between banks.

Reserves

Exchange settlement ES a/cs are an integral part of the current settlement system. The ES amounts are more commonly referred to as bank reserves. They ’exist’ in the financial system to enable banks to settle amounts of behalf of its customers. In pre-digital days settlement procedures were more difficult, with cheques being overwhelmingly used. But today settlements are done in cyber space. Reserves are simply numbers on a spreadsheet at the RBA. Reserves are nominally banks’ assets. They aren’t lent out. This is the biggest misunderstanding people have. They are only used when payments are made on behalf of customers. Payments to other banks and payments to the government.

How a bank deals with a reserve shortfall can be shown with a reworking of the last case study. Suppose A pays B $7 instead of $2. Bank One doesn’t have enough reserves for the transaction.

Table 5: Two banks/two depositors after payment (V2)

ASSETS
LIABILITIES
BANK ONE
Cash  & investments
4
Deposit from  A
83
Exchange settlement a/c
-1
Equity
10
Loans
90
93
93

BANK TWO
Cash  & investments
2
Deposit from B
52
Exchange settlement a/c
10
Equity
5
Loans
45
57
57
Total ES a/cs
9
Total deposits
135



The ES or reserve a/c is negative. To fix this it borrows $2 from Bank Two. It swaps $2 of investments for $2 of reserves.

Table 6: Two banks/two depositors after payment (V3)

ASSETS
LIABILITIES
BANK ONE
Cash  & investments
2
Deposit from  A
83
Exchange settlement a/c
1
Equity
10
Loans
90
93
93
BANK TWO
Cash  & investments
4
Deposit from B
52
Exchange settlement a/c
8
Equity
5
Loans
45
57
57
Total ES a/cs
9
Total deposits
135



It could have borrowed from the RBA by swapping investment(bonds) for reserves. In this instance overall reserves in the system will increase.

Reserves are needed to settle on behalf of customer at different banks not to lend to customers. The other crucial point about reserves is that when the government is included, payments to government will reduce reserves and payments from government will increase reserves. Before considering this in a little more detail let’s just have a quick look at the borrowing and lending activities of banks.

Borrowing

What distinguishes banks from other non-bank financial institutions is they are permitted to accept deposits from the public. They are authorised deposit-taking institutions (ADIs). Deposits are unsecured, guaranteed  up the $250k by the Government. From an accounting perspective deposits are liabilities.



Lending

If you were taught economics in the 1960s you probably would have learnt about fractional reserve banking or the deposit multiplier which argued that monetary authorities created central bank money (base money or reserves which were deposited into the banking system and which then were multiplied. by a factor of, say, 10, by private banks to create more money. Whenever a bank received a deposit it could then lend out 90% to a borrower retaining 10% as a prudent amount to provide liquidity should one of its depositors require repayment. This would in turn create another deposit of which 90% would be subsequently lent out to another borrower, and so on. Additional base money of $100 would lead to $1000 of deposits/money created by private banks.

This description of how money is created is known as the loanable funds model of banking. It presupposes banks are intermediaries which require deposits before loans are made.

It’s a nonsense view. It’s not what happens in practice. What happens …..as the Bank of England pointed out in 2014…… and which our RBA confirmed as recently as a month ago…..and heterodox economists have increasingly been saying for years ………is that deposits are created by loans not the other way around. This is the model sometimes called financing through money creation.

Let’s return to a case study.

Table 7: Bank lending before and after

ASSETS
LIABILITIES
Before
Cash  & investments
4
Deposits
90
Exchange settlement a/c
6
Equity
10
Loans
90
100
100

After loan/deposit of $5
Cash  & investments
4
Deposits
95
Exchange settlement a/c
6
Equity
10
Loans
95
105
105



There is no need for the bank manager to check whether he has enough deposits to lend out. If asked by a credit worthy customer, he simply creates a deposit (in this case $5) and a loan of $5. Both sides of the bank’s balance sheet increase by $5. If the deposit when spent is redeposited with the same bank, then the balance sheet doesn’t change (as we saw above in Table 1). It may have become a little more unbalanced. The extra loan may be for 20 years say, but the extra deposit is likely for a much shorter term. Certainly, if spent and subsequently deposited in another bank it will be. Let’s look at that situation.



Table 8: Bank lending before and after (V2)

ASSETS
LIABILITIES
Before
Cash  & investments
4
Deposits
90
Exchange settlement a/c
6
Equity
10
Loans
90
100
100

After loan/deposit of $5
Cash  & investments
4
Deposits
95
Exchange settlement a/c
6
Equity
10
Loans
95
105
105

After spending new deposit of $5
Cash  & investments
4
Deposits
90
Exchange settlement a/c
1
Equity
10
Loans
95
100
100



The balance sheet returns to its ‘before’ size, but the proportion of loans on the asset side has increased and the reserves (ES) reduced to $1. The balance sheet has become unbalanced. This is where extra deposits are needed to rebalance the balance sheet. Deposits aren’t needed to finance loans, but to fix the balance sheet after loans have been made. This is not a theory. It’s what happens in practice.

Extra deposits address the liability side of a balance sheet. But the asset side can also be addressed. This is usually done via securitisation.

Securitisation

 Loans are assets which can be on-sold. Pooling loans and then issuing securities representing a share of the pool is called securitisation. The securities can then be sold to third parties. Being entitled to a share of a large pool is less risky for an investor than being exposed to say one or two loans. For a bank selling securitised loans, its loan portfolio has been reduced and its cash a/c and/or reserve a/c boosted.

Table 9: Bank lending before and after securitisation

ASSETS
LIABILITIES
Before
Cash & investments
4
Deposits
90
Exchange settlement a/c
6
Equity
10
Loans
90
100
100

After loan proceeds of $5 spent
Cash & investments
4
Deposits
90
Exchange settlement a/c
1
Equity
10
Loans
95
100
100

After loan securitisation/sale of $5
Cash & investments
4
Deposits
90
Exchange settlement a/c
6
Equity
10
Loans
90
100
100



Investors like asset backed securities (ABSs) if they’re after income producing investments with reasonably predictable returns. If the assets are mortgage loans for housing they’re called residential mortgage backed securities (RMBSs). But other loans are also securitised, car loans, credit card loans for instance. ABSs usually contain tranches with varying level of risk. Lenders such as banks will make a commission when the loans are securitised and transferred off their books. The balance sheet will be in better shape for the next round of lending. It will be in better shape particularly if the bank has managed to offload dodgy loans.

 To reiterate, securitisation is a means to restructure the asset side of a bank’s balance sheet. Deposits or wholesale funding restructure the liability side. To achieve securitisation in the example below, mortgages (1000) are tipped into a pool. Shares/securities(6) are issued which gives security holder a proportionate share of all mortgages in the pool. The securities are sold to larger wholesale investors.




Government activities

In this context we are referring to the federal government.

Conventional wisdom maintains that the government needs money in its account before spending. It does this by raising taxes or by borrowing. Both have the effect of reducing bank reserves. But reserves only arise when governments spend. Spending precedes taxation or borrowing, not the other way around as is commonly believed.

Only the government can create reserves and only the government can withdraw them. When the government spends, reserves are boosted. Increased customer deposits (bank liabilities) occur simultaneously with increased reserves (bank assets).

When government borrowing occurs reserves are reduced, and the bank and/or bank customers receive a bond, an IOU from the government.

Too many reserves will lead to banks requiring a better rate of return on those reserves. Issuing bonds achieves this. Banks pay interest to depositors, so they will want a return on the increased reserves that they are holding. The RBA pays banks the official cash rate less 0.25%. The official rate is currently 1.5%.  If banks run out of reserves the RBA will lend them but charge the official rate plus 0.25 %. If banks are short of reserves, remembering they always have to maintain a positive balance in their reserve a/cs, they are more likely to borrow from another bank at the official cash rate. That is the purpose of the official rate, to set a price on default borrowings. Whilst the official rate may influence mortgage rates it is by no means the sole determinant.

Bonds pay a higher rate of interest than money in reserves. Government borrowings, if only to ensure the government’s a/c is in credit before spending, are therefore a form of corporate welfare for banks. It must be noted that governments borrow, thereby reducing reserves, for reasons of monetary policy, not just to raise money.

The government transacts most of its business at the RBA. The following is a snapshot of the RBA balance sheet.

Table 11: RBA balance sheet $ billions

ASSETS
LIABILITIES
Investments
176
Bank notes/coins on issue
76
Reserve a/cs
30
Aust government a/c
40
Other liabilities
16
Equity
14
176
176



Reserve a/cs which are assets for private banks appear as liabilities on the RBA’s balance sheet. As does the Australian government’s a/c. At last glance there was $40 billion there, roughly 2 months’ worth of outlays. When private banks require more notes and coins for their customers, the RBA swaps reserves for the notes and coin. Currently there’s about $76 billion in circulation. The RBA’s assets of $176 billion consists of bonds and other investments, gold and foreign currencies.

The government adds to its a/c via taxation or borrowing from the private sector. In both cases there is simply a decrease in banks’ reserve a/cs and an increase in the government’s deposit a/c. When it spends the process is reversed.

The government could if it wished, spend without raising taxes or borrowing from the private sector.  Using the above figures imagine if it spent $60 billion, which is $20 billion more than the balance of its deposit a/c. The RBA could lend the government $20 billion. In practice it would follow a more circuitous route by buying bonds that the government had issued. The effect is the same. Issuing bonds reduces bank reserves. The RBA then buying the newly issued bonds would restore bank reserves. The RBA’s balance sheet increases by $20 billion with just a click of a mouse. Incidentally it increased by $30 billion in 2017 and no-one noticed. This is what would happen:

Table 11: RBA balance sheet after govt overspend
ASSETS
LIABILITIES
Investments
176
Bank notes/coins on issue
76
Loan government
20
Reserve a/cs
90
Aust government a/c
0
Other liabilities
16
Equity
14
196
196



Reserve a/cs rise to $90 billion.  Reserves may get shuffled from bank to bank but only government can reduce them. As we have noted reserves attract interest at 0.25% less than the official rate, in other words only 1.25%. One reason for reducing reserve a/cs by borrowing and issuing bonds is to give the banks and their customers a higher rate of return.

Shadow banking

Shadow banks are essentially vehicles designed to avoid banking rules. They are involved,  as are banks, in borrowing and lending financial products.  If banks as most people know and experience them, is the iceberg above the surface, then shadow banks are the below surface out-of-sight part of the finance industry. What distinguishes banks from shadow banks is the structure of their balance sheets. A bank can accept deposits, essentially unsecured loans from lenders. Governments even guarantee the unsecured deposits. Shadow banks are not authorised deposit takers. The liability side of their balance sheet is usually made up of equity. When one invests one receives a unit certificate representing a share of equity, not a deposit certificate representing an unsecured loan. Banks accordingly require more regulation. The asset side of shadow banks is also different. Direct loans are rarer. Instead the assets are ABSs and other securitised products transferred from banks, often crappy loans given questionable ratings by conflicted rating agencies. Once ABSs move across into the shadow world of investment bankers all hell breaks loose. ABSs are sliced and diced into tranches with varying amounts of risks, combined with tranches from other ABSs to produce new products called collateralised debt obligations (CDOs). Other investors and hedge funds acquire CDOs.

Summary and discussion points

·       Banking as currently practiced principally involves the creation of money out of credit. Money is essentially a medium of exchange and credit is a method of deferred payment.  The two functions, however, can and should be separated.  They are conjoined twins overdue for separation.

·       The Australian government can create money without debt. We need a mixed system of money creation. Outsourcing all money creation to private banks hasn’t worked. Has the public interest been best served?

·       Money is a public good. The government can create money/deposits just as private banks currently do, simply by spending and crediting depositors’ a/cs at the RBA.

·       Government spending increases private assets. Bank reserves increase simultaneously. The question then become….. does the RBA pay interest on the extra reserves or does it create a debt for itself by draining reserves and issuing a bond? That’s why bond issues can be seen as welfare for banks. Why create a debt when it’s not necessary?

·       If you look at the Australian government’s balance sheet there was negative equity of $318 billion at 30th June 2018, due mainly to the $585 billion of bonds on issue. At that time the RBA had positive equity of $14 billion. If one were to combine the two, present a consolidated view, which is quite appropriate because the government owns the RBA, then the consolidated negative equity position would be $304 billion. If the RBA lent the government money or bought purpose  issued bonds as suggested above, its consolidated net equity positions wouldn’t change. It’s essentially lent money to itself. This is how governments can create debt free money.

·       Reducing the ability of private banks to be the sole creator of money is a serious option. Recently, in June 2018 there was a referendum in Switzerland aiming to prevent money creation by private banks. 24% voted to remove the ability of private banks to create money and to confine the practice to government. It was a surprisingly high vote in favour of curbing bank behaviour.

·       Prima facie, money creation by the government is no more inflationary than money creation by private banks. In fact, it may be less so. Inflation occurs when too much money chases too few goods or services. In today’s economy we have masses of unemployed resources and a huge demand for more services, but supposedly no money to employ the resources to help satisfy the unmet demand. Money creation by banks has mainly been channelled into buying second hand housing, not boosting the real economy. The effect has seen house prices growing faster than the real economy, necessitating increased extractions from the real economy to service the increased loans. As we have seen, loan repayments, if and when they occur, won’t provide a source of funds to be then lent out to the real economy. That notion is based on an incorrect view of how banks operate.

·       Banks have distorted the economy for their own ends. Banks create money to maximise the returns to banks, their managers and shareholders. What’s the most profitable area? To businesses which may grow the economy? Too risky? Mortgages to home owners are easier? With a taxation system that encourages investment in residential property, the demand for homes is governed by the supply of finance. Credit is essential for growing economies. But if credit grows much faster than the economy itself, an imbalance must occur. That imbalance in modern Australia is a growth in house prices faster than the economy itself.  A good thing? Not if the money needed to service the ever-increasing loans must come from the real economy. Where else? We’ve granted banks the exclusive right to create money and it’s been channelled into excessive mortgages which increasingly need funds to be extracted from the real economy to service the loans and keep profits flowing to banks and their shareholders. The biggest loser in all of this is the real economy as distinct from the financial world of paper shufflers, bankers, accountants and real estate agents. Evidence of excessive mortgages have been revealed at the banking Royal Commission. Possibly as much as $500 billion of total mortgage debt of $1.8 billion has been based on ‘liar loans’ using dodgy income figures for borrowers and a massive understatement of borrowers’ ability to service loans, based not on actual or estimated expenditure by households but rather on HEMs (Household Expenditure Measures). Westpac has just received a $35 million fine for a breach of consumer protection laws for using HEMs as a measure of borrowers’ ability to service loans. Many have labelled this banking behaviour as fraud. Regardless it massively undermines the real economy. The following shows how banks have been forced to revise estimates of household living expenses, which directly affects the loans that banks will approve. Reductions of up to 42%.



Table 10: Major banks’ reduction in borrowing limits



·       GFC in part caused by fraudulent behaviour involved with securitisation. Securitised products sold to unsuspecting buyers. The sellers knew they were dodgy and in some cases designed them to fail so they could take bets against them ….…The Big Short. The Royal Commission hasn’t looked at this problem in Australia.

·       Outsourcing settlement services to a few private banks is no longer necessary. To facilitate settlements following the digital revolution it would be a simple matter for everyone to have an account at the RBA. It’s called competitive neutrality. We buy airline tickets direct from airlines rather than travel agents, online newspapers directly from the publishers rather than newsagents, yet we are forced to deal with a few banks if we want settlement services. Why shouldn’t we be able to access settlement services directly from the wholesale operator, the RBA rather than having a private bank clipping the ticket? It would be more efficient. Additional assistance could be given by settlement providers. We don’t necessarily need private banks to provide settlement services. There are other ways.


·       Without reserves there would be a lesser need for the government to issue bonds (IOUs) which it does now in part to drain reserves. Government borrowings would be lower.

·       If a bank’s balance sheet ends up being the same, regardless if one accepts the view that loans create deposits or the alternative hypothesis that deposits are needed to lend, is it not just a nit-picking question? No, it’s not. Accounting identities often give a valuable snapshot of reality but give no clue as to the direction of causation. The direction of causation is crucial if one is trying the model the macro economy. The loanable funds hypothesis doesn’t adequately explain that if savings being an alternative to consumption are a prerequisite to lending, then why did money expand as rapidly as it did over the last 20 years, not only here in Australia but on a global basis. In any event loans creating deposits is what happens in practice. How can one model the economy if one gets the direction of causation wrong? The loanable funds theory allowed banks to be ignored in economic models because they were simple intermediaries linking borrowers with lenders. That’s one reason economists failed to predict the GFC. But slowly acceptance of how loans create deposits is filtering thru the profession. As recently as Sept 19th, Assistant Governor Kent of the RBA gave a speech on money, in part noting that loans create deposits. Deposits are money.

·       People think when a bank accepts a deposit it has more money to lend?  What else would a bank do with “my money” is a not an uncommon reaction. But it shows a misunderstanding at both the macro and micro levels. At the macro level there is no change. The aggregate level of deposits and reserves across the economy does not change as we saw when we discussed settlement involving two banks. At the micro level an additional deposit is accompanied with a similar increase in reserves. But as we have seen reserves aren’t lent. Increased reserves simply give the bank a little more liquidity. If the additional deposit is then use to reduce a loan, then both sides of the banks’ balance sheet are affected…. the deposit on the liability side and the loan on the asset side are both reduced. The bank doesn’t have a pile of money it can lend to someone else. The bank can and will create a new loan out of thin air when the next eligible customer asks.

·       A similar misconception occurs when the almost universal belief in the need for a federal government surplus as soon as possible is trotted out. A surplus doesn’t result in a pile of money accumulating somewhere which provides a buffer for the future. The government can create money out of thin air if it wishes just like a private bank. It’s actually better than a private bank because it can be debt free money.

·       As an aside a government surplus implies a private deficit. Thanks to greedy banks Australia has the second highest household debt to GDP in the world. The private sector is not ideally placed to take on more debt which inevitably must follow if the government moves to a surplus.

·       Banking requires regulation because of the way balance sheets are structured. There are financial products on both sides of the balance sheet. The asset side contains loans and the liability side contains deposits. Regulations are avoided by shifting assets and liabilities into the shadow world. Players jump the boundary and continue playing where the rules don’t apply. Regulation is hugely difficult because of this boundary problem. One person’s financial liability is someone else’s financial asset. Balance sheets become linked like a daisy chain. A fall in the value of one asset can have a domino effect thru the system as happened in 2007/08. One proposal which will prevent daisy chains is a solvency rule that would require a company’s equity to exceed its financial assets at all times. This would apply to all companies not just banks. The effect on other companies would be negligible because few have financial assets exceeding equity. Special rules would be needed for insurance companies. The boundary between banks and shadow banks would disappear.

·       Banks would have additional competitors providing credit whose source of funds would come from equity not unsecured loans. If asset values fell then losses are borne by equity holders. No need to give banks an implicit subsidy by guaranteeing deposits/liabilities. This subsidy is currently estimated to be worth $5 billion annually. Banks could still create loans provided they had enough equity. Banks could still transfer loans, via securitisation to others to allow room to create of more money/loans provided the transferee had enough equity. Credit could be provided by anyone with equity. The provision of credit would be largely separated from money creation. Banking as we know it, the creation of money out of credit would end. Governments would create money as required to pursue economic and social goals in addition to that raised by taxation and bond issues.



Further reading









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