Macro 101 – Bank operations

With the slow gurgling sound of  the lack of retail spending by the public in my ear, it is time to get back to my other stream of conversation.  I am going to continue on with my macroeconomics series.

Today I am going to talk about banks and how they operate in the context of macroeconomics and credit. I hopefully will not be introducing any ground-breaking concepts; this will just be an overall discussion of the processes.

However given my experience with the “average” citizen’s understanding of how the economy actually functions I will not be surprised if I shock a few people with the concepts I discuss below. At this stage I will try not to wander too far into the realm of the government as I want to leave that for another post.

Banking processes are important to understand because without them you have trouble reconciling my previous two macroeconomics posts. Sectoral balance and credit effects

Before I begin I need to introduce a little known monetary concept. Something I have discussed previously in a more abstract way in centralbankopia.  There are actually two types of “money” in a modern economy.  There is “money” owned by the monopolist issuer, and there is other money.  Money owned by the monopolist issuer is the only “money” that can be held in a reserve bank account. It is issued by the sovereign nation and is not backed up by any asset of corresponding value. This money is called “high power money” and is sometimes called “the monetary base”. I prefer to call it “money of exchange” for reasons I will discuss below. It is made up of bank reserves ( and equivalents ) and currency.

There is also another type of money called “credit money” which is sometimes called “money of account”. This is the money that is used within the walls of a finiancial institution but has no value to other financial institutions including the reserve bank. 

Hopefully I have not confused you too much already.  Please bear with me for just a little more background.

Unlike many other countries Australian banks have no reserve requirements. They are not required by legislation to hold any proportion of their deposits at the reserve bank. So anything you have heard about money multiplier theory is irrelevant to Australia. ( In fact it is irrelevant everywhere, but that is another story ).  Banks in Australia have a capital requirement. To explain why I defer to the RBA. 

An important part of the Bank’s prudential supervision of banks in Australia is the setting of capital adequacy guidelines with which banks must comply. A bank’s capital can be viewed as evidence of the willingness of shareholders to commit their own funds to a bank on a permanent basis, as interest free resources and, ultimately, as a cushion to absorb possible future losses. A strongly capitalised banking system engenders confidence in the banking and payments systems as a whole.

So how much capital do they actually require? 

In line with international capital standards, Australian banks are required to maintain a ratio of capital to risk-weighted assets of not less than 8 per cent, with at least 4 per cent in core capital.

There are two type of capital in relation to capital requirements. Tier 1 capital ( otherwise known as “core” capital )  is basically stock ( at its current value ) and retained earnings. Those are earnings that have not been passed on as dividends to stock holders.

Tier 2 capital is basically loan-loss reserves ( known as “provisions” ) plus subordinated debt. Subordinated debt is long term debt that, in case of insolvency, is paid off after depositors and other creditors.
 
Assets held by the banks are risk weighted by their type and attributes. Risk weighting is actually fairly complex so I will simplify it for now. You can read APRA’s APS 112 Attachment C or check out the BIS site for an idea of how weightings are applied to various asset types.

Remember that loans are an asset to a bank while deposits are a liability. To simplify things lets say that currency and government securities are risk weighted at 0%, loans to other banks at 20%, residential mortgages at 75% and all other loans and lines of credit at 100%.

So if an Australian bank had $50 million in cash , $100 million in government securities, $150 million in interbank loans, $500 million in residential mortgages and $200 million in other loans then its risk weighted asset value would be $605 million. ($50m * 0% + $100m * 0% + $150m * 20% + $500m * 75% + $200m * 100%). As the banks requires 8% capital adequacy then this bank must have $48.4 million in capital to meet its requirement, with at least half of that value being Tier 1.

So now I have said all of that , let’s look at what happens when a loan is issued.

When a bank issues a loan of $250,000, it creates an asset and a liability on its balance sheet each of $250,000. The asset is the loan ( the IOU to be paid back by the mortgager) and the liability is the deposit that it creates in an intermediary account. This operation costs the bank nothing, just a few clicks of the mouse and a couple of taps on a keyboard and it has created $250,000 of “money of account” from nothing.

If the recipient of the loaned money is at the same bank then the bank simply transfers the money into that person’s account from the intermediary account and the transaction is complete. Again this cost the bank nothing. Overtime this loan will be paid back.; as it is the value of the asset ( the loan) will fall and the “money of account” will slowly be destroyed. It will go back to where it came from… Nowhere.

Although the issuance of the loan didn’t seem to cost the bank anything it can have 2 flow-on effects.

Firstly the loan is an asset; it therefore counts in the capital requirement calculations. The issuance of this loan may in turn require the bank to issue more subordinated debt and/or stock to cover its capital requirement position. I will not confuse this topic by discussing the implications of that.

Secondly, if the “money” from the loan needs to be transferred out of the bank then it must be converted from “money of account” into “money of exchange”.  Remember “money of exchange” comes in two basic forms, currency and bank reserves. (Which are interchangeable).

If a member of the public wants to hold some “money of account” as cash, then the bank needs to transform it into “money of exchange” ( reserves ) in the form of currency. To do this it issues the person with the currency ( which lowers its reserves by that amount) and then lowers the person’s bank balance by the same amount ( lowering the banks deposit liability). When a person deposits currency at the bank the reverse occurs, the currency is converted  into “money of account” by adding to the person’s account balance ( an increase in the bank’s deposit liability ) and the currency is added back to the bank’s reserves.

If the recipient of the loan is at another financial institution, then the lending bank must give up $250,000 of “money of exchange” and transfer it to the other institution. At the same time it removes its “money of account” deposit liability from its balance sheet.

Now the big question. How do banks actually “exchange” the “money of exchange”. The answer; through the reserve bank.  Each Australian bank has an account at the reserve called an Exchange Settlement Account. These accounts are used to do all interbank transfers, but as I said at the top of the post, only “money of exchange” can be held in central bank accounts. 

The RBA also stipulates that these accounts cannot not be overdrawn at the end of a banking day, and it is this little tiny rule that allows the government to control interest rates, or in other words the ” base price of money of exchange”.

I think that is enough for today.  I am sure people already have quite a few questions about what I have discussed. I will leave the governments interactions through the reserve bank and the reason for them for another post.

Comments

  1. ED,

    This might be another subject but if the Aussie banks have borrowed all this money from overseas what effects does the AUD have on the repayments. If they borrowed the money several years ago when the AUD was down and they are making repayments with the high AUD wouldnt that go in the favor. If they borrow the money now or when the AUD is high and then the AUD goes down and they have to make repayments does that go against them. Does it matter at all?

    LBS

      • The idea that banks are making money out of nothing is not strictly true. The value is created from the future repayment of the borrower. A bank is a make believe ‘time machine’ : it allows a person to borrow against future income. Our banking system will collapse if enough people decide that the time machine is a fake. This is why Central Banks are willing to print ‘money of exchange’ to perpetuate the myth in times of financial crisis.

        • >The idea that banks are making money out of nothing is not strictly true. The value is created from the future repayment of the borrower. A bank is a make believe ‘time machine’

          Ronin, although I agree you need to assess your statement. Credit money comes from nothing or a time machine ???

          I am seen as crazy enough, I am not sure I need to add time travel to the mix 🙂

  2. Its all a big ponzi scheme which couldn’t survive without a fiat currency and central bank.

    Every bank is insolvent.

  3. I’m a bit hazy on this paragraph:

    “If the recipient of the loaned money is at the same bank then the bank simply transfers the money into that person’s account from the intermediary account and the transaction is complete. Again this cost the bank nothing. Overtime this loan will be paid back.; as it is the value of the asset ( the loan) will fall and the “money of account” will slowly be destroyed. It will go back to where it came from… Nowhere.”

    I follow most of the rest of your post (and it is eye opening to a non-economist to see and try to absorb) but this paragraph seems to be about 2-3 sentences short =)

    I also need to do a flow chart to follow the rest of the post. My wife and I recently divested from our RE and I’d like to follow what happened in our simple transaction. In short and with round numbers, we sold our paid off house for $100,000, which we took as a cash deposit at another institution where it now sits in an account (ie “money of account”). If my quick reading was correct… this $100,000 only “cost” the buyers bank $6,000 ($100000 * .75 * .08) in “money of exchange” (how’s that for mind blowing?!!). Yet I’m still a bit hazy on the subsequent transfer from their bank into ours.

    Anyway, thanks for a mostly accessible description to the monetary system to a laymen!

    Cn

    • Ok, running the second half out a bit…

      Am I correct in that from the borrowers bank, we received $100,000 in “money of exchange” ($e), where they were required to hold… ? (I’m still hazy at this step).

      Then when we took that $e100,000 to our bank, we deposited it and now hold “money of account” ($a) of $a100,000. Now this $a100,000 deposit is required to have a 0% reserve held against it (as it’s risk-less cash), so in essence our new bank can fund $a1,666,667 ($a100,000 / $e6,000 = $aX / $e100,000) in loans?

      So our $e100k deposit “supports” nearly $a1.7 million in mortgages? Tell me I got the math wrong =)

      Cn

      • Ok I will make a few assumptions, to make the explaination a little easier.

        – Someone took out a loan to purchase your home lets say $350,000
        – You had $250,000 left on your loan
        – Your loan was at a different bank to the person who took out the new loan.

        So the bank of the person who purchased your house creates an asset of $350,000 ( the loan ) and a deposit in an intermidiary account of the same value. At this stage this is money of account. As you are at different bank then this bank must transfer $350,000 in money of exchange to your bank. It does this through the reserve bank. We will assume that the bank has enough reserves, so $350,000 is deleted form its reserve account and added to your banks account. At the same time the originating bank removes its “money of account” deposit liability in its intermediary account.

        On receipt of the reserves, your bank will create $350,000 in money of account. $250,000 of that money goes to pay off your existing loan, which was also money of account. Your loan ( an asset to your bank ) is now no more. The rest of the money is added to your savings account as a $100,000 liability to the bank as money of account.

        >so in essence our new bank can fund $a1,666,667 ($a100,000 / $e6,000 = $aX / $e100,000) in loans?

        Hmm… Not quite.

        You may have been told that banks lend on deposits. This is not true. Banks can lend any amount of money as long as they have the capital to do so. So the fact that you paid off your $250,000 loan means that the risk weighted assets of the bank have decrease by $250,000. This has freed up some capital which can be recycled to issue another loan. How large that loan can be depends on its attributes. Lower LVR loans have a lower risk weighting and therefore require less capital.

        The bank may also have some retained earnings ( out of the profit they made from your loan ) which can also be used as the capital base to new support loans.

        • Thanks for the walk thru!

          In our case, the story was actually a bit simpler (our house was paid in full, so no loan to extinguish), but I was able to follow the path you outlined above.

          But… with a fresh deposit of funds into our bank of $e100,000 (which becomes $a100,000) wouldn’t the $e100,000 be placed into the bank’s “capital” (speaking in general terms, of course)?

          It’s not like it’s a “demand deposit” (a US term that may or may not translate down here, yet these are “swept” stateside anyway so it really doesn’t apply there anymore either 😉 so speaking simply I would think the $e100,000 would be rolled into the banks “capital”. Else, what would they do with it?

          So… (this is the part that has never added up for me in fractional reserve banking, so please bear with me)…

          *IF* the $e100,000 is rolled into the bank’s “capital” and that in turn can “support” $a1.7 million of mortgages collecting, say a 7% coupon… why do I only get 6.25% on my $a100,000 when it’s earning $116,667 per annum in interest?

          So, there is my misconception regarding reserve banking (or do I have it correct?) so if someone could clear that up that’d be awesome!

          Cn

        • Ok, re-reading more carefully (and with slide rule in hand)…

          BankA $a350,000 ~> $e350,000 (via RBA) -> BankB

          So BankB now has an “extra” $e350,000 in its RBA account. This results in BankB creating a $a350,000 deposit, where $a250,000 zero’s out the $a250,000 remaining loan and the remaining $a100,000 is placed into our savings. But BankB now has an “extra” $e350,000 sitting in its RBA account, correct?

          So this $e350,000 (which was from BankA’s RBA account) now contributes to BankB’s “capital”, correct? Now, I realize this is being looked at in isolation, and that generally speaking while money is moving thru the RBA accounts more-or-less the AM and PM balances will be roughly the same (as BankB would move mortgages to BankA in parallel). But in isolation it looks like BankB gets a boon in their “capital” by this single transition that has a disproportionate effect on their ability to lend (the $e100k = $a1.7 mil question above).

          I know I’m missing a gear here somewhere, so maybe this will help you figure out what I’m missing! It probably doesn’t help that I always approached Math about 180 degrees from how it is taught, so I’m probably seeing a downflow issue without bothering to finish an upflow sum =)

          Thanks again!

          Cn

          PS- I greatly appreciate the free Econ101 lesson, by the way!

          • >So this $e350,000 (which was from BankA’s RBA account) now contributes to BankB’s “capital”, correct? Now, I realize this is being looked at in isolation, and that generally speaking while money is moving thru the RBA accounts more-or-less the AM and PM balances will be roughly the same (as BankB would move mortgages to BankA in parallel). But in isolation it looks like BankB gets a boon in their “capital” by this single transition that has a disproportionate effect on their ability to lend (the $e100k = $a1.7 mil question above).

            Yes it is correct that they now have $350,000 in reserves extra, but reserves are working capital and are a small proportion of the deposit base. So as you rightly point out the demand for reserves is not one way.

            There will be demand in reverse to support transactions away from your bank. So “removing” reserves in some way ( This is more difficult than you think ) may require them to replace it an hour later. Also note that banks can make money from their excess reserves by lending them to other banks or by parking them overnight at the reserve, the RBA also interacts with the reserve base to maintain a set interest rate spread

            I will talk about this in another post.

            In regards to how much reserves banks try to keep to “back-up” their deposit base in Australia it is a bit of a mystery. As there is no legislative requirement banks each have their risk management systems that provide metrics for them as to whether they think they have enough reserves to meet their on-demand transactions. This changes over time, for instance at Christmas lots more people “demand” their deposits as “cash”, after Christmas that cash is re-deposited back into the banking system by the shops that all those presents were purchased at.

            If banks don’t think they have enough reserves at some point they may have to adjust other banking products to draw reserves away from other banks, but this will come at a price of margins.

            I.e Why did suncorp offer a 6.5% term deposit when none of the other banks were even close ?

            Could it be that their risk management system had big red lights flashing on it about their ability to match “on-demand” requests ?

    • Ben , I assume by your question that you are specifically referring to the “offshore” part of your question.

      I cannot address this topic in this little comment box, as it gets quite complicated.

      I promise to address it in my next Macro 101 post.

  4. ED,

    So what you do think of all this crap about the banks making all these record profits that is all over the media. Do you think the majority of it is BS and they are hiding things from the public?

    LBS

    • NO.. I think they are making record profits because of the way their capital requirements allows them to leverage their tiered capital. I am going to post about this topic shortly because I think the MSM has completely missed the point on how funding costs actually effect the banks.

      But this leverage also has a big downside. RISK

      This is coming in two ways. Firstly the whole system is primed because it is based on allowing banks to leverage small amounts of equity and subordindated debt. It is also primed because bankers are gaming the system. Please read Deep Ts latest article for a description of some of this.

      http://macrobusiness.com.au/2011/02/big-profits-huge-risk/

      If you check out the big banks balance sheets and you will see that they only need 2-3% default rates across their loan book to be in serious trouble.

      The reason is because defaults cause the banks to realise “credit money” losses as “money of exchange” losses. When your loan to equity ratio is floating around 16:1 bad times can appear very quickly.

  5. “if people understood how really our banking system works, it would be a revolution by tomorrow morning”

    Henry Ford, US President

    • I think you’ve managed to confuse Henry Ford (the source of that quote, founder of Ford Motors) with Gerald Ford, unrelated US President who followed Nixon.

  6. Thanks for the very informative report. You are very clear with respect to what happens between the various accounts mentioned. Where I’m still a bit unclear is regarding the nature of the reserve money and its relationship to capital requirements. Retained earnings is the easy part, but what about stock? When a bank issues stock, doesn’t the bank trade it for money of exchange, and how does the current value of the stock affect the capital of the bank? Isn’t the value of the stock really a matter of concern between parties who might trade it back and forth, not the bank? And what are loan-loss reserves? Finally, isn’t subordinated debt just a loan to the bank, which becomes reserve money at the point at which it is obtained, but which is a liability on future earnings of the bank?

    I hope I’m not asking too many questions, but I am delighted to find an informed blogger able and willing to help the innocent.

    • Ricky .. There are never too many questions.. Everyone should try to learn how the economy “actually” functions so they can make informed decisions about economic policy. Although as you have probably found, finding information on how the economy “actually” functions isn’t as easy as you would expect in a democracy.

      If you don’t understand the economy then how are you supposed to know if you are being told BS from vested interests? If you know how the system works you can also make an assessment of whether economic policy is going to help or hinder the economy, or is simply a one-sided “wealth-grap” by vested interested.

      For instant my assessment of the flood levy in terms of sectoral balance.

      http://macrobusiness.com.au/2011/01/macroeconomics-101-part-1/

      Another one would be to ask where you think the “Future Funds” bank account will be if it is setup by the government from taxes paid by the miners. Do you think it might be at the CBA?

      If so then think to yourself what CBA could do if it had a very large and very long term deposit liability created by taxation on miners which is money that ,in part, usually be flowing overseas.

      Think … Think… Now read this and let me know what you think.

      http://macrobusiness.com.au/2011/02/revive-the-rspt/

      Now to your questions.

      >When a bank issues stock, doesn’t the bank trade it for money of exchange.

      Not always.. Someone could take out a loan at the same bank, or have an existing deposit at that bank and uses those funds to buy shares.

      > and how does the current value of the stock affect the capital of the bank?

      It is counted as Tier1 capital at current face value.

      > Isn’t the value of the stock really a matter of concern between parties who might trade it back and forth, not the bank?

      Technically yes. But it is also “the markets” relative measure of the strength of the company. Wrongly or rightly it is seen as a measure by the regulators as the likelihood of failure.

      Stock is lowest form of subordinate debt, meaning that if the company goes belly up they will be paid last in the line of creditors.

      >And what are loan-loss reserves?

      They are profits set aside by the a bank in expectation of loss of asset value. This is usually loan defaults.

      >Finally, isn’t subordinated debt just a loan to the bank, which becomes reserve money at the point at which it is obtained, but which is a liability on future earnings of the bank?

      Yes, but subordinated debt that counts towards Tier2 capital must be long dated maturity. Meaning that the bank does not have to pay back that money for some time. This gives them time to profit from the income via issuing loans at a greater interest rate.

      You will also note that the value of those loans is far greater relative to the debt issuance. So a rise in the cost of that debt by 1% does not translate to a 1% rise in the “cost of funding loans”. Ooops, I just let the cat out of the bag. :))

  7. A deposit taking bank does write up its deposit liabilities when it makes a loan, but that doesn’t mean it funds itself by “creating” money. If it thought it could do this, it would be out of business pretty fast. Once they make the loan and create a deposit this newly created inside money does not have to stay in the banking system. It’s possible to have credit growth without money growth and visa versa.