The problem is not the banks … it’s capitalism

In April 2017 the German central bank, the Bundesbank, published a paper on ‘The role of banks, non-banks and the central on the money creation process’ ( Accepting the current prevailing definition of money as including bank loans, it was mainly about bank lending and what determined its level. Some have read into it more than may have been intended.

At one point, the article stated:

‘… a bank can grant loans without any prior inflows of customer deposits. In fact, book money is created as a result of an accounting entry when a bank grants a loan. It posts the associated credit entry for the customer as a sight deposit by the latter and therefore as a liability on the liability side of its own balance sheet. This refutes a popular misconception that banks act simply as intermediaries at the time of lending – ie that banks can only grant loans using funds placed with them previously as deposits by other customers.’ (‘book money’ and ‘sight deposits’ are translations of German terms corresponding to ‘bank credit’ and ‘current account’ in English.)

This passage was seized on by adepts of the thin-air school of banking to support their contention that banks mysteriously create out of nothing the money they lend. But this is not what the passage or the rest of the article says. Just because banks may not get all the money they lend directly from deposits does not mean that they therefore simply conjure it up out of thin air.

The passage was in fact very carefully worded. First, it brings out, with the use of the terms ‘book money’ and ‘accounting entry,’ that what is being described is an accounting practice followed by banks when a decision to grant a loan has been made. Double-entry bookkeeping requires that a loan, like a deposit, be entered both as an ‘asset’ and as a ‘liability’.

Second, its description of the ‘popular misconception’ is qualified by the words ‘at the time of lending’, leaving open the possibility that the loan may have to be funded at some point from deposits. These words were clearly deliberately inserted because this is precisely what the article does go on to explain.

Whatever the way in which the accounts are presented, the money has to exist since, as soon as the borrower spends the money that the bank has put into their bank account, it has to be found. So where does it come from? According to the article, it comes in the first instance from the bank’s ‘reserves’ at the central bank. The article uses the example of where the borrower uses the loan to buy a machine and where the seller puts the money paid for it into an account at a different bank. The first bank therefore owes the second bank money, which is settled by a transfer of some of its reserves at the central bank to the reserves held there by the other bank.

But what are these reserves? Where do they come from? Far from being conjured up out of thin air, they will have come either from the bank’s capital or from depositors. In either case, previously- existing money.

But that’s not the end of the story. In a section entitled ‘Constraints on the creation of money and credit by individual banks’, the article lists three: ‘interaction with non-banks’ (i.e., other businesses and households), banking regulations, ‘and, not least, by banks’ own inherent interest in profit maximisation’.

Banks are profit-seeking financial intermediaries that borrow money at one rate of interest (either ‘retail’ from individuals or ‘wholesale’ from the money market) and relend the money to borrowers at a higher rate. The spread between the two rates is the source of a bank’s income; after it has paid its operating costs, including staff wages, what remains is the bank’s profits.

Banks’ ‘inherent interest in profit maximisation’ affects how what the article describes as ‘the need for banks to find the loans they create’ is met. It means that they are going to seek to obtain the needed funding as cheaply as possible, i.e., at the lowest possible rate of interest:

‘Deposits play a major role in this regard, for while banks have the ability to create money – that is, to accumulate a stock of assets by originating liabilities themselves in the form of sight deposits – they need funding in the form of reserves.’

They need this because, when a bank makes a loan and the borrower spends it, the money will leave the bank and most if not all of it will normally be deposited by those the borrower bought things from in some other bank. Although the immediate way to replace this – fund the loan – will be to use reserves the bank already has or can procure ‘at any time via the interbank market or the central bank’, this is not the cheapest way:

‘Using short term interbank liabilities as a source of funding gives rise to liquidity and interest rate risk because of the danger that the bank might, at some point in the future, no longer be in a position to prolong the short-term interbank loan or that it can only do so at a higher cost. As for interest rate risk, the risk of interest rates increasing for central bank and interbank could drive up funding costs, thus eroding, or wiping out altogether, the income derived from lending.’

Which is precisely what happened to Northern Rock and HBOS during the financial crash of 2008.

To avoid this, banks seek longer-term loans, in particular from depositors (deposits into a bank are in effect, and in law, a loan to the bank). Here they face competition from other banks. Fixing what rate to pay those they want to borrow from is a delicate balancing act. If it’s too low it will put off depositors who will then go instead to one of the bank’s competitors; if it is too high this will cut into their income and so their profits.

Although we can have misgivings about describing a bank’s decision to authorise a loan, and the accompanying accounting practice, as ‘creating’ money rather than simply ‘making a loan’, the Bundesbank article shows that even the banking authorities themselves acknowledge that banks are financial intermediaries which borrow money at one rate of interest and re-lend it at a higher rate; that banks cannot really ‘create credit’ whatever the bookkeeping practice might suggest.

What banks deal in – and lend – is a financial representation of wealth, not wealth itself which can only be produced by humans working on materials that originally came from nature, fashioning and refashioning them into something useful.

There is nothing especially bad about banks compared with other profit-seeking capitalist enterprises. They are merely in a different line of business. Banks are not the cause of the problems that the majority class of wage and salary workers face. It is capitalism and its production for profit. So the solution is not to reform banks but to abolish capitalism