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Bank income and spending – John Hermann

One of the most common difficulties many people encounter in understanding the mechanics of the contemporary financial system lies in their failure to understand the difference between stocks and flows.

For example they might have difficulty understanding why commercial bank interest income is a flow while at the same time the credit money created by banks is a stock. One difference lies in the fact that bank credit money creation entails no change in bank equity (equal to assets – liabilities, also known as net worth), while bank interest received represents a temporary increase in equity. From a conventional accounting perspective, that temporary increase in its equity enables a commercial bank to spend in order to accommodate its many costs – including such things as interest paid to depositors, shareholder dividends, salaries, overheads, tax – and also to acquire new investments.

Bank equity is not money

The financial assets of a bank are its: (a) reserves, (b) investment securities and (c) loan securities. The investment and loan securities are also liabilities of the borrowers and/or security issuers. However some of these bank assets are not matched by bank liabilities, and bank equity is defined to be a measure of the mismatch.

One should be aware of the difference between an operating account – which does not contain entities that can function as money, and a transaction account – which (if positive) always contains some form of money. In order for something to function as money, it requires the existence of a marketplace of players who have access to it, accept it, and use it for transactional purposes.

When a bank wishes to spend into the real economy in order to accommodate any of its costs, it creates new credit money. And commensurately, it marks down its operating account , which reduces its equity. Bank equity is not money, so when a bank spends there is no monetary transfer within the real economy. That is, bank equity does not make up any part of the monetary aggregate M1. Any expectation that if something can be given a monetary value then it can function as money is unwarranted. When a bank lends or spends, the money supply temporarily increases. While when a bank receives a retail payment, the money available to the public is temporarily reduced.

One also should recognise that banking institutions have no need for bank credit money and do not store it. Banks can create or destroy credit money simply by adjusting the entries in the accounts of bank depositors. If these entries are in credit, then they are at the same time depositors’ assets and banks’ liabilities. For this reason, a deposit (of credit money) in a bank is not a loan to the bank, as some people have been misled into believing, because anything that is borrowed is necessarily an asset of the borrower.


Lending and spending by a bank are facilitated in large measure by the volume of the bank’s equity in relation to the totality of the bank’s risk-weighted assets (the ratio between these two is known as capital adequacy). Also bank lending and spending operations effectively transfer reserves between banks. In this explanation we have in mind a broad definition of the word “reserves”, which can embrace such things as (i) cash held in bank vaults and tills (or currency reserves), (ii) exchange settlement funds (or creditary reserves), and (iii) bank-held short-term government securities (“near money”). The first two may be thought of as “narrow” state fiat money, and the last may be thought of as a part of “broad” state fiat money.

Reserves held by commercial banks are not part of the money supply, and neither are they interchangeable with bank credit money. We have a dual monetary system consisting of state fiat money (bank reserves plus currency) and bank credit money. These two forms of money tag along with each other with every transaction involving a bank, but they don’t mix. Members of the public and non-bank businesses have no access to banking reserves.

Banks never lend or spend reserves into the real economy – never. That line is never crossed. Reserves created by the central bank remain entirely within the banking system, and are transferred between banks as and when required.

For countries like Australia and Canada which possess no formal requirements for reserves holdings by banks (other than that their credit balance must remain positive as a condition for the continuation of their depository facility with the central bank), the commercial banking institutions have no incentive to hold more creditary reserves than they require to satisfy their expected exchange settlement operations and their liquidity management. This is especially the case if they can obtain better interest returns from holding investments.

Investment securities

Lets us suppose that a bank decides to purchase an investment security from a bond dealer. The bond dealer might have purchased it from another dealer. Pursuing the sequence of such buying and selling by various dealers, one arrives ultimately at a first transaction in which a dealer purchased a newly created security from either (a) a corporation, (b) a federal government agency, (c) the central bank, in association with its open market operations. In some of these transactions, reserves were returned to the government or the central bank. In particular the return of reserves to the government facilitates spending and/or lending by the government into the real economy.

The various operations described above always occur as a result of the temporary increase in bank equity derived from interest payments and are monetary flows. Implying that bank interest income is not a static entity and is therefore a flow.

Retained earnings

It is sometimes supposed and stated that the portion of bank income which is held in the form of “retained earnings” or “retained profit” represents ongoing withdrawal of money from the real economy, thereby appearing to justify (at least in part) the claim by advocates of the so-called “debt virus hypothesis” that money must be created specifically to accommodate the interest paid to banks for the retail loans they advance. However this claim can be shown to be illusory, when the various monetary flows associated with the creation of this component of bank equity are carefully investigated.

Bank retained earnings form part of a bank’s equity, and overwhelmingly take the form of securities originally purchased from a federal Treasury agency. As stated previously, banks prefer not to hold on to more than a very minimal level of reserves, and to retain only the estimated coins and banknotes they require for satisfying the immediate needs of their customers.

The purchased securities may be subdivided into those that are purchased directly from Treasury and those that are purchased from a securities dealer. Direct Treasury purchases free up government fiscal space, which facilitates government spending into the non- bank private sector (limited only by the necessity to constrain undue inflationary pressures). Purchase from a dealer enables that dealer to purchase other securities from another source, with the intention of making a profit from the interest margin. In addition, a certain fraction of these assets also will be purchased by the central bank, as part of its open market operations. In practice a sequence of borrowing and lending operations by security dealers occurs, providing each dealer in the chain with substantial income, and the money thus obtained will be largely spent into the real economy in order to accommodate the dealer’s living costs.

The important consequence of all this is that, one way or another, the purchase and repurchase of these assets assists the flow of money through the economy, rather than having the money saved or stored in some way.

Bank interest income

Let’s consider the repayments on a loan made by a commercial bank to a retail borrower. One might ask why the loan interest received increases the bank’s equity while the loan principal received does not. In order to fully understand this, one should carefully examine the way in which the respective transact- ions are accounted.

The simplest conceivable model for demonstrating the financial mechanics would have an economy containing a single commercial bank (and note that for such an idealised single-bank economy there will be no need for exchange settlement funds).

Let us suppose that the borrower possesses a loan account (account 1, into which the bank creates the initial demand deposit) and a savings account containing previous savings (account 2, which pays interest on deposits). In this simple model, the borrower does not actually spend the newly created bank credit money, but uses it to create a deposit in account 2 as collateral in support of business activities for a convenient period of time, after which time the full payment of principal and interest will have been made. It should be recognised that the original creation of each of these accounts entailed no change in bank equity.

The original bank loan advance created two assets and two liabilities; thus the loan security is the bank’s asset and the borrower’s liability, while the deposit of bank credit money is the borrower’s asset and the bank’s liability.

  1. Repayment of principal using bank credit money

    The repayment of principal is an exact

    reversal of the original creation of two assets and two liabilities. The net result is that there is no change in bank equity.

  2. Repayment of interest using bank credit money

    The repayment of interest entails a reduction in the borrower’s assets and in the bank’s liabilities. This reduction in bank liabilities without a commensurate reduction of bank assets implies an increase in bank equity.

  3. Repayment of interest using currency (coins and banknotes)

The borrower withdraws from account 2 at some stage in order to obtain the currency (which withdrawal entails no change in bank equity) and at a later time will pay that currency to the bank as loan interest. There are two possibilities here. The first is that the transact- ions will occur within the timeframe allocated for the bank to compute its equity (the accounting period), and for this case the net result is a reduction in the level of bank liabilities without a commensurate change in bank assets.

The second possibility is that the borrower withdraws currency from account 2 and places it in a wall safe for a period of time exceeding the bank’s timeframe for computing its equity, before using it to pay the interest. In the latter situation, arguably the interest payment may be identified with an increase in the level of bank assets (more specifically, currency reserves) without a commensurate change in bank liabilities.

Analysis of the accounting procedures will be obviously more complicated for a multi-bank system, particularly if the existence of creditary reserves and the operations of a central bank are taken into account. The model for a two-bank system is a little more complicated but still straightforward, and the transfer of reserves between the spending bank and the payee’s bank must be taken into account.

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