Even so, to this day, what banks do is essentially a conjuring trick. In fact they do not wait for anyone to make a deposit before making a loan. If they think that the borrower looks creditworthy they simply open a bank account and declare that the borrower has those funds in it. As the Canadian-born economist JK Galbraith memorably put it: ‘The process by which banks create money is so simple that the mind is repelled. Where something so important is involved a deeper mystery seems only decent.’
Is the loan really money? Yes it is. The borrower can write a cheque, or make a bank transfer, on this amount to buy goods. If this transaction is with another customer of the same bank then the funds are transferred from one to the other. If the check is paid into an account in another bank much the same situation applies, except that there has to be an exchange between banks. In practice the major banks have a huge number of mutual transactions every day, most of which cancel out. But what if they do not? Enter the central bank.
Central banks
Each country that issues its own currency has a central bank. In the US, for example, this is the Federal Reserve. In Australia it is the Reserve Bank of Australia. In Canada it is the Bank of Canada. There are also central banks for countries that share a currency; in the case of the euro, this is the European Central Bank. While you might assume that central banks are government operations, in fact many started out as private companies. The Reserve Bank of India, for example, was established in 1935 as a private company, though it was nationalized at independence in 1949.
The oldest of the central banks is the Bank of England which was founded in 1694 by a Scotsman, William Paterson. At that time the King of England, William III, also known as William of Orange, was in dire need of funds, not least because of his frequent quarrels with France. Paterson came up with a solution. He would create a new bank and sell shares in it. Then he could lend all the proceeds to the King, who could use these funds to fight the French. Paterson’s proposal went down well. The King awarded the Bank of England a Royal Charter and promptly borrowed all the capital – £1.2 million. Previously all banks had been privately owned. Paterson’s Bank of England, however, was to be a ‘joint stock’ company. This meant that it would not only raise its initial capital funds by selling shares but would also be a ‘limited’ company, so if it collapsed its owners would not have to pay debtors out of their own pockets – they had limited liability, in other words.
At the same time the Bank of England was a commercial operation that could take deposits and make loans. The fact that the King had already walked off with all the bank’s subscribed funds, and thus its capital, was not a problem since he had left an IOU. The King was a decent credit risk and was likely to repay eventually, if only by taxing his citizens. This meant that the shareholders got double value for their investment. First, the King was paying interest on the loans. Second, based on his £1.2 million the bank could lend out the same amount in banknotes – it could ‘monetize’ the debt for other profitable lending through the issue of Bank of England banknotes. King William was much impressed by this wizardry and wanted further loans, requiring the Bank to raise yet more capital by selling more shares. The Bank of England had thus issued the notes that formed the British money supply based on a royal debt. To this day the British Crown has not repaid this. Indeed, it has been argued that, if it did, the entire British monetary system would collapse.3
The new Bank of England maintained a reputation for sound management. It ensured that it always kept enough coins on hand so that anyone who presented one of its notes was promptly repaid in silver or gold coins. But since the bank had government backing, few people actually tried to redeem their notes. At that point other English banks were also still issuing notes, but these were considered less reliable and thus less acceptable for payment. Soon most of the notes in circulation were those of the Bank of England. Nevertheless, it did occasionally run into problems after it issued large numbers of notes and at one point was forced temporarily to suspend the right of bearers to redeem their notes for gold or silver. To correct this tendency to overlend, in 1844 a new Bank Charter established that the Bank could only print additional notes that corresponded to the gold and silver that it maintained in its vaults – akin to what would later be called the ‘gold standard’.
At that point, in most respects, the Bank of England remained just one commercial bank among many. In time, however, it started to take on what we now recognize to be the functions of a central bank. Not only did it have a quasi-monopoly on the right to issue paper money, it also became responsible for the control of other banks.
Nowadays, if any company wants to become a bank, they need a banking licence. This brings certain privileges but also a degree of regulation. The main privilege is that they can create deposits out of thin air and lend them to customers. Other institutions, such as savings and loan institutions, are allowed to make loans but these have to be with funds that have been saved with them. They are not allowed to create money. A banking licence thus sounds like a licence to print money, and in many respects it is.
But there are limitations. One is that every licensed bank is required to maintain a substantial sum at the central bank in the form of ‘central bank reserves’. Another is a requirement for the bank to hold enough ‘liquid assets’ to meet potential withdrawals – which could be central bank reserves or government bonds or cash. Originally in the UK this was fixed as a set percentage or ‘fraction’ of all its outstanding loans. Should the percentage drop below this critical level, it would need topping up, by offering the central bank government bonds, for example, or by borrowing from the central bank at the prevailing interest rates. This system is known as ‘fractional reserve banking’. The UK subsequently dropped this reserve ratio and instead now tries to achieve the same thing by requiring important banks to pass a ‘stress test’, to check that they can withstand a crisis. Other countries, including the US, still maintain such a ratio, also called a liquidity ratio, of around 10 per cent. Canada and Australia, like the UK, do not.
This also addresses the issue of how to resolve payments between banks. If one bank owes a net amount to another, this can ultimately be settled by making transfers between their reserve accounts at the central bank.
Pulling the monetary levers
In countries such as India, where the state owns many of the banks that lend funds to the general public, it is easy enough for the government both to dictate to banks and to control the money supply. In most developed countries, however, the banks have largely been independent commercial enterprises so the central bank has to exert control indirectly. Although the terminology differs from country to country, the means are more or less common.
The first lever of control is through interest rates. Interest rates can be thought of as the charge for renting out money. If you were renting someone a car you would take into account many factors. What is the risk that the renter might drive off into the sunset and never return? What could I otherwise have done with the car during that time? Will the engine wear out during that period? What are other people charging for that kind of car?
Renting out money involves similar considerations. You have to assess the risk that the borrower might default or disappear. You have to consider the rate of inflation, and thus the likelihood that when you get your money back it will be worth less. And of course you have to check what your competitor banks are offering since they might undercut your rates.
Within these constraints, banks can charge whatever they like. But they are also influenced by what the central bank declares to be the ‘minimum lending rate’ – in the US the ‘discount rate’. This is the rate at which the central bank will lend to the commercial banks. They may, for example, need to borrow from the central bank if they have to boost their central bank reserves, or they need a reliable source of ready cash should they be faced with a sudden bout of withdrawals. The commercial banks can smooth out some of these daily fluctuations by borrowing from each other, but they also have the option of borrowing from the central bank. Commercial banks making loans to their customers will generally use the central bank rate as a starting point, while adding a percentage point or two to cover their expenses, the likelihood of default, and the desired profits.
Interest rates