However given my experience with the “average” citizen’s understanding of how the economy actually functions I will not be surprised if I shock a few people with the concepts I discuss below. At this stage I will try not to wander too far into the realm of the government as I want to leave that for another post.
Banking processes are important to understand because without them you have trouble reconciling other posts in the Macro 101 series.
Before I begin I need to introduce a little known monetary concept, types of money.
There are actually two types of “money” in a modern economy. There is “money” owned by the monopolist issuer, and there is other money. Money owned by the monopolist issuer is the only “money” that can be held in a reserve bank account. It is issued by the sovereign nation and is not backed up by any asset of corresponding value. This money is called “high power money” and is sometimes called “the monetary base”. I prefer to call it “money of exchange” for reasons I will discuss below. It is made up of bank reserves ( and equivalents ) and currency.
There is also another type of money called “credit money” which is sometimes called “money of account”. This is the money that is used within the walls of a financial institution but has no value to other financial institutions including the reserve bank.
Hopefully I have not confused you too much already. Please bear with me for just a little more background.
Unlike many other countries Australian banks have no reserve requirements. They are not required by legislation to hold any proportion of their deposits at the reserve bank. So anything you have heard about money multiplier theory is irrelevant to Australia. ( In fact it is irrelevant everywhere, but that is another story ). Banks in Australia have a capital requirement. To explain why I defer to the Reserve Bank of Australia(RBA).
An important part of the Bank’s prudential supervision of banks in Australia is the setting of capital adequacy guidelines with which banks must comply. A bank’s capital can be viewed as evidence of the willingness of shareholders to commit their own funds to a bank on a permanent basis, as interest free resources and, ultimately, as a cushion to absorb possible future losses. A strongly capitalised banking system engenders confidence in the banking and payments systems as a whole.
So how much capital do they actually require?
In line with international capital standards, Australian banks are required to maintain a ratio of capital to risk-weighted assets of not less than 8 per cent, with at least 4 per cent in core capital.
There are two type of capital in relation to capital requirements. Tier 1 capital ( otherwise known as “core” capital ) is basically stock ( at its current value ) and retained earnings. Those are earnings that have not been passed on as dividends to stock holders.
Tier 2 capital is basically loan-loss reserves ( known as “provisions” ) plus subordinated debt. Subordinated debt is long term debt that, in case of insolvency, is paid off after depositors and other creditors.
Assets held by the banks are risk weighted by their type and attributes. Risk weighting is actually fairly complex so I will simplify it for now. You can read APRA’s APS 112 Attachment C or check out the BIS site for an idea of how weightings are applied to various asset types.
Remember that loans are an asset to a bank while deposits are a liability. To simplify things lets say that currency and government securities are risk weighted at 0%, loans to other banks at 20%, residential mortgages at 75% and all other loans and lines of credit at 100%.
So if an Australian bank had $50 million in cash , $100 million in government securities, $150 million in interbank loans, $500 million in residential mortgages and $200 million in other loans then its risk weighted asset value would be $605 million. ($50m * 0% + $100m * 0% + $150m * 20% + $500m * 75% + $200m * 100%). As the banks requires 8% capital adequacy then this bank must have $48.4 million in capital to meet its requirement, with at least half of that value being Tier 1.
So now I have said all of that , let’s look at what happens when a loan is issued.
When a bank issues a loan of $250,000, it creates an asset and a liability on its balance sheet each of $250,000. The asset is the loan ( the IOU to be paid back by the mortgager) and the liability is the deposit that it creates in an intermediary account. This operation costs the bank nothing, just a few clicks of the mouse and a couple of taps on a keyboard and it has created $250,000 of “money of account” from nothing.
If the recipient of the loaned money is at the same bank then the bank simply transfers the money into that person’s account from the intermediary account and the transaction is complete. Again this cost the bank nothing. Overtime this loan will be paid back.; as it is the value of the asset ( the loan) will fall and the “money of account” will slowly be destroyed. It will go back to where it came from… Nowhere.
Although the issuance of the loan didn’t seem to cost the bank anything it can have 2 flow-on effects.
Firstly the loan is an asset; it therefore counts in the capital requirement calculations. The issuance of this loan may in turn require the bank to issue more subordinated debt and/or stock to cover its capital requirement position. I will not confuse this topic by discussing the implications of that.
Secondly, if the “money” from the loan needs to be transferred out of the bank then it must be converted from “money of account” into “money of exchange”. Remember “money of exchange” comes in two basic forms, currency and bank reserves. (Which are interchangeable).
If a member of the public wants to hold some “money of account” as cash, then the bank needs to transform it into “money of exchange” ( reserves ) in the form of currency. To do this it issues the person with the currency ( which lowers its reserves by that amount) and then lowers the person’s bank balance by the same amount ( lowering the banks deposit liability). When a person deposits currency at the bank the reverse occurs, the currency is converted into “money of account” by adding to the person’s account balance ( an increase in the bank’s deposit liability ) and the currency is added back to the bank’s reserves.
If the recipient of the loan is at another financial institution, then the lending bank must give up $250,000 of “money of exchange” and transfer it to the other institution. At the same time it removes its “money of account” deposit liability from its balance sheet.
Now the big question. How do banks actually “exchange” the “money of exchange”. The answer; through the reserve bank. Each Australian bank has an account at the reserve called an Exchange Settlement Account. These accounts are used to do all interbank transfers, but as I said at the top of the post, only “money of exchange” can be held in central bank accounts.
The RBA also stipulates that these accounts cannot not be overdrawn at the end of a banking day, and it is this little tiny rule that allows the government to control interest rates, or in other words the ” base price of money of exchange”.
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