Still On The "Accounting View" Of Money: What Is Commercial Bank Money?
...commercial
banks are not simple financial intermediaries of already existing
money, but do create their own money trough lending (McLeay et al.,
2014) - and more generally any time they issue liabilities in the form
of sight deposits.
We discussed
this issue recently in our contribution to the "Accounting View" of
money (Bossone and Costa 2018). Here, we purport to further elaborate
on the implications of the new approach with specific reference to
commercial bank money.
By Biagio Bossone & Massimo Costa
Bank deposits and central bank reserves
If banks create
money, they do not need to raise deposits in order to lend or sell
deposits (Werner, 2014). Still, they must avail themselves of the cash
and reserves necessary to guarantee cash withdrawals from their clients
and to settle obligations to other banks emanating from client
instructions to mobilize deposits (i.e., payments and transfers).
In this regard, it
should be noted that relevant payment orders are only those between
clients of different banks, since settlement of payments between clients
of the same bank ("on us" payments) do not require use of reserves and
takes place simply by the debiting and crediting of the accounts held on
the books of the same bank.
For cash
withdrawals and payments to other banks' clients, every bank must
determine the optimal amount of, respectively, cash and reserves needed
to cover deposits. More specifically, the availability of cash and
reserves to support cash withdrawals and payment settlement consists of:
i. Cash reserves and reserves deposited with the central bank;
ii. Reserves from settlement of incoming payments from other banks;
iii. Borrowings from the interbank market;
iv. Borrowings from the central bank;
v. Immediate liquidation of unencumbered assets in the balance sheet, and
vi. New deposits of cash from old and new clients.
ii. Reserves from settlement of incoming payments from other banks;
iii. Borrowings from the interbank market;
iv. Borrowings from the central bank;
v. Immediate liquidation of unencumbered assets in the balance sheet, and
vi. New deposits of cash from old and new clients.
Debt or what?
Commercial bank
money constitutes a debt liability for deposit issuing banks, since
these are under obligations to convert deposits into cash on demand from
their clients and to settle payments in central bank reserves at the
time required by payment system settlement rules.
However, in a
fractional reserve regime banks hold only a fraction of reserves against
their total deposit liabilities (even independently of regulatory
reserve requirements). Also, the amounts of reserves they actually use
for settling interbank obligations are only a fraction of the total
transactions settled. This is true not just for netting settlement
systems but for gross settlement systems as well, since every unit of
reserves is used to settle multiple units of transactions.
The more limited
the use of cash in the economy, and the larger the economies of scale in
the use of reserves allowed by payment system rules and by clients'
non-simultaneous and deferred mobilization of deposits, the lower is the
volume of reserves that banks need to back the issuance of new
deposits. In particular, payment system rules affect the use of
reserves via two channels: the settlement modality (i.e., netting or
gross settlement) and the technology adopted. Modern technologies, such
as hybrid systems, (re-)introduce elements of netting into gross
settlement processes and increase the velocity of circulation of
reserves, thereby allowing banks to economize on their use for any given
volume and value of payments settled.
In
the hypothetical, extreme case of a fully consolidated banking system
in a cashless economy where all agents' accounts were held with only one
bank, all payments and transfers would be "on us" for the bank. This
implies that the bank would need no reserves for settling transactions
and would be under no debt obligation towards its clients. In such
circumstances, the bank might in principle create all the money that the
economy could absorb without holding reserves, and its money would (de
facto, if not de jure) become legal money for all purposes, having the
same power as legal money to settle all debts.
What is then bank money?
In real-world economies, however, there are multiple banks whose payment activities necessarily generate interbank settlement obligations. Yet, the fractional reserve regime and the economies of scale allowed by the payment system and depositors' behavior reduce the reserves needed by the banks to back their debts: with growing scale economies, banks can create more debt (by lending or selling deposits ) with decreasing reserve margins needed to cover their debt liabilities. From the hypothetical case above, and from this discussion, follows that, all else equal, a more consolidated banking system can afford a lower coverage for its debt (and at lower cost) vis-à-vis a less concentrated system.
In real-world economies, however, there are multiple banks whose payment activities necessarily generate interbank settlement obligations. Yet, the fractional reserve regime and the economies of scale allowed by the payment system and depositors' behavior reduce the reserves needed by the banks to back their debts: with growing scale economies, banks can create more debt (by lending or selling deposits ) with decreasing reserve margins needed to cover their debt liabilities. From the hypothetical case above, and from this discussion, follows that, all else equal, a more consolidated banking system can afford a lower coverage for its debt (and at lower cost) vis-à-vis a less concentrated system.
More generally, it
follows that, in normal circumstances - that is, absent adverse economic
or market contingencies that would induce depositors to convert
deposits into cash - the liabilities represented by each deposit
constitute only partly debt liabilities of the issuing bank, which as
such require reserve coverage. The remaining part of the liabilities is a
source of income for the issuing bank - an income that derives from the
bank's power to create money by issuing deposits, which is therefore a
form of seigniorage. Note that, in accounting terms, to the extent that
this income is undistributed it is equivalent to equity.
It should be
noticed that this double (accounting) nature of money is stochastic in
as much as, at the point of issuance, every deposit unit can be both
debt (if, with a certain probability there will be a request for cash
conversion or use in interbank settlement) and equity (with
complementary probability). Faced with such stochastic double nature, a
commercial bank finds it convenient (for profit purposes) to provision
the deposit unit issued with an amount of reserves that equals only the
expected value of the associated debt event, rather than the full value
of the deposit unit issued.
"Stochastic" refers
to the fact that - ex ante - the bank creating a deposit unit expects
(probabilistically) that only a share of that unit will translate into
debt, whilst the remaining share (still probabilistically) will not be
subject to requests for conversion or settlement, and will therefore
represent equity proper for the bank. The share of debt and equity
(which obviously are each complementary to 1) are stochastic variables
that are influenced by behavioral and institutional factors as well as
by contingent events. For example, in crisis times the share of debt
tends to increase, and it tends to be lower when there is strong trust
in the banking system. Policy and structural factors that strengthen
such trust, such as the elasticity with which the central bank provides
liquidity to the system when needed or institutional arrangements that
support confidence in bank money (e.g., deposit insurance), increase the
share of deposits having nature of equity.
This argument is
eminently evident when applied to the whole banking system, but it does
hold identically for each individual bank - albeit to a different extent
depending on the size of each bank for a given settlement system and
cash usage. From the discussion so far follows that, all else being
equal, the stochastic share of debt deposits for a small bank are
greater than for a larger bank. Vice versa, the larger is the bank, the
greater is the share of equity contained in its deposit liabilities.
Accounting principles
The
stochastic double nature of bank money is consistent with the
principles of general accounting as defined in the Conceptual Framework
of Financial Reporting that sets out the concepts underpinning the
International Financial Reporting Standards (IFRS). According to the
Framework,
"A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably".
"A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably".
Therefore, when an
outflow of economic benefits is "not probable", there is no debt
obligation and sight deposits become a hybrid instrument - partly debt
and partly revenue, which, once accumulated, becomes equity, as
discussed above.
Now, since there is
no accounting standard that governs hybrid instruments explicitly, IAS
32 applies (in force of IAS 8) and provides that in the context of a
hybrid liability instrument the debt component must be separated from
the equity one. From such separation derives that once the debt
component is identified, the residual component is equity. In the case
of deposits, the nature of undistributed income of the share of deposits
that (probably) will not translate into debt represents retained
earnings (or equity).
The application of
IAS 32 is a textbook case. It implies that the balance sheet of the
issuing bank should report amongst debts only the share of deposits that
gives origin to a "probable" outflow of economic benefits, while the
residual share should be reported in the income statement as
(seigniorage) revenue. Moreover, since the share of profits attributable
to this revenue is undistributed, it would add to the bank's equity in
the statement of assets and liabilities.
To further support
the validity of the approach here proposed, consider IAS 37 (governing
risk provisioning, charges and contingent liabilities). This standard
considers as debt all commitments that fall under the Framework's
definition of "liability", that is, those that generate outflows of
economic benefits with a probability greater than 0.5. Below such
threshold, the liability is a contingent liability and must only be
reported in the Notes to the financial statements.
The implication is
inescapable: the existence of legal claims is not per se sufficient for a
liability to be considered as debt; the essential requisite is the
probable outflows of economic benefits. In the case of bank money, the
share of deposits that are not debt must be regarded as revenue, and
since such revenue from money issuance (seigniorage) is not reported in
the income statement, it constitutes retained earnings (or capital).
Conclusion
The double nature
of commercial bank money draws its origin from the power de facto
conferred by the state on the banks to create a form of money of their
own, which only partly can be considered as debt. An important
implication, which has been largely ignored so far, is that a relevant
share of deposits that banks report in the balance sheet as "debt
towards clients" generate revenues that are very much similar to the
seigniorage rent extracted by the state through the issuance of legal
money (coins, banknotes and central bank reserves). As shown elsewhere,
such type of seigniorage introduces in the economy a structural element
of net detraction of real resources, with deflationary effects on
profits and / or wages, potential distributional consequences, and
frictions between capital and labor, which should all be studied
carefully.
Riferimenti Bibliografici
Bossone, B. (2017), Commercial bank seigniorage: A Primer, mimeo (available from the author on request).
Graziani, A. (2003), The Monetary Theory of Production, Cambridge University Press, Cambridge UK.
McLeay,
M., Radia, A. and Thomas, R. (2014b), "Money Creation in the Modern
Economy", Bank of England Quarterly Bulletin, 54(1), 14-27.
Moore, B. (1979), The Endogenous Money Stock, Journal of Post Keynesian Economics, 2(1), 49-70.
Moore, B. (1983),
Unpacking the Post Keynesian Black Box: Bank Lending and the Money
Supply, Journal of Post Keynesian Economics, 5(4), 537-556.
Werner, R. A.
(2014), How do banks create money, and why can other firms not do the
same? An explanation for the coexistence of lending and deposit-taking,
International Review of Financial Analysis, 36, 71-77.
[1] See, for
instance, Moore (1978, 1983) and the literature on monetary circuit
theory. As this is too vast to be cited here and do justice to its many
contributors, we refer only to the work by Augusto Graziani (2003), one
of the theory’s most authoritative exponents.
[2] The new
non-cash deposits from clients can only consist of deposits transferred
from other banks, which fall under item ii) above.
[3] This multiple
value varies according to payment settlement modalities: it is larger in
netting settlement systems and lower in gross settlement systems.
[4] As regards the
use of cash, in cases where the monetary authority declares deposit
inconvertibility and prohibits deposit transfers across borders, bank
money effectively replicates central bank money, whereby reserves cannot
circulate out of the central bank’s books: any single commercial bank
may dispossess itself of it own reserves (if some other banks demand
them), but all of them cannot altogether do so since reserves once
created remain outstanding until they are paid or sold back to the
central bank.
[5] Lending
deposits features very close analogies to selling deposits. As banks
issue deposits to clients in exchange for money, they become owners of
the money received and acquire the rights to use the money as they wish
(subject to existing laws and regulations). Even if the banks are
constrained in the use of the money – such as, for instance, in the case
of regulation prescribing types of assets to be held – they (not the
depositors) are the owners of the purchased assets and they (non the
depositors) are the owners of the income generated by the purchased
assets.
[6] See discussion in Bossone and Costa (2018).
[7] Size here
refers specifically to the volume of payment transactions that the bank
intermediates relative to the total payment transactions in the system.
[8] See section 4.46 of the Framework.
[9] Specifically,
IAS 8 (Sections 10-11) requires that, “In the absence of an IFRS that
specifically applies to a transaction, other event or condition, …
management shall refer to, and consider the applicability of, the
following sources in descending order:
(a) the requirements in IFRSs dealing with similar and related issues; and
(b) the
definitions, recognition criteria and measurement concepts for assets,
liabilities, income and expenses in the Framework.”
[10] See IAS 32, Sections 28 et.ss. It is noteworthy that, in the case
ruled by the quoted standard, the hybrid instrument has the double
nature of 'liabilities-capital' and not of 'liabilities-revenue';
however, both capital and retained earnings belong to equity. Briefly,
equity can be shared into at least two major components: capital and
other ownership's contributions, on the one hand, and retained earnings,
on the other. IAS 32 provides regulation for splitting hybrid
instruments between a part attributable to liabilities and a part
attributable to equity. As said, based on the definitions of the
Framework, once the component recognizable as debt liability is
identified, the residual component is attributed to equity.
[11] See IAS 37,
Section s 12-13, where the fundamental distinction is drawn between the
adjective "probable" for the debt liabilities and the adjective
"possible" for contingent liabilities to be reported in the Notes to the
financial statements.
[12] See Bossone (2017).
Photo Courtesy of Steven Lilley
