Syndicate content

The “accounting view” of money: money as equity (Part II)

Biagio Bossone's picture

In part I of this blog, we discussed the implications of our proposed “Accounting View” of money as it applies to legal tender. In this part and the next, we elaborate on the implications of the new approach, with specific reference to commercial bank money.

Bank deposits and central bank reserves

After long being a tenet of post-Keynesian theories of money,1 even mainstream economics has finally recognized that commercial banks are not simple intermediaries of already existing money; they create their own money by issuing liabilities in the form of sight deposits (McLeay, Radia, and Thomas 2014).2

If banks create money, they do not need to raise deposits to lend or sell (Werner 2014). Still, they must avail themselves of the cash and reserves necessary to guarantee cash withdrawals from clients and settle obligations to other banks emanating from client instructions to mobilize deposits to make payments and transfers.

The relevant payment orders are only those between clients of different banks, since the settlement of payments between clients of the same bank (“on us” payments) does not require the use of reserves and takes place simply by debiting and crediting accounts held on the books of the bank.

For cash withdrawals and interbank payments, every bank must determine the optimal amount of cash and reserves needed to cover deposits. These consist of:

  1. Cash reserves and reserves deposited with the central bank
  2. Reserves from settlement of incoming payments from other banks
  3. Borrowings from the interbank market
  4. Borrowings from the central bank
  5. Immediate liquidation of unencumbered assets in the balance sheet
  6. New deposits of cash from old and new clients (since new, noncash deposits from clients can only consist of deposits transferred from other banks, which fall under item ii).

Debt or what?

Commercial bank money constitutes a debt liability for deposit-issuing banks, since they are under obligation to convert deposits into cash on demand from their clients and settle payments in central bank reserves at the time required by payment system settlement rules.

However, in a fractional reserve regime, banks hold only a fraction of reserves against their total deposit liabilities. The amounts of reserves they use for settling interbank obligations are only a fraction of the total transactions settled.

The more limited is the use of cash in the economy, and the larger are the economies of scale in the use of reserves (as permitted by payment system rules and clients’ nonsimultaneous mobilization of deposits), the lower is the volume of reserves that banks need to back up the issuance of new deposits.3

Payment system rules affect the use of reserves via two channels: the settlement modality (that is, netting or gross settlement) and the technology adopted. Modern technologies introduce elements of netting into gross settlement processes and increase the velocity of circulation of reserves, thereby allowing banks to economize on the use of reserves for any given volume and value of payments settled.

In the hypothetical case of a fully consolidated banking system in a cashless economy where all agent accounts sit with only one bank, all payments and transfers would be "on us" for the bank. The bank would need no reserves for settling transactions and would be under no debt obligation to its clients. It might create all the money that the economy could absorb without holding reserves, and its money would have the same power as legal money in settling all debts.

What is bank money?

In real-world economies, however, there are multiple banks whose payment activities generate interbank settlement obligations. Yet, the fractional reserve regime and the economies of scale allowed by the payment system and depositors’ behavior reduce the reserves needed by the banks to back their debts. Under increasing scale economies, banks can create more liabilities (by lending or selling deposits) with decreasing reserve margins for coverage. From the hypothetical case above and this discussion, it follows that, all else equal, a more consolidated banking system affords lower coverage of its liabilities (and at lower cost) than a less concentrated one.

More generally, absent adverse economic or market contingencies inducing depositors to convert deposits into cash, the liabilities represented by deposits only partly constitute debt liabilities of the issuing bank, which as such require reserve coverage. The remaining part of the liabilities is a source of income for the issuing bank—income that derives from the bank’s power to create money. In accounting terms, to the extent that this income is undistributed, it is equivalent to equity (as discussed in part I of this blog).

In part III of the blog, we demonstrate that the double nature of commercial bank (sight) deposits is consistent with the principles of general accounting.

References

Graziani, A. 2003. The Monetary Theory of Production. Cambridge, UK: Cambridge University Press.

McLeay, M., A. Radia, and R. Thomas. 2014. “Money Creation in the Modern Economy.” Bank of England Quarterly Bulletin 54 (1): 14–27.

Moore, B. 1979. “The Endogenous Money Stock.” Journal of Post Keynesian Economics 2 (1): 49–70.

———. 1983. “Unpacking the Post Keynesian Black Box: Bank Lending and the Money Supply.” Journal of Post Keynesian Economics 5 (4): 537–56.

Werner, R. A. 2014. “How Do Banks Create Money, and Why Can Other Firms Not Do the Same? An Explanation for the Coexistence of Lending and Deposit-Taking.” International Review of Financial Analysis 36: 71–77.

______________________________________________
1 See, for instance, Moore (1979, 1983) and the literature on monetary circuit theory. As this is too vast to be cited here and do justice to its many contributors, we refer only to the work by Graziani (2003), one of the theory’s most authoritative exponents.

2 Banks create money by lending or selling deposits. Lending deposits features very close analogies to selling deposits. As banks issue deposits to clients in exchange for money, banks become owners of the money received and acquire the rights to use it as they wish (subject to existing laws and regulations). Even if banks are constrained in the use of money—such as, for instance, in the case of regulation prescribing the types of assets to be held—they (not the depositors) are the owners of the purchased assets and they (not the depositors) are the owners of the income generated by the purchased assets.

3 For the use of cash, in cases where the monetary authority declares deposit inconvertibility and prohibits deposit transfers across borders, bank money effectively replicates central bank money, whereby reserves cannot circulate out of the central bank’s books: any single commercial bank may dispossess itself of its own reserves (if some other banks demand them), but all of them cannot altogether do so, since reserves once created remain outstanding until they are paid or sold back to the central bank.

Add new comment