My Big Book of Modern Banking
Jul. 30th, 2011 11:12 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
peristaltorI'm still obsessing over my theory about the mechanism banks use to literally create money for themselves regardless of the overall economy's need for that money's creation. I decided to try my hand here at turning the story of banking into a picture book.
This is a dollar.
Let's see how more are made. In the United States, dollars are made in banks, specifically in commercial or depository banks, commonly referred to as Savings and Loan banks.
This is a bank.
When doing business, these banks take money from depositors and keep it safe for them in a, well, safe. Since we all know what safes look like, we'll simplify a bit and show the deposits simply inside the bank, being kept safe.
Safe and Sound.
Now we come to the legally approved magic, the actual mechanism that adds dollars to our economy. For every dollar the bank holds as a deposit, the bank can create money for lending. Though these dollars are exactly the same as the dollars brought into the bank by depositors, we'll shade these newly lent dollars a bit differently to indicate that the bank just created them. New dollars are a whiter shade of green. Let's also assume a ten percent fractional reserve requirement. This means the bank can only lend a maximum ten dollars for every dollar they have in reserves.
I've only showed you eight dollars being loaned for every dollar of reserves simply because in real life one always has to have some "wiggle room." What if someone needed some or all of the money they had on deposit? What if one of the borrowers failed to pay, what the bank calls a "default?" By keeping more money in reserves than the law allows, the bankers are being "prudent." A prudent banker will probably stay in business longer than a reckless one. (Probably.)
Something else needs to happen when the bank lends money into existence. It needs to secure the loans. The most common security is the item being purchased by the lender with the loan. We'll put some of these items in the bank's ledgers, the records the bank must keep to show that it remains a good bank in the eyes of the law.
Here is a ledger showing the assets the bank holds as collateral on the left, and the liabilities the bank has on the right.
Nice and Balanced.
As you can see, in this case a "liability" is the money the bank lends to the borrower. (I should have made that money less green like the money being lent in the last picture. Sorry.) The "asset" in this case is not literally the houses or farm equipment, but rather the Note that legally secures the asset for the bank. Until that loan is completely paid off, the bank will hold on to the Note. Should the borrower fail to pay the loan in full, the bank can exercise its legal right to foreclose on the collateral, taking the property purchased by the loan and selling it to bring the bank's books once again into order.
There is another kind of lending we should mention here: Lines of credit. Lines of credit are most familiar to people who hold and use credit cards. The interest charged on these are (generally) larger than collateralized loans simply because the bank is taking a bigger risk. With no asset on which it can foreclose or repossess, the bank is relying on the borrower's ability — and willingness — to pay back his or her charges on the credit line. Because this kind of borrowing lacks the security of an asset held as collateral, it is called "unsecured lending."
This is how things should work.
A question should be bubbling up from the back of your heads right now: Why should we care? It's a good question. It should be asked.
You may have heard of a man touted quite a bit in economic circles, Adam Smith. He wrote The Wealth of Nations, a book widely regarded as starting the modern interest in economics as we know it. His most famous phrase from that book — a phrase he used exactly once — is the "invisible hand." He notes that as we trade, purchase, sell, and in general do what we do with all the people around us, exactly as much stuff (more or less) gets made as is needed. This invisible hand of self-organization is exactly the phenomenon noted by Steven Johnson in his book Emergence and James Surowiecki in his The Wisdom of Crowds. We humans have an uncanny ability, when free of overt restraint or influence, to organize ourselves and our affairs quite without planning.
In this way, we should look at the act of lending as putting money not just into "the economy," but into something so complex as to be difficult to understand. When a bank creates money for a borrower and the borrower uses that money to make a purchase, these are but the first steps in a path the borrowed dollars follow that, should the economy be functioning well, lead back to the borrower and ultimately the bank in the form of loan payments. Really, it's difficult to follow the path of every single dollar. Think of that path as some consider the internet today, as a cloud of transactions too numerous to track. As with clouds, where just about every molecule of water in clouds eventually falls as precipitation, every dollar may fall in someplace different than its origin, but fall it will, and should eventually make its way back to the bank. Sometimes the money comes more quickly and sometimes more slowly, but the money circulates and pools and finds its way back.
Just like the rain.
I'm worried, though, that today banks have taken it upon themselves to re-order the path some of its lending activity has taken. To understand that, we must first understand another kind of banking, investment.
We really don't need graphics to understand investment banking. A few smart traders gather their resources together and pool them. They hire a few more smart traders and open an investment house. Though they are called banks, I think I will only call them "houses" or (if they are a smaller part of a larger organization) "desks" from here on, simply to avoid confusion.
Once established, the owners of these houses announce that they are able through investing to increase people's money beyond what a regular bank's small interest rate will provide. All they have to do is bring in their extra money, and that money will be wisely invested in all kinds of ways. The house will take that money and buy stocks in companies, bonds of all sorts, futures contracts — whatever investment the traders think will best make a positive return. As long as the market is rising (as it mostly is), or the traders invest in rising assets before a boom-and-bust cycle happens (as they sometimes do), the investor will make more than the few measly percent offered in a standard savings account.
Very importantly, all of the money circulated by an investment house will be existing money. None of it will have been created through lending. Lawmakers had, in fact, officially separated the two types of banks back in 1932 when they passed The Glass-Steagall Act of 1932.
Starting in about 1983, though, the banks started to ignore that separation between the two banks. Under President Reagan, who didn't really support government oversight of banking, they got away with flouting the restrictions set in 1932. Finally, the restrictions were officially removed with passage of the Gramm-Leach-Bliley Act, or Financial Services Modernization Act of 1999. After that bill passed into law, larger banks were legally allowed to open their own investment operations (called "proprietary trading desks") and through them to buy and sell speculative instruments like bonds, stocks, futures contracts and the like.
What very few people discuss, however, is why they do this. Here's my idea. I'd like to emphasize that all of this is completely speculative on my part, but that I haven't been shown any evidence to suggest that my theory isn't plausible.
Let's get back to that bank, with money in the vaults and loans flying hither and nigh. Let's add a prop trading desk to the image to complete the picture allowed by Gramm, Leach, Bliley and all those that helped passed their bill into law. Supposedly, all that desk does is accept money from outside investors and use it to purchase what every investment house purchases.
But what if this isn't the case?
What if we added another pale blue arrow of lending to indicate a line of credit extended from the bank to its proprietary trading desk? Furthermore, what if we personalized the institution just a bit? This might help clarify later illustrations. Instead of just a "BANK," let's call it something nice.
Remember, for every dollar the bank held as capital, it could lend up to $10 assuming a 10% fractional reserve. Remember also that the earlier "prudent" banker refrained from lending $2 of that possible $10, just to make sure money was left in case "something happened." Why, then, would a prudent banker use a bit of the cushion, a bit of the leeway (as we mariners call it) to invest in stocks and bonds? Wouldn't that be imprudent, especially for stocks, items that are a bit of a gamble in a normal universe?
It would, it would. But, as I hope to show, this is not a normal universe.
Let's assume this theoretical bank of ours — well, of Bob's — is not alone. Other banks exist. Some of them are large enough to also start proprietary trading desks. Let's say they make a deal. Let's say the guys at Bob's and Jon's desks call each other and agree to a swap of some sort. Let's say each of them has a large holding and would like to insure it against loss.
"Hey, Ron!" says Don at Bob's, "We'd like some 'insurance' against our General Motors stock."
"Say, Don!" says Ron at Jon's, "We'd like some 'insurance' against our AIG stock."
Ron and Don and Jon's and Bob's each write up a contract called a credit default swap, which, as the wiki explains, "is a form of insurance which protects the buyer of the CDS in the case of a loan default." I put "insurance" in scare quotes because banks and investment houses don't actually have to have enough money on hand to pay out should one of these CDSs actually have to be enforced.
In fact, if you think about it, prior to the banking crisis very, very few people thought either GM or AIG would ever go under. Why would any self-respecting investment banker want to insure assets that have very little perceived risk of default — if any? Here's where my theory explains what may have happened. This is how the contracts and money for them would be exchanged:
It would be a swap in every sense of the word. Remember, though, that the money flowing to each bank is good money, not newly-loaned and ethereal. It doesn't go "into the cloud" of the economy like most of the loaned money the banks produce. Instead, it goes straight into the vaults of the respective banks. As soon as that dollar from Jon's Bank gets into the vault, Bob's Bank can use it almost immediately to back future loans, as can Jon's with Bob's. Ron and Don have made a few million a month for their employers in pure profit, but put almost nothing at risk, all by avoiding sending the loaned money into any cloud. They have moved away from that annoyingly risky invisible hand.
Which is exactly what should never happen.
I'd truly like to know if my theory has any credence whatsoever. So few people understand how banking creates money (especially those supposedly tasked not just with understanding it, but with explaining to others how everything works, like the media) that very few even understand the principals, let alone how those principals can be manipulated for increasing the supply of money dramatically over the last eight years before the crash. I'm finding it an amazingly difficult topic simply to broach in conversation, let alone check for veracity.
Ah, well. I may return to my kitchy illustrations, especially if any of you out there have any suggestions that might clarify the message they attempt to convey.
Again, ah well.
This is a dollar.
Let's see how more are made. In the United States, dollars are made in banks, specifically in commercial or depository banks, commonly referred to as Savings and Loan banks.
This is a bank.
When doing business, these banks take money from depositors and keep it safe for them in a, well, safe. Since we all know what safes look like, we'll simplify a bit and show the deposits simply inside the bank, being kept safe.
Safe and Sound.
Now we come to the legally approved magic, the actual mechanism that adds dollars to our economy. For every dollar the bank holds as a deposit, the bank can create money for lending. Though these dollars are exactly the same as the dollars brought into the bank by depositors, we'll shade these newly lent dollars a bit differently to indicate that the bank just created them. New dollars are a whiter shade of green. Let's also assume a ten percent fractional reserve requirement. This means the bank can only lend a maximum ten dollars for every dollar they have in reserves.
I've only showed you eight dollars being loaned for every dollar of reserves simply because in real life one always has to have some "wiggle room." What if someone needed some or all of the money they had on deposit? What if one of the borrowers failed to pay, what the bank calls a "default?" By keeping more money in reserves than the law allows, the bankers are being "prudent." A prudent banker will probably stay in business longer than a reckless one. (Probably.)
Something else needs to happen when the bank lends money into existence. It needs to secure the loans. The most common security is the item being purchased by the lender with the loan. We'll put some of these items in the bank's ledgers, the records the bank must keep to show that it remains a good bank in the eyes of the law.
Here is a ledger showing the assets the bank holds as collateral on the left, and the liabilities the bank has on the right.
Nice and Balanced.
As you can see, in this case a "liability" is the money the bank lends to the borrower. (I should have made that money less green like the money being lent in the last picture. Sorry.) The "asset" in this case is not literally the houses or farm equipment, but rather the Note that legally secures the asset for the bank. Until that loan is completely paid off, the bank will hold on to the Note. Should the borrower fail to pay the loan in full, the bank can exercise its legal right to foreclose on the collateral, taking the property purchased by the loan and selling it to bring the bank's books once again into order.
There is another kind of lending we should mention here: Lines of credit. Lines of credit are most familiar to people who hold and use credit cards. The interest charged on these are (generally) larger than collateralized loans simply because the bank is taking a bigger risk. With no asset on which it can foreclose or repossess, the bank is relying on the borrower's ability — and willingness — to pay back his or her charges on the credit line. Because this kind of borrowing lacks the security of an asset held as collateral, it is called "unsecured lending."
This is how things should work.
A question should be bubbling up from the back of your heads right now: Why should we care? It's a good question. It should be asked.
You may have heard of a man touted quite a bit in economic circles, Adam Smith. He wrote The Wealth of Nations, a book widely regarded as starting the modern interest in economics as we know it. His most famous phrase from that book — a phrase he used exactly once — is the "invisible hand." He notes that as we trade, purchase, sell, and in general do what we do with all the people around us, exactly as much stuff (more or less) gets made as is needed. This invisible hand of self-organization is exactly the phenomenon noted by Steven Johnson in his book Emergence and James Surowiecki in his The Wisdom of Crowds. We humans have an uncanny ability, when free of overt restraint or influence, to organize ourselves and our affairs quite without planning.
In this way, we should look at the act of lending as putting money not just into "the economy," but into something so complex as to be difficult to understand. When a bank creates money for a borrower and the borrower uses that money to make a purchase, these are but the first steps in a path the borrowed dollars follow that, should the economy be functioning well, lead back to the borrower and ultimately the bank in the form of loan payments. Really, it's difficult to follow the path of every single dollar. Think of that path as some consider the internet today, as a cloud of transactions too numerous to track. As with clouds, where just about every molecule of water in clouds eventually falls as precipitation, every dollar may fall in someplace different than its origin, but fall it will, and should eventually make its way back to the bank. Sometimes the money comes more quickly and sometimes more slowly, but the money circulates and pools and finds its way back.
Just like the rain.
I'm worried, though, that today banks have taken it upon themselves to re-order the path some of its lending activity has taken. To understand that, we must first understand another kind of banking, investment.
We really don't need graphics to understand investment banking. A few smart traders gather their resources together and pool them. They hire a few more smart traders and open an investment house. Though they are called banks, I think I will only call them "houses" or (if they are a smaller part of a larger organization) "desks" from here on, simply to avoid confusion.
Once established, the owners of these houses announce that they are able through investing to increase people's money beyond what a regular bank's small interest rate will provide. All they have to do is bring in their extra money, and that money will be wisely invested in all kinds of ways. The house will take that money and buy stocks in companies, bonds of all sorts, futures contracts — whatever investment the traders think will best make a positive return. As long as the market is rising (as it mostly is), or the traders invest in rising assets before a boom-and-bust cycle happens (as they sometimes do), the investor will make more than the few measly percent offered in a standard savings account.
Very importantly, all of the money circulated by an investment house will be existing money. None of it will have been created through lending. Lawmakers had, in fact, officially separated the two types of banks back in 1932 when they passed The Glass-Steagall Act of 1932.
Starting in about 1983, though, the banks started to ignore that separation between the two banks. Under President Reagan, who didn't really support government oversight of banking, they got away with flouting the restrictions set in 1932. Finally, the restrictions were officially removed with passage of the Gramm-Leach-Bliley Act, or Financial Services Modernization Act of 1999. After that bill passed into law, larger banks were legally allowed to open their own investment operations (called "proprietary trading desks") and through them to buy and sell speculative instruments like bonds, stocks, futures contracts and the like.
What very few people discuss, however, is why they do this. Here's my idea. I'd like to emphasize that all of this is completely speculative on my part, but that I haven't been shown any evidence to suggest that my theory isn't plausible.
Let's get back to that bank, with money in the vaults and loans flying hither and nigh. Let's add a prop trading desk to the image to complete the picture allowed by Gramm, Leach, Bliley and all those that helped passed their bill into law. Supposedly, all that desk does is accept money from outside investors and use it to purchase what every investment house purchases.
But what if this isn't the case?
What if we added another pale blue arrow of lending to indicate a line of credit extended from the bank to its proprietary trading desk? Furthermore, what if we personalized the institution just a bit? This might help clarify later illustrations. Instead of just a "BANK," let's call it something nice.
Remember, for every dollar the bank held as capital, it could lend up to $10 assuming a 10% fractional reserve. Remember also that the earlier "prudent" banker refrained from lending $2 of that possible $10, just to make sure money was left in case "something happened." Why, then, would a prudent banker use a bit of the cushion, a bit of the leeway (as we mariners call it) to invest in stocks and bonds? Wouldn't that be imprudent, especially for stocks, items that are a bit of a gamble in a normal universe?
It would, it would. But, as I hope to show, this is not a normal universe.
Let's assume this theoretical bank of ours — well, of Bob's — is not alone. Other banks exist. Some of them are large enough to also start proprietary trading desks. Let's say they make a deal. Let's say the guys at Bob's and Jon's desks call each other and agree to a swap of some sort. Let's say each of them has a large holding and would like to insure it against loss.
"Hey, Ron!" says Don at Bob's, "We'd like some 'insurance' against our General Motors stock."
"Say, Don!" says Ron at Jon's, "We'd like some 'insurance' against our AIG stock."
Ron and Don and Jon's and Bob's each write up a contract called a credit default swap, which, as the wiki explains, "is a form of insurance which protects the buyer of the CDS in the case of a loan default." I put "insurance" in scare quotes because banks and investment houses don't actually have to have enough money on hand to pay out should one of these CDSs actually have to be enforced.
In fact, if you think about it, prior to the banking crisis very, very few people thought either GM or AIG would ever go under. Why would any self-respecting investment banker want to insure assets that have very little perceived risk of default — if any? Here's where my theory explains what may have happened. This is how the contracts and money for them would be exchanged:
It would be a swap in every sense of the word. Remember, though, that the money flowing to each bank is good money, not newly-loaned and ethereal. It doesn't go "into the cloud" of the economy like most of the loaned money the banks produce. Instead, it goes straight into the vaults of the respective banks. As soon as that dollar from Jon's Bank gets into the vault, Bob's Bank can use it almost immediately to back future loans, as can Jon's with Bob's. Ron and Don have made a few million a month for their employers in pure profit, but put almost nothing at risk, all by avoiding sending the loaned money into any cloud. They have moved away from that annoyingly risky invisible hand.
Which is exactly what should never happen.
I'd truly like to know if my theory has any credence whatsoever. So few people understand how banking creates money (especially those supposedly tasked not just with understanding it, but with explaining to others how everything works, like the media) that very few even understand the principals, let alone how those principals can be manipulated for increasing the supply of money dramatically over the last eight years before the crash. I'm finding it an amazingly difficult topic simply to broach in conversation, let alone check for veracity.
Ah, well. I may return to my kitchy illustrations, especially if any of you out there have any suggestions that might clarify the message they attempt to convey.
Again, ah well.