What do we know about banks? PART II

Banking system has not always been like it is now. This is perhaps no surprise. However the fact that it seems now to be more sophisticated does not necessarily signifies progress. In fact it’s something else. What do we really know about banks?

In the previous part there has been considered an initial case for contemporary banking system being the source of inflation and economic crisis. Some farther-going implications should be now identified.

Recap
First of all, I would like to summarise the essence of the part one in a manner that will be useful for this article. You will recall our simplified scenario in which there have been spent more money in the economy than exist in nature. When you and another guy in our scenario paid by debit cards what happened was exchange of 'receipt notes for cash' for the goods: recall that every time you pay by debit card you have to sign a ticket - a 'receipt note for cash' that is being created and authorised by you. Should we not have debit cards, for example, you would have a paper note from the bank in return for your deposited cash, or cheque-book, and you would be able to endorse this paper-note to another person (write a cheque).

The fact, therefore, described in part one, put another way, is this: the number of 'receipt notes for cash' is not equal to the physical units of cash (never ever).

Again, it is not the purpose of this note to explain some generally accepted truth, it is rather to question why the fact stated is to be regarded as generally accepted truth.

Circulation, liquidity and central banking
One important consequence of the fact stated above is that the banking system keeps running as you will recall (and your debit card bills get paid, which is the same as to say the 'receipt notes for cash' get exchanged for physical units of cash) only due to the fact that physical units of cash are being constantly moved around the system so that each bank has the opportunity to use the cash of someone else to settle a particular client's needs in cash. This movement of physical units of money around is called circulation (of money).
Liquidity is then defined in terms of how well the money is circulated around the system to ensure uninterrupted settlement of all needs in cash at every moment in time. Whenever there is a danger of circulation being disrupted (for example, bad debtors not returning on time the loans taken), this is referred to as 'liquidity' problem. Should the circulation be disrupted in a way that a particular bank becomes unable to settle someone's need for cash, this bank is insolvent at that point in time. Needless to say what may be the consequences for the insolvent bank.

It is not difficult to comprehend that banks are linked into a system and the liquidity (and therefore solvency) becomes dependent on that of the other banks and also all counterparties, i.e. each individual bank becomes dependent on the circulation of money and each single one is interested in ensuring the uninterrupted circulation. This is precisely the role of central bank to provide coordination mechanism in this quest for uninterrupted circulation of money. There has to be no illusion that when it is said that one of the main objectives of any central bank is financial stability all what is meant to be said is the ensuring of uninterrupted circulation of money. Simply said, central bank is there to help other banks to conceal the process of constant stealing, to the extent that it actually commits itself to lend money to banks at times when there is a pervasive risk of circulation failure (also referred to as 'injecting liquidity' into the system, and the role is termed 'lender of last resort').

It has to be well understood that the central banking, as institution, appeared with the objective of keeping the system of fraction-reserve banking system stable in the sense that the 'system' has enough cash to be able to settle the cash needs of its customers. Whenever term 'liquidity' is pronounced by various commentators, what they mean is precisely the risk of particular banks not having enough cash to settle the needs of its customers in cash. The risk arising from the very fact described in part one, that there is less cash (physical units of money) in nature then there exist receipt notes for cash not only for each individual bank but for the banking system as a whole.

Real-life example
It is not difficult at all to understand the essence of the liquidity/circulation problem and the need it gives to have a central bank because you can built the very same system and check how it works in real-time (however you will be taking risks and may end up in deep trouble, so think before actually doing it, the author disclaims all responsibility for any outcome and this is not an advice):
- take a credit card from bank A, with the limit of, let's say, USD 2.000 (and let's say the balance is repayable in total within 30 days of the statement date - American Express is a good example), assume no interest
- spend USD 2.000 to buy whatever you want (something you've dreamed for long)
- to repay the credit card you would need USD 2.000 which you do not have (your existing sources of cash do not provide you with the opportunity to settle in full without hurting your normal consumption)
- take another credit card from bank B (card B), with the limit of USD 2.000 allowing you to take the balance in cash and repayable in instalments (for example 10% minimum monthly), assume no interest
- take the USD 2.000 in cash from the card B and settle your AmEx statement
- you now have USD 2.000 still available to you (on AmEx)
- spend it again, buy more stuff
- to repay in the next month, take a loan in the bank C repayable in instalments
In this way you can continue not settling your AmEx card (and keep spending USD 2.000 every month) so long as you can handle the monthly repayments, from your existing sources of cash, on your other loans and credit cards (to make it extreme, you could even respend all amounts repaid each month). You would soon reach the limit where no more new credit cards/loans can be obtained (because you will not be able to maintain minimum monthly instalments) and the next AmEx statement will not be settled. Like in real banking system the circulation in your system would have depended on the constant inflow of new cash (new credit cards/loans in our case); the circulation would have interrupted (in our case because of you inability to maintain more loans that you've already taken). You would have what is called 'liquidity' problem: circulation in your system would be stopped and liquidity in fact would be zero, you would become insolvent.

Imagine now that some fairy has given you USD 2.000 for free in exchange for AmEx card, so that you settle it but not use again (and therefore you would be left with other loans that you can maintain with your existing sources of cash). This would be a chance and miracle for you.

Although the central bank will not normally be the fairy from our example (it can nevertheless), it will often be the one to give you the credit card/loan to help you settle your AmEx card. You, as well as the bank, will normally refer to 'the next credit card' solution only if you don't have another way about it: you might count on future salary increases (bonus?), bank counts on new term deposits and current accounts from customers, for example. Should you not receive your anticipated bonus, you will have to take a new loan, so will the bank if not enough cash has been brought in by the time it expected.

So what?
Every bank is behaving like someone taking an AmEx card and expending it while knowing that the amount would not be repaid next month out of the existing sources of cash. As an individual, ask yourself if you would want to do it for yourself? I am sure you know the common sense reasons for not doing so. Yet somehow these common sense reasons seem to be not applicable to the bank. Unlike yourself, for whom such behaviour would turn out a financial disaster, banks are not convinced that a disaster can happen to them since there is a system in place to prevent it. Why is this system not available to us then? Simply because you would probably not agree to give money to someone else to settle his AmEx card for not more than a reasonable expectation that when you are in the same situation someone will likewise give away his money to settle your AmEx statement. Yet, this is exactly what you are doing, but on a much larger scale, every time you bring your money in a contemporary bank.

So long as it works well, why should we care?
Well, the thing is, by saying 'works well' one implies uninterrupted circulation of physical units of cash; he means this, in other words: 'if I can freely withdraw my funds in cash whenever I want; or use them to pay my liabilities - why should I bother?' He also probably means this: 'even if I know that there is not enough cash for everyone at any moment in time, it is very unlikely that everyone will come altogether to withdraw their money so I will most likely always be able to withdraw my funds'.
Not quite correct; if one implies uninterrupted circulation of physical units of cash, he should also not forget to add at least this: 'I believe it is unlikely that too many borrowers of the bank will not repay their loans due during the period of time when I am planning to use this particular bank' and 'I also believe this particular bank will not have difficulty to borrow from other banks directly when need be' and 'I also believe the bank will enjoy fresh cash-in at sufficient level'
I think you now should have quite a few reasons to care:
- how do you make sure the borrowers or your bank will repay on time?
- how do you reliably know how many people will open new accounts and deposit 'new' cash?
- how do you make sure other banks will be willing to make your bank a loan?
You don't. Because you can't - it's the banks' job. Yet, your ability withdraw your cash in ATM tomorrow depends directly on the banks ability to manage those and many other things. Note, however, that it shouldn't: this is your cash and your right to have it withdrawn is unconditional.

Okay, what if we just want it this way: it's risk-management, it's 21-st century, we can handle it: we have insurance system in case things go bad, we have central bank to make sure things won't get bad
First, insurance system cannot help return everyone his cash (because simply the amount of physical units of cash is not equal the 'receipt notes for cash') - there will always be a limit per person. Second, central bank cannot prevent 'things from getting bad', what central bank can do is to restore uninterrupted circulation of money. Central bank has only one way of doing this: making more physical units of cash available in the system. There are several tools to use: (i) reduce reserves requirement (so that banks can take the cash they previously deposited with central bank as a guarantee), (ii) give loans to banks, (iii) buy securities from banks and, least likely, (iv) print cash (i.e. directly increase the amount of physical units of cash). Central banks do not control the forces interrupting the circulation. For example, central banks do not control:
- your desire to open an account in certain banks
- lending policies of individual banks and decisions of individual banks to make a loan
- soundness of the projects financed through borrowings from individual banks
- demand for the product produced as a result of projects financed through banks
- success of the businesses
- creation of new businesses
and many other things

So what's the conclusion?
There is nothing economically fundamental in having a central bank and financial stability policy: all it stands for is having the uninterrupted circulation of money. The uninterrupted circulation of money is only a problem when the right of ownership to the money we place with the bank is not observed (so that the quantity of physical units of money are not equal the 'receipt notes for cash'). Because the interruption of circulation immediately reveals that the money placed with the bank have been stolen, the circulation requires to be policed and coordinated. Liquidity problem is when circulation is interrupted and corresponding 'liquidity injections' are simply the increases of physical units of money intended to restore the circulation. Liquidity problem is therefore not an economic problem but a mathematical problem arising from the inferior legislation (and as such is a legal problem). Solving it does not solve any real economic problem but in fact worsens one (that of inflation).

Disclaimer to the critics
Relax, this is not a scientific publication. Scenarios are simplified but reasonable, terminology is avoided where possible on purpose - to keep things simple. If you have inescapable desire to dismiss my argument, please first read this scientific publication (which was reference material for the author) and you are more than welcome. Seriously, I will be very glad to have more sophisticated discussion with any interested person. Non-sophisticated comments are also welcome. Questions will be very much appreciated as the author could not include all aspects of the problem in one article (some questions may be answered in the later parts of this essay therefore the author will kindly refuse to give answers to them).