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Cashless funding

Ideas 5 and 20 August, text 22 August and 14–15 September 2012

None the richer, none the poorer

This part: idea 20 August, text 22 August

In my first article I showed how money creation occurs when a bank grants a cash loan to a borrower. The cash amount had been previously deposited by some other bank client.

In article 10 I showed the cashless equivalent of that operation: the borrower doesn’t get the loan amount as cash, but gets it available in an on demand account, for later use.

Here the funding (‘where does the money come from?’) is less obvious, and I stated that in this situation in fact the borrower funds his own loan: because the amount isn’t immediately spent, it is still in the bank, so the bank (if it has sufficient reserves) can use the unspent loan amount as funding for that same loan!

The money creation process in this case is more obvious than in the example of my article 1: in article 10 the bank simply books a debit amount representing the loan, and the same amount at the credit side to represent its availability to the borrower.

So money is created that wasn’t there before. Note however – and this is important – that this money creation hasn’t made the bank any ‘richer’: the bank has more assets (claims), but also more liabilities, and the balance of the two increases is zero. The liability counts as M1-money, the asset does not. Hence the creation of M1-money.

If the borrower later redeems part of the loan, the reverse process takes place: both the loan itself (an asset of the bank, debit side of the balance sheet) and its availability to the borrower (a liability of the bank, credit side of the balance sheet) are diminished.

Because again only the liability counts as money, it means money was destroyed by the redemption. But it doesn’t make the bank any poorer: the remaining loan amount (asset) is still balanced by the remainder of the on demand claim by the borrower towards the bank.

What if the borrower spends the loan?

This part: idea 5 August, text 22 August and 14–15 September 2012

In article 10 we continued until the point where the borrower had the loan amount available, but didn’t spend it yet. As a result, the bank could use that amount to fund the loan itself.

Now what happens if the borrower does spend part or all of the loan amount? That of course is bound to happen, otherwise, why did he take out a loan at all? Will the loan no longer have its funding? Let’s look at some situations in detail.

(I consider money transfers here, which is usual in some European countries including the Netherlands, where I live. In other countries (France, USA) it is more likely to work with checks. The net effect however is the same. The difference is technical and organisational only.)

Paying a client of the same bank

After the bank made the loan available but the borrower didn’t use any of it yet, the situation was as follows:

Description Debit (assets) Credit (liabilities)
Cash in bank 100
Checking account (on demand) of Villager A 100
Checking account (on demand) of Villager B 900
Loan facility for Villager B 900

Now the borrower uses a part (say 90 dollars) of the money he has available from the loan that the bank provided, to make a payment to Villager C, who is also client of that same bank. Transaction:

Description Debit (assets) Credit (liabilities)
Checking account (on demand) of Villager B 90
Checking account (on demand) of Villager C 90

Resulting balance sheet:

Description Debit (assets) Credit (liabilities)
Cash in bank 100
Checking account (on demand) of Villager A 100
Checking account (on demand) of Villager B 810
Loan facility for Villager B 900
Checking account (on demand) of Villager C 90

For the bank, nothing really changed much. There is a total of 1000 dollars (100 + 810 + 90) in checking accounts. This is backed by 100 dollars, or 10%, of cash, serving as a reserve.

The new owner of the 90 dollars in the payment, Villager C, has them available, but doesn’t actually use them for anything yet. So the bank can use that amount, as before, as funding for the loan to Villager B.

That part of the money for the loan is still ‘coming from somewhere’, although it was once the result of money creation. The paradox still holds.

The money supply hasn’t changed: it is the total of the checking accounts (1000), because cash in the bank isn’t M1-money and none of the villagers has any cash right now. They all have all their money in the bank.

Withdrawing cash from the loan

Suppose Villager B also wants to spend or hold part of his loan as cash. I use 50 dollars as the example amount, for no particular reason. The transaction is:

Description Debit (assets) Credit (liabilities)
Checking account (on demand) of Villager B 50
Cash in bank 50

The transaction results in this balance sheet situation:

Description Debit (assets) Credit (liabilities)
Cash in bank 50
Checking account (on demand) of Villager A 100
Checking account (on demand) of Villager B 760
Loan facility for Villager B 900
Checking account (on demand) of Villager C 90

Now the bank has a problem: it can no longer meet the reserve requirement (which I assumed to be 10%):
50 / (100 + 760 + 90) = 50 / 950 = 5.3%.
So the bank will soon have to find extra funding that also serves as extra reserves.

This sudden shortage is not quite realistic, because in article 10, I assumed that the bank’s excess reserves (and therefore, its lending capacity, disregarding the capital requirement) was completely used for this one loan. In the real world, individual loans are much smaller than the reserves, and the bank will probably have some excess reserves at all times, so that normal everyday banking transactions do not immediately overdraw the minimum reserves.

Paying to a client of a different bank

Bilateral settlement

(For simplicity I now take the situation at the beginning of this article, or the end of article 10, as the starting point.)

What happens exactly, depends on how the settlement (also called clearing) between banks is done. This can work with accounts that banks have with each other. This was the case in the Netherlands before 1990. There were two separate payments circuits, one for the Postbank and one for all the other banks in the country. Payments between those two circuits were done using account that the other banks, and the payment handling organisation, held with the Postbank.

The method with bilateral bank accounts can also be used for international payments (before and outside SEPA), using vostro accounts (roughly, but not quite the same as loro accounts) and nostro accounts.

If Villager B want to use part of his 900 dollar loan, available to him in his bank account, for a payment to somebody (Party D) with an account with a different bank, and the settlement is done as described above, in fact the amount will be transferred from Villagers B’s account to the account of Party D’s bank with Villagers B’s bank. Further handling of the payment in Party D’s bank does not have any impact on the balance sheet of Villagers B’s bank.

So the role that Villagers C’s account played in the intrabank example, is now played by the loro account of the other bank. For the funding of Villager B’s loan (which is what this and the previous article is about) this makes no difference. In fact, the other bank helps fund the loan (as long as the money in that account isn’t withdrawn to use it for something else).

The money for the loan is still coming from somewhere, not out of thin air; but money creation by credit granting by commercial banks is a reality. That is the paradox.

Settlement by central bank

In many cases the settlement, the clearing of payments to and from of clients of different banks, is done via a central bank. Examples: DNB in the Netherlands, the ECB for the eurozone, federal and regional FEDs in the USA.

Such a settlement effectively results in crediting a reserve account (that has a debit balance, from the viewing point of the non-central bank), held with the central bank. So after the payment has been settled, the bank has fewer cash reserves (which consist in part of real cash, and another part a reserve deposit with the central bank).

So the lending capacity of the bank is diminished by the transaction, and the bank will have to go look for extra funding for the existing loan. The situation is quite similar to that after a cash withdrawal.


Copyright © 2012 R. Harmsen. All rights reserved.

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