EDITOR NOTE: Banks have always served as a cornerstone to a nation’s economic development. Facilitating transactions between citizens, merchants (today’s businesses), and government, the banking system has also played a key role in the expansion of money and credit. In today’s digital era, banks are about to undergo a massive set of changes--one coming from the past and the other looking toward the future. A significant part of the international Basel III accord is the re-introduction of gold as a Tier 1 asset. Meanwhile, on a seeming collision path, the development of central bank digital currencies (CBDCs) threatens to usurp the power and function that banks have held for centuries. How banks will navigate through these changes and banking priorities is a matter of speculation--it’s too early to measure the impact, negotiations and interventions between banks and government, and the banking system’s response. As for how gold and silver will fare, we can assume it’s going to be as steady as it has been over the last 2,000 years--that it stands above the monetary mess created by those who complicate the principles of value, trade, and lending.
The introduction of both Basel 3 banking regulations and central bank plans for digital currencies will affect commercial banks' priorities and their role in the overall financial system. Basel 3, particularly with regard to the application of the net stable funding ratio (NSFR), will change banking priorities by imposing standardized risk factors across the industry, and central bank digital currencies (CBDCs) threaten to cut the banks out of their intermediary role between central banks and non-financial users of money and credit.
Few members of the public think positively about the banks and their cartel, so popular opinion is unlikely to shed many tears if CBDCs displace them. Ever since the goldsmiths in London began in the seventeenth century to take in deposits upon which they paid six percent, with the agreement that they were not trustees of the money but proprietors of it, banking has contravened the spirit of Roman law by taking in deposits and using them as they please, without depositors fully realizing the arrangement. This breach of "natural" law was originally a ruling by the Roman juror, Ulpian (170-228 AD), later codified by Emperor Justinian (527-565 AD).
Ulpian had a point. If a depositor is unaware that his property is to be possessed by another without a banking licence, even today it would be ruled in the courts as fraudulent behaviour. But in 1848 English Judge Lord Cottenham in Foley v. Hill and others ruled otherwise in the case of banking relationships, that a deposit becomes the property of the bank, despite the majority of depositors unaware they no longer possess it. Ever since the practice of a bank taking into its possession someone else's property and disposing of it as it sees fit has been indisputably accepted in banking law.
For classical economists, banks are responsible for a credit cycle, first accelerating progress unsustainably and then halting it as the negative consequences of credit expansion manifest themselves. Keynesians, who fail to associate periodic banking crises with an earlier credit expansion, believe that money and credit should be guided by the state, blaming free-market shortcomings for economic failures. Then there is the public perception of bankers being too ready to deny honest folk credit while paying themselves massive bonuses -a malevolent combination that particularly fuelled the political narrative following the Lehman failure. From every angle, banks appear to be always under attack.
From a banker's perspective, the political narrative, in particular, has to be controlled, which is why banks are such large contributors to campaign funds in America. Their political influence in other jurisdictions is on similar lines as those of other businesses, mainly through lobbying, which might be less obvious to the public but is just as effective. Politicians, central banks, and regulators all consult the banks before introducing regulatory changes and it is the lawyers employed by large banks who often end up setting the regulatory agenda.
The introduction of Basel 3 NSFR regulations has followed a different course from national regulatory evolution, broadly independent from these influences. Framing supranational regulations at the behest of the G20, the Basel Committee is broadly unaffected by bank lobbying and the lobbying of national politicians and their regulatory bodies. In the wake of the Lehman failure, both the brief and the objective were simple: to ensure that the risk of one bank failure leading to others was to be prevented. After much delay (the final NSFR regulations were published in October 2014) this aspect of Basel 3 is now being implemented.
Whether they succeed in their objective remains to be seen. It has always been possible for national regulators to soften some aspects of Basel regulations in minor ways. But it appears to be a reasonable attempt at ensuring that the financing of illiquid, or risky assets is not overly dependent on liquid deposits.
Contrasting with the imposition of a global regulatory standard under Basel 3, central bank digital currencies (CBDCs) are still at the concept stage. The possibility of central banks issuing a new form of a fiat currency directly to the general public or sections of it is being discussed by central banks in the context of directing the application of extra currency to stimulate those parts the expansion of commercial bank credit does not appear to reach. Alternatively, the issuance of a CBDC might be available to promote specific economic and political objectives, such as for the benefit of businesses and activities associated with climate change. It is certainly less controversial than paying for costly political projects with additional taxes.
The production and dissemination of CBDCs are massive projects, requiring all businesses and consumers to have accounts with an agency under the direct control of the central bank. The coordination of tax, welfare, and other state records will be required to ensure all accounts created for CBDCs are genuine and eligible for whatever the central bank dictates from time to time. It will require consumers and businesses alike to cede control over their activities to the state, raising deep issues of personal freedom. It would almost certainly require central banks to be more accountable to politicians, undermining the concept of their independence from political influences.
It would appear that CBDCs are a long-term project still in its early stages, pregnant with issues not easily addressed and requiring extensive, controversial legislation.
The current role of the banks
There are significant misunderstandings to be corrected about the role of banks in the economy. Both their users and their regulators seem either unaware of a commercial banker's true motivation, or only view one aspect of banking while ignoring others.
It is usual for depositors to believe they have deposited money with their bank, when in fact they have transferred credit to the bank's possession. Even if they have paid physical cash into their bank, they have not contributed to a deposit. Instead, they have increased the bank's liability to them, and the bank will use these balances as it sees fit. The ultimate test is what happens if the bank is declared insolvent. The depositor will then find he or she is simply a creditor.
Of course, there are depositor protection schemes in some jurisdictions, but it can be argued that they are to protect the banks from old-fashioned runs rather than protecting depositors. Importantly, a depositor protection scheme insulates banks from its depositors' anticipation of impending failure. Combined with the exclusivity of being granted a banking licence, a bank's sense of responsibility to service the needs and wishes of its deposit customers is substantially reduced by deposit protection schemes. The amelioration of a bank's responsibility to its current and future depositors encourages a cavalier approach to its own reputation.
In effect, regulators have sought to make banking risk depositor-proof as a matter of policy. Both regulators and central banks view commercial banks as intermediaries between depositors and borrowers, and all their licensing, regulation, and monetary policy is with this belief in mind. But as can be seen from Foley v. Hill and others the legal facts are otherwise, with depositors having no rights over their former property.
Despite the facts, the conventional understanding is that banking is the negotiation for interest between depositors and borrowers. Only those who lend the money of others are bankers. And so long as its borrowers repay the bank before the money is due to be returned to the depositors, the bank will remain solvent. With depositors generally able to withdraw deposits at little or no notice, and with loans being less liquid in their repayment solvency, maintaining solvency until Basel 3 has been seen to be mostly a matter of experience and calculation by bankers.
Only a small portion of the original source of these deposits is money itself. Most of it originates as credit, from payments, salaries, the sales of goods and services, and the like, whose origin from other bank accounts. When tracing it back even further, we must note that money is the one good that is not consumed and that a current payment is the result of a series of payments which in all cases originated from bank credit where the payment is not made in cash. And even cash is in fact credit when it is not specie, in this case, drawn from a central bank and a liability to it.
We can approximately estimate credit originally drawn on a central bank distinguished from credit originating from a commercial bank. Total payments in the non-financial sector relate to an economy's gross output. Gross output is the sum of all transactions which cover the intermediary steps of the production of goods and services up to and including final sales to consumers. In the case of the USA, this was approximately $39.5 trillion in the year ending Q1, 2021[i]. The Fed's monetary base at that time was $5.8 trillion, which tells us that by nearly seven times the origin of payments could be deemed to originate from bank credit compared with credit originating from the Fed.[ii] In the past the ratio was in fact far higher. Before the Fed increased its balance sheet as a response to the financial crisis of 2008-09, payments originating from bank credit were over 30 times the Fed's monetary base.
The change in this ratio is an important consideration for the future relationship between central and commercial banks and is discussed later in this article.
That an average of the origin of only one-seventh of a depositor's dollars is central bank originated as opposed to originating from commercial bank credit does not occur to the depositor. Nor can anyone distinguish between the two, both sources of credit being fully fungible. But it does show how dependent modern economies have become on bank credit expansion as opposed to central bank credit. And today, we are referring to credit based on money being issued out of thin air, the logical development of the moneylender's fraudulent treatment of other peoples' property identified as such by the Roman juror Ulpian 19 centuries ago.
The diminishing importance of bank credit for industry
It is commonly assumed that bank credit is created by money being loaned into existence and the banking system as a whole recycling loan expansion into deposits as the loans are drawn down. Any imbalances between individual banks are subsequently reconciled through wholesale money markets. Most commentators explain the creation and expansion of bank credit this way. But this is not how it actually works.
In fact, banks expand credit by a process of double-entry book-keeping. Once a loan agreement is signed, the bank will credit its balance sheet with the value of the loan as an asset. At the same time, it credits the counterparty's current account with the proceeds of the loan, which for the bank is a matching liability to the loan recorded as an asset. As the loan facility is drawn down or repaid, both sides of the bank's balance sheet adjust in lockstep. The customer's account with the bank does not necessarily reflect the bank's own double-entry book-keeping, typically showing only the customer's net balance.
A bank's internal accounting procedures were effectively confirmed by the Foley v. Hill and others case referred to above and was common practice before. The important point to note is that banks create credit out of loan agreements without any other parties being involved. The role of wholesale markets is entirely different from involvement with credit creation, being restricted to fulfilling other requirements for interbank relationships.
Since the erosion and eventual ending of the Glass-Steagall Act, which was introduced in 1933 to separate commercial from certain investment banking activities, the creation of bank credit for the purpose of conventional lending have been outpaced by other banking activities. Even before the 1980s financial deregulation in London, large American banks such as Citibank saw fee income as an increasingly important source of revenue compared with net interest income derived from bank lending.
The degree to which American banking has changed is reflected in the Fed's H.8 release for the largest 25 domestically chartered banks (Table 6). Out of a total of $9.128 trillion of bank credit between them, only $1.269 trillion is loaned to commercial and industrial businesses compared with $5.653 trillion to the government and its agencies, mostly in the form of securities. The idea that bank credit primarily supports commerce is denied by these figures.
We must inquire, therefore, as to the current and future purpose of commercial banks, and whether their interests are in line with those of society as a whole.
Commercial banks and their relationship with economic activity
From the evidence of their balance sheets, we can see that the major US banks overwhelmingly expand credit for the benefit of governments and government interests. The position for smaller American banks is more in favor of business lending but is still 60% less than their total lending to the Federal Government and its agencies. Undoubtedly, the relative reduction in non-financial business lending is attributed to the increase in funding required by governments generally in a post-Lehman crisis world, the increased perception of relative lending risk, and the general trend towards purely financial activities and securitization.
The granting of licenses by governments to banks to undertake activities that otherwise would not be permitted also appears to have encouraged a trend to use banking licenses to a wider extent. Particularly for the major banks, traditional lending activities have become a lower priority.
The ability to create any form of money or credit out of nothing seems certain to tempt banks to drift from their original commercial purpose, not that such a purpose actually existed other than in the public's collective mind in the first place. There is little doubt that their customers see banks as intermediaries between depositors and borrowers and are in the main unaware of their ability to create credit, let alone how they do so. They naturally assume that banking is simply a process of lending savings that already exist. This assumption is consistent with the regulatory approach as well, which addresses systemic risks in the interests of depositors by limiting the relationship between a bank's own capital and the size of its balance sheet. It used to be described as fractional reserve banking from regulations historically aimed at controlling this ratio.
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