Introduction

Recently, I read the book Where Does Money Come From?, which reshaped my understanding of currency. In this article, I aim to construct a logical framework that covers the essentials of money, its operation within banks, and the role banks play in this process.

Detail

Currency is a special commodity that possesses intrinsic value and, based on this, achieves exchange value and store of value, thereby becoming currency.

This is traditional currency theory, which views banks as intermediaries of currency, responsible for transferring deposits to others, and based on this, analyzing currency similar to commodity trading. For example, calculating currency supply and demand, etc. [Not sure exactly what this refers to]

However, this hypothesis always has difficulties explaining real-life situations.

It is obvious that if bank loans depend on deposits, then how are the deposits on which the first loan depends generated? [The book mentions other problems, but I didn’t understand them]

The loan process is even more complex.

Consider the example of a bank loan. A bank customer borrows 100 yuan from the bank, which is a process of balance sheet expansion. It can be understood that the bank and the customer exchange IOUs. When the customer gives the bank an IOU, the customer needs to repay the loan (excluding interest) of 100 yuan. This is an asset of the bank and a liability of the customer. The IOU given by the bank to the customer is that the customer can withdraw a loan of 100 yuan from the bank, which is a liability of the bank and an asset of the customer.

Any entity can achieve the process of “exchanging IOUs.”

For example, three people, A, B, and C, imagine that A is similar to a bank, B is similar to a bank customer, and C is a third person. Consider the following scenario: A and B exchanged IOUs of 100 yuan. B holds an IOU issued by A for 100 yuan. If A has good personal credibility, such as C believes that A will definitely pay its IOU, B can even use A’s IOU as “currency” to pay C. Just as C is willing to accept bank deposits as a means of payment because C also believes that the bank will pay the bank deposits it holds.

The above two examples reveal the mechanism of currency generation. Loans create currency, and IOUs are currency. Bank IOUs are bank deposits, government IOUs are government bonds, company IOUs are corporate bonds, and personal IOUs are private IOUs. All of these can act as “currency,” and because of their different degrees of acceptance and liquidity, they constitute a “currency spectrum.” The most widely accepted is bank deposits, and government bonds are also considered extremely safe and highly liquid, capable of acting like currency. Continuing along the spectrum, the “currency nature” gradually decreases, until private IOUs can only be recognized within a certain circle of personal credibility.

Modern credit currency theory states that currency is a form of credit, which can be understood as a payment commitment within IOUs. The more recognized this credit commitment is, the stronger its currency attributes.

The development process of the British banking industry well reflects the credit characteristics of currency.

In the 17th century (approximately), in addition to making gold jewelry, goldsmiths also provided gold storage services. Citizens deposited gold, and the goldsmith issued IOUs. The IOU represented a gold payment commitment. Afterwards (for some reasons), the demand for depositing gold increased. This led to (maybe this way) the direct use of the IOU instead of gold for payment was more convenient. The goldsmith realized (don’t know who started) a way of lending. When citizens borrow gold from the goldsmith (that is, loans), the goldsmith does not need to actually deliver gold, just issue an IOU to the citizen (similar to bank deposits), because this type of IOU has been recognized by the market. This operation allows the goldsmith to provide lending services without actually having a large amount of gold, which seems to be profitable but actually exposes the goldsmith to the risk of irrecoverable loans. This private financial innovation was eventually recognized by the British authorities and passed the law (forgot what it was called) to recognize its legitimacy. Because Britain needed a large amount of currency for foreign wars, coinage could not keep up with demand, and using IOUs as currency could greatly accelerate the currency production process (logically reasonable and needs to be verified).

Think about the changes in the aforementioned process. Originally, the goldsmith’s IOUs strictly corresponded to the gold deposited by citizens—IOUs = gold. Later, the goldsmith arbitrarily increased IOUs, with no physical gold corresponding to them. In other words, what corresponded to them was the commitment of borrowers who had obtained related loans. These commitments are the credit hidden behind currency.

Since bank loans create currency, banks can effectively “print money” based on credit. It is obvious that most currencies in the world are not equivalent to toilet paper. This inevitably brings up the settlement system between central banks and banks—the bank of banks.

Consider the following scenarios.

First, loans. Citizens A and B respectively borrow 100 yuan from Bank A. Both citizens A and B’s bank accounts receive 100 yuan.

Second, intra-bank transfers. Citizen A transfers 100 yuan to citizen B within Bank A. For Bank A, it only needs to reduce its debt to citizen A from 100 yuan to 0 yuan and increase its debt to citizen B from 100 yuan to 200 yuan.

Third, interbank transfers. Suppose citizen C has a bank account at Bank B, and citizen A needs to transfer 100 yuan to citizen C. This cannot be handled internally within Bank A’s balance sheet like intra-bank transfers. The central bank must be introduced. Both Bank A and Bank B have reserve accounts at the central bank, similar to how citizen A and citizen B both have accounts at Bank A. In this case, the operation of citizen A transferring 100 yuan to citizen C is that Bank A reduces its debt to citizen A by 100 yuan to 0 yuan, simultaneously reducing the central bank reserve on the asset side by 100 yuan. On the liability side, the central bank reduces Bank A’s debt by 100 yuan and increases Bank B’s debt by 100 yuan, while Bank B’s assets increase by 100 yuan in reserves and its liability side increases by 100 yuan to citizen C.

In short, interbank transfers are settled through reserve accounts each bank holds at the central bank.

Banks must ensure they have sufficient balance in their reserve accounts at the central bank to settle with other banks. If a bank issues a large amount of loans without sufficient reserves, the bank will face a liquidity crisis. The appearance of such crises will lead to more severe phenomena such as bank runs and withdrawals, endangering the bank.

There is also an unexplained issue of how banks obtain reserve accounts at the central bank. Reserves are liabilities of the central bank to banks, corresponding to assets on the central bank’s asset side. In the domestic context, the most common way is through foreign exchange settlement, where banks give dollars to the central bank, and the central bank gives reserves to the bank. Or, the central bank purchases government bonds on the secondary market, the seller receives a bank deposit, the seller’s bank asset side increases reserves, and the liability side increases debt to the seller. The aforementioned process is also known as quantitative easing.

In addition to liquidity control, loans that cannot be recovered will directly lead to losses in bank shareholders’ equity. From the perspective of the balance sheet, after the bank loans, the liability side increases customers’ bank deposits, and the asset side increases loan assets. Customers’ bank deposits on the liability side are rigid; customers can withdraw cash or transfer to other banks. If the loan assets on the asset side cannot be fully or partially recovered, the asset value must be written down, resulting in corresponding losses. These losses mean a decrease in owner’s equity on the balance sheet, which is a loss for bank shareholders.

The aforementioned mainly explains two points: bank loans create credit currency, and banks need to bear the risk of loan funds being unrecoverable.

From the perspective of cash flow, banks are the starting point of cash flow. Banks carefully choose borrowers to provide loans, and borrowers choose the best products from the commodity market to buy, the best talent from the labor market to hire, the best suppliers from the supplier market to cooperate with, and the best investments from the financial market to invest in. Each link in the cash flow is a process of selection, which provides significant incentives for providing better products, better services, etc. (which is far more effective than preaching, learning, influencing, coercion, etc.). At the same time, banks must urge borrowers to repay loans. This requires borrowers to recover currency from the cash flow cycle as described above. To avoid their own losses, banks will go to great lengths in this regard, such as requiring borrowers to provide a large amount of collateral (if they do not repay, they will be homeless), requiring borrowers to provide audit reports regularly, or even directly intervening in borrowers’ production and operation activities.

The corruption of the banking industry is an important part of modern economic corrosion. When banks lend without repayment, the aforementioned positive selection cycle immediately reverses into a negative cycle of haphazardness. The more people can influence banks through various means to obtain loans without repayment, the greater the benefits they will receive. Those who strive to provide goods and services will receive currency that is constantly diluted in purchasing power. The Pandora’s Box of vicious inflation has also opened.

It is worth mentioning the division between exogenous and endogenous monetary theories. In short, exogenous monetary theory believes that the central bank can control the quantity of money, while endogenous monetary theory believes that the quantity of money is determined by the current economic level. For example, exogenous theory believes that the central bank can control the bank’s reserve reserves by controlling the reserve interest rate and the method of issuance, thereby controlling bank lending and ultimately controlling the quantity of money. Endogenous theory believes that lenders create money by borrowing from banks, and the central bank must provide sufficient reserves to maintain the liquidity of the banking system, which the central bank cannot control.

Regardless of which theory, banks are seen as tools for implementing the will of the central bank or the wishes of lenders. The confidence level of banks themselves in whether loans can be repaid is also very important. When bank information is insufficient, the reduction of loans will also reduce the total amount of money. Of course, if considering a scenario of free competition, starting a new bank is no longer as difficult as a seesaw. Banks with different confidence levels will naturally provide loans to all suitable potential borrowers who are willing to take risks. Therefore, free competition makes endogenous monetary theory sustainable. However, the actual financial industry faces many barriers to entry and complex regulations, making the actual situation much more complicated (shrug).