The underpinnings of the modern financial system are not sexy but they are certainly important.
I’ve spent many hours digging into the financial basement, getting my head around inter-bank payment systems, foreign exchange settlement arrangements, the fine print of derivatives contracts, and the normally unseen workings of banks and trading platforms.
Financial inventor Ian Shepherd led me down there. Shepherd is an international expert in payment systems and the design of financial markets. His ‘Alice market’ was the subject of the famous 2014 US Supreme Court case Alice v. CLS. It is also the subject of my 2024 book, Alice.
As a relative novice in the basement, I was struck by the gulf between how money, banking and finance are commonly understood and how things actually work down at the foundations.
To help explain the gulf, here’s a quick bit of ‘Money and Banking 101’.
The word ‘money’ refers to many different things including coins, banknotes, bank deposits and bank ‘reserves’. Right now, coins and banknotes are becoming less and less important as a form of money — so much so that armoured transport companies are going out of business.
Bank deposits (including checking and savings accounts) are by far the most important category of money. They are the dominant form used in financial markets, for example, and they are the principal means by which taxes are paid and goods and services are bought.
Many people (including more than a few academics and financial journalists) assume bank deposits as a form of money are analogous to coins and banknotes. In particular, people often assume that once created, bank-deposit money persists over time, circulating through the economy and remaining largely unchanged as it circulates.
When speaking of everyday banking, people use phrases such as ‘putting money in my account’; and they conceive of inter-bank transfers as involving the movement of money from one account to another. This kind of phrasing is nearly universal, and it is part of an intuitive and widely held view of banking.
The concept of ‘fractional reserve banking’ is central to that view. According to this idea, commercial banks use a proportion of their customers’ deposits to make loans, while holding back some of the money as reserves, for use when needed, such as if there is a shortage of money to cover requests for withdrawals.
In a ‘run’ on deposits, as it is generally understood, a bank is at risk because money in deposit accounts is not immediately available to return to customers; much of the money has been ‘lent out’, and the bank cannot ‘call in’ loans quickly enough to satisfy the demand for withdrawals.
The intuitive understanding of money also extends to taxation and public finance. In that understanding, the tax collecting authorities gather money that is then used for various public purposes, principally government spending.
Viewed from the level of the financial plumbing and individual payment steps, the intuitive view of money and banking breaks down. The reality is very different.
At the most fundamental level, for example, the ‘money’ in a bank account has no separate existence from the stated account balance, which is effectively a record of an IOU from the bank. A positive deposit account balance is no more than a record of the deposit holder’s status as an unsecured creditor of the bank.
Contrary to a common belief, bank deposits are not and cannot be used as the basis for loans. When loans are created, the associated balances are created anew, not out of existing deposits or some other form of money. Banks do not intermediate between borrowers and lenders, and nor do they hold a proportion of customer deposits as reserves. ‘Fractional reserve banking’ is neither a useful nor accurate description of how modern banking works.
Banks don’t gather deposits to make loans — and nor do they collect repayments to use as the basis for new loans or for other purposes. When a bank receives repayments, those funds cancel out a proportion of the money that was created when the loan was first written. The money used for the repayments therefore ‘disappears’ at the moment they are made.
In advanced, monetarily sovereign countries (such as the US, Japan, Sweden, Australia, Canada and New Zealand), bank ‘reserves’ are ‘exchange settlement account’ (ESA) balances held with the relevant central bank. The ESA balances operate as units or tokens for inter-bank settlement of payments. (Many inter-bank payments are settled with ESAs on a net basis, just as cheques have been netted between banks since the nineteenth century.)
Again contrary to intuition, an inter-bank ‘transfer’ does not involve moving money from an account at one bank to an account at another. Instead, the original deposit (an IOU from the first bank) is cancelled, and a new deposit (an IOU from the ‘receiving’ bank, which may have different creditworthiness) is created. The ‘transfer’ can only take place if the first bank has sufficient ESAs to cover the transfer in net terms.
If a bank suffers a ‘run’ on deposits, the outflow of deposits is not what puts the bank at risk. The deposits are a liability for the bank, and they are not intertwined with the bank’s loans, which are its principal asset. The bank can, however, experience an acute shortage of ESAs due to the outflow of deposits, and therefore the bank may be unable to settle the netted inter-bank transfers. Therein lies the danger of a run.
Public finance is also materially different when viewed from the basement.
The truth of taxation is a long way from the intuitive idea of tax authorities gathering money that is then used for various public purposes. The overwhelming majority of national-level taxation is paid using bank deposit money; and the somewhat striking reality is that the money paid to acquit tax liabilities disappears at the time of payment. Taxation is a process of money destruction, not money collection.
Likewise, government borrowing (such as through the sale of bonds) involves the temporary destruction of bank deposit money. The destruction is temporary because, over the life of the bond, money is created for coupon payments; and then, at the time of the bond’s maturity, money is created to pay the bond’s face value.
People are primed to think of money moving from banks into the government’s ‘coffers’. In reality, while governments make an accounting record (in the ‘treasury general account’ or its equivalent) of the amount of money destroyed through taxation, the coffers are just metaphorical. They don’t exist and neither do their contents. The treasury general account balance does not correspond to a stock of money held at any given time.
So what? Why are these differences in understanding important?
If we ditch the idea that deposits are the basis for loans, numerous innovations present themselves, including lending-only and deposit-only institutions, and new, more effective modes of prudential regulation.
For investors and other participants in financial markets, the clearer view of money and banking makes the job of valuing banks much simpler; and in the event of bank failures, it makes the job of receivers and administrators much easier.
The basement view of taxation implies a powerful shift in the understanding of fiscal budgeting. Specifically, it shows that the real constraint on government spending is not the amount of money ‘collected’ via taxation. Rather, the constraint is the amount of money creation that the economy can tolerate without generating excessive inflation.
In advanced economies, money is created in multiple ways: through government spending; through central bank asset purchases; and via private bank loan creation. But not all money creation is equal. Creating money to build essential infrastructure and to fund essential public services is not the same, for example, as creating money inside private banks for financial speculation.
Keynes and Friedman might roll in their graves if they hear this, but viewed from the basement, fiscal and monetary policy are not all that different from each other. Both involve money creation and both operate within an inflation constraint. This affinity underlines the importance of adopting a holistic approach to macroeconomic policy — one that considers the aggregate, consolidated financial position of the executive branch of government plus the central bank; and one that involves using fiscal and monetary levers in concert.
Improving the general understanding of money, banking and taxation is essential at a time when central banks are experimenting with digital currencies, billionaires are looking to control the payments system, and governments are looking to improve macroeconomic management.
Sometimes, it seems, the best view is the one from the basement.
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