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No Mystery About Banking

Banks have been in the news, with the failure of the Intra Bank in Lebanon, the largest in the Middle East and a bank in Detroit, the Public Bank of Detroit.

Both banks claimed to have assets more than sufficient to pay depositors eventually, but neither had the cash available when the depositors took fright and wanted their money back. The Intra Bank is reported to have invested much of the £86 million deposits (some of it from oil-rich Arab clients) in such varied properties as a West End Hotel in London, docks in France and properties in Paris and America. As the Sunday Telegraph (23 October) remarked:– "This is dangerous banking practice – office blocks cannot be sold overnight to repay depositors".

The Detroit Bank, which had deposits of $117 million at the end of 1965, had got heavily involved in financing "home improvement" work.

It was the biggest American bank failure in thirty years.

It was the familiar story, recalled by the failure of a small British bank a few years ago, when the manager complained sadly that "depositors were taking the money out faster than they were putting it in".

The outcome has been that the Detroit bank has been taken over by another American bank, and the Intra Bank, with Government and other aid, has re-opened. Among those who propped it up were the Maronite Patriarch of Antioch, with that the Times described as "the not inconsiderable resources of his Church".

But what is of more lasting interest is the light such bank failures throw on the absurdities of the banking theories held by what the late Professor Cannan called the "Mystical School of Banking Theorists".

Before their ideas gained their present widespread acceptance economists and bankers, though they disagreed about other things, had no doubts about the basic principle that what a bank lends or invests is placed at its disposal by depositors.

Marx for example wrote: –

“A bank represents on one hand the centralisation of money-capital, of the lenders, and on the other the centralisation of the borrowers. Its profit is generally made by borrowing at a lower rate of interest than it loans” (Capital Vol. 111. P. 473).

And a banker, Mr. Walter Leaf, Chairman of the Westminster Bank, wrote: –

“The banks can lend no more than they can borrow – in fact not nearly so much. If anyone in the deposit banking system can be called a "creator of credit" it is the depositor; for the banks are strictly limited in their lending operations by the amount which the depositor thinks fit to leave with them.” (Banking. Home University Library 1926.)

But the mystical school (which included Keynes) would have none of this. They saw by experience that a prudently conducted bank, having the confidence of depositors, could rely on them to leave the bulk of their deposits in the bank, so that the latter could safely invest about twelve to fifteen per cent, keep about 20 per cent in a form of lending which they could call on immediately, keep about 10 per cent in cash in their tills or at the Bank of England, and use about one half to make advances to customers. From this they make the topsy-turvy deduction that out of the 10 per cent cash (it is now down to 8 per cent) the bank had "created" the rest.

The Committee on Finance and Industry (The Macmillan Committee) in its report in 1931 claimed that "the bulk of the deposits arise out of the action of the banks themselves, for by granting loans, allowing money to be drawn on an overdraft or purchasing securities a bank creates a credit in its books, which is the equivalent of a deposit".

They went on to give what they called a simple illustration. First they assumed that all banks had been merged into one bank. Then they described what they said would happen if a depositor deposited £1,000 in cash, the bank relying on past experience that it was only necessary to keep £100 of it in cash. The bank, they said could now make loans (or purchase securities) up to a total of £9,000 "until such time as the credits created . . . represent nine times the amount of the original deposit of £1,000 in cash". They were of course assuming that when each borrower drew on his account to make payments the cheques would come back into other accounts in the bank.

Two things they overlooked or obscured. In the real world there are quite a lot of separate banks and in the nature of things most of the loans made by each bank are used to make payments, not to customers of the same bank, but to customers who have accounts in other banks. So if for the moment we accept the assumption that the banks by making loans have created deposits they are doing most of it not for themselves but for their rivals. More important, their simple illustration is too simple. If their argument is sound it could be applied to a bank just being formed just as well as to a bank already functioning. (They were silent on this.)

But as soon as it is put like that its absurdity becomes apparent. A newly formed bank with no deposits except the £1,000 cash just handed in would, on the past experience which the Macmillan Committee itself accepted, invest £150, have £200 on call, £100 in cash and make advances of £550. Thus its total of investments and advances would be, not £9,000, but £900. It would only need one borrower of £1,000 to draw a cheque paying it to an account in another bank, for the first bank's £1,000 cash to be reduced to nothing.

The same principle applies to an existing bank; for example if we take total deposits £100,000, with £15,000 invested, £20,000 on call, £10,000 in cash and advances of £55,000. For the existing bank would only have been able to expand to the £100,000 level by treating each additional deposit of £1,000 cash in the same way, with investment and advances totalling £900 out of each £1,000, not the mythical £9,000.

The members of the Committee were soon faced with a problem. Taking their words at their face value the late Major Douglas concluded that this power of "creation" meant that a bank "acquires securities for nothing", creates new money "by a stroke of the banker's pen", and that the banks "are the potential or actual owners of everything produced in the world".

Faced with this, members of the Committee who were asked about it, including the late Reginald McKenna, Chairman of the Midland Bank, had to repudiate Major Douglas. The fact remains however, that Major Douglas was only taking them to the logical conclusion of their own mystical theory of banking.