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Do banks relend interest?

Idea 7 August 2013, elaboration 27 October 2013 and 6–8 February 2015

What?

That’s an idea that keeps coming back in what people write. What idea? That the interest that borrowers pay to banks, is lent out again at more interest. For new loans, new interest must be paid, so we’d get a perpetual circle with ever more debt.

Is it true? Does this happen? Can it even happen?

Quotes

First, some quotes from people who claim that it can and does:

Quote 1

Anthony Migchels of the site Real Currencies published an article on 1 April 2013, but it’s not a joke, I suppose. Did Anthony also write the article? It says “by Anthony Migchels” above it, but below, Dick Eastman is suggested to be the author.

Anyway, the title is “Is there enough money to pay off debt plus interest? A closer look” and this is the quote:

Then the other issue: is the interest spent back into circulation? The answer is: far from all the interest payments are spent back into circulation. Sure, the banks pay their people massively bloated bribes (‘bonuses’) for their handiwork and to control their conscience, and they build major citadels (‘office buildings) everywhere, but banking is an incredibly profitable business and this profit is not spent back into circulation.

In the first place, banks use profit as capital reserve requirements for more lending. Basically this means the money is lent back into circulation, not spent. Because it is lent back into circulation, even more money is needed for interest payments, aggravating an already grim situation.

Quote 2

In Oh Canada! Imposing Austerity on the World’s Most Resource-rich Country” (an article I referred to already in my previous article, number 22), Ellen Brown wrote:

The presumption was that borrowing from a central bank with the power to create money on its books would inflate the money supply and prices. Borrowing from private creditors, on the other hand, was considered not to be inflationary, since it involved the recycling of pre-existing money. What the bankers did not reveal, although they had long known it themselves, was that private banks create the money they lend just as public banks do.

(There is no contradiction there, both statements are true. Explained in my many other articles in this series.)

To continue the quote:

The difference is simply that a publicly-owned bank returns the interest to the government and the community, while a privately-owned bank siphons the interest into its capital account, to be re-invested at further interest, progressively drawing money out of the productive economy.

Quote 3

Here’s one from the site Real Currencies again, this time, I suppose, actually written by Anthony Migchels. The article is called Cause and Effects of Money Scarcity and its date is 7 October 2013.

Usury (note) is a constant drain on the money supply. Banks spend some of the interest back into the economy, but not all. They relend another part back causing even more debt and associated interest costs and indeed, worsening money scarcity.

Quote 4

The same thought also lives (note) among MPE people, for example, in the Canadian subsidiary of the MPE movement, as expressed in this 5 October 2013 tweet:

Ratel @Canada4MPE 5 Oct
As unwitting subjects of such systems of exploitation are implicitly obligated to maintain a vital circulation by perpetually re-borrowing..

and this one:

principal and interest paid out of the general circulation with this perpetual re-borrowing perpetually increasing the sum of debt...

and this one:

by so much as periodic interest on an ever greater sum of debt until the unwitting subjects succumb to a terminal sum of artificial debt..

Then and now

This is where my article ended in October 2013. I wasn’t sure how to continue. More than 15 months have passed since then, and now the whole matter is so much clearer to me. So I can explain.

I now know that all the statements quoted above are wrong. And I think they are wrong as a result of the authors’ wrong ideas of what is money.

Money is claim

They see money as something held by its owners, that might go into a bank or come out of it again. Literally, in the case of banknotes, this is accurate. But only seemingly so, because a banknote is physically a worthless piece of paper.

What makes an authentic banknote valuable, is that it is recognised as a financial claim. In this case: a claim on the central bank that issued the banknote. The only difference between that and the balance on a bank account, is that bank accounts are held by the public (households and firms) with non-central banks.

Money in an account doesn’t go in and out of a bank. It is always in a bank, being a claim on the bank administered by that bank. Money is always a claim and what matters is whose claim it is, who is the claimant.

What happens

Introduction

With this understanding of money, it is easy to see what happens when a member of the public takes out a loan or repays it, when paying or receiving interest, when a bank pays salaries or dividends, etc. It also clearly shows thatcapital reserve requirements [...] lent back into circulation [...]” is not something that can really happen.

Therefore I will now look at a number of financial transactions, presented not as journal entries, but in terms of how financial values change position, and often change claimant, in a bank’s balance sheet and income statement (the latter also known by some as ‘statement of profit and loss’).

In the real world, these transactions sometimes involve more than one bank. For example: a borrower has a mortgage loan with one bank but pays the monthly interest from his transaction account with another bank. When looking at the banking sector as a whole, as part of the economy as a whole, these interbank transactions are immaterial. So to keep things simple, I look at one hypothetical non-central bank, which in fact represents the non-central portion of the whole banking sector.

Some references to places where I mentioned or discussed these transactions before: 2130601, 004intrs, 020crein and more specifically Reserves, 015rstab.

Transactions

Borrower pays interest

The amount moves from the borrower’s transaction account to one of the bank’s revenue accounts. Both accounts are at the right side (credit side) of the bank’s balance sheet / income statement.

Depositor receives interest

The amount is added to one of the bank’s expense accounts, which is at the left side (debit side) of the bank’s income statement. The same amount is added to the depositor’s transaction account or savings account, either of which are at the right side (credit side) of the bank’s balance sheet.

Net profit appropriation

By the end of the accounting year, all the revenue accounts and cost accounts are summarised as the statement of profit and loss. Its bottom line is the net profit. Portions of the net profit will become corporation tax, dividends, additions to reserves or provisions, and strengthening of the capital base, of the bank’s own funds.

Draw-down from a loan

This may be the draw-down of the complete loan amount at once, which means the bank put it at the disposal of the borrower – or it may be a partial draw-down from a revolving credit.

The amount is added to the loan account, at the left side (debit) of the bank’s balance sheet.

The same amount is added to the borrower’s transaction account, which is at the right side (credit side) of the banks’ balance sheet.

This transaction causes money creation, because only the credit site is counted as monetary money (M1).

Redemption of a loan

The amount is subtracted from the borrower’s transaction account, which is at the right side (credit side) of the banks’ balance sheet.

The same amount is subtracted from the loan account, at the left side (debit) of the bank’s balance sheet.

This transaction causes money destruction, because only the credit site is counted as monetary money (M1).

Saver deposits amount

The amount goes from the saver’s transaction account to his savings account. Both are at the credit side (right side) of the bank’s balance sheet.

Depending on the exact conditions of the savings account and the definitions of the various monetary aggregates, this transaction will usually decrease M1 while M2/M3 remain the same (because M2/M3 also include money in demand deposits).

In terms of M1, this means money destruction.

Saver withdraws amount

The amount goes from the depositor’s savings account to his transaction account. Both are at the credit side (right side) of the bank’s balance sheet.

Depending on the exact conditions of the savings account and the definitions of the various monetary aggregates, this transaction will usually increase M1 while M2/M3 remain the same (because M2/M3 also include money in demand deposits).

In terms of M1, this means money creation.

Bank pays expenses

The amount is added to one of the bank’s expense accounts, which is at the left side (debit side) of the bank’s income statement. The same amount is added to the debtor’s (or in case the expense is a salary: the employee’s) transaction account, which is at the right side (credit side) of the bank’s balance sheet.

Bank pays out dividends

The amount goes from the net profit appropriation to the shareholders’ transaction account, which is at the right side (credit side) of the bank’s balance sheet.

Bank adds net profit to loan-loss reserves

The amount goes from the net profit appropriation to the loan-loss reserve account, which is at the right side (credit side) of the bank’s balance sheet.

Bank draws on loan-loss reserves

This can become necessary when part or all of a loan proves irrecoverable.

The amount is subtracted from the outstanding loan (debit, left side of the balance sheet) and eventually also subtracted (probably via an expense account) from the loan-loss reserve account, which is at the right side (credit side) of the bank’s balance sheet.

Bank adds net profit to capital reserves

The amount goes from the net profit appropriation to the equity capital, which is at the right side (credit side) of the bank’s balance sheet.

Conclusions

From the above we can see that the bank’s own funds, its equity, its capital (whatever you prefer to call it), is never lent out to the public. Not at interest and not interest-free. It just cannot happen.

When people write such things, it betrays their insufficient knowledge of business terminology and of the basics of accounting.

All the debit interest a bank receives, it either pays out as credit interest, or spends as expenses, or add to reserves or capital. None of the interest is ever relent back into circulation, simply because that is impossible from an accounting point of view.

Adding part of the interest margin, which results as net profits after subtraction of expenses, to the loan-loss reserves, does temporarily decrease the money supply.

In Ellen Brown’s words, this does “draw[ing] money out of the productive economy.” But only temporarily so: until the reserves are used for what they were built up for: to cover irrecoverable loans. Such cover by the way means that the other bank clients, those who do pay the interest due, pay the price.

If a bank adds part of its net profits to its capital, it is permanently withdrawn from the money supply. That is, except in the case of future losses, and when more dividends would be paid than there are net profits.


Notes

Note 1

Where Anthony Migchels uses the word “usury”, actually he simply means ‘interest’. Calling all interest usury is his way of expressing his propagandistic anti-bank attitude.

Note 2

This expression, about that a thought can live among people, is probably a Dutchism? But I’ll leave it in anyway, because I like it. Sorry ’bout that.


Copyright © 2013, 2015 R. Harmsen. All rights reserved.

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