Wednesday, January 5, 2022

Are Banks the Most Misunderstood Businesses in the World?

research piece released last December by Morgan Stanley titled "Cryptocurrency vs Traditional Finance" included this back and forth between Stani Kulechov (Founder and CEO of Aave) and Giulia Aurora Motto (Banks and Fintech Research at MS, emphasis added):

[SK] Lending and borrowing: DeFi vs banks. We currently see some overlaps between DeFi and wholesale markets, especially on collateralized lending, yet DeFi in its pure decentralised form doesn't translate exactly to the way the fractional reserve banking system operates today. For example, unsecured loans, a mortgage or a corporate loan would require some form of centralised layer on top of current DeFi protocols as the vast majority of lending in DeFi is over-collateralised at the moment. In contrast, banks typically collect deposits, carry out a credit assessment and then lend this money out by taking some credit risk where the loan is unsecured, leading to money supply expansion. Stani Kulechov, however, didn't see this as a hurdle, and in fact argued that all lending is somehow over-collateralised, by a property, or also by data. Looking forward, he thought that tokenizing real world assets (for example London properties) is the most tangible opportunity to add assets on-chain and expand the use cases for DeFi beyond crypto.

[GAM] Morgan Stanley view: regulation evolution key to watch. The higher yields that users can achieve by depositing funds in DeFi protocols, relative to fiat bank deposits, definitely raises the question of the role of traditional banks and their role in lending out deposits, and hence we will watch this space extremely closely. We think the next key steps will come from regulation, as the key enabler for further institutional involvement, and more use cases to emerge beyond crypto.

On its face, this sounds reasonable. Banks do indeed lend out deposits, right? Right????

As a matter of fact, banks DO NOT lend out deposits. Banks create deposits when they make loans. This is a shockingly misunderstood reality. Many economic textbooks repeat the myth that banks lend out deposits. People in high finance and other positions of power, such as Ms. Motto and Mr. Kulechov, likewise believe this to be truth.

But it isn't true. To find out why so many have fallen for this fantasy, read on...

Money Scarcity Myth

There is a mass delusion that permeates our society which can generally be referred to as the Money Scarcity Myth (MSM). MSM promotes the idea that money is inherently scarce; that it must "come from" private savings and investments. Believers in this illusion insist that government spending must likewise come from taxes or borrowing from the private sector, and therefore "crowds out" private investment. This fallacy feeds into our politics, culture, laws, and general way of life, and has created other falsehoods related to money.

However, as MMT shows us, the truth is exactly the opposite: private sector savings and investment are uses of the government's money; the government is the source. Think about it: private sector savings and investments in the US are (generally speaking) denominated in dollars. But where do those dollars actually come from? The federal government! Indeed, it is helpful to think of Uncle Sam as a currency monopolist. In the US, Congress has legal authority to "coin money" as per the Constitution. The US government pays the non-government (i.e. "private") sector in for goods and services in dollars it creates. It can purchase anything that is for sale in its own currency. Since President Nixon ended the Bretton Woods system in 1971, the dollar has been a free-floating currency without any sort of fixed conversion feature.

Before we get to banks, a quick note on where MSM likely comes from. People have long believed that gold and other "precious metals" are "real" money. This seems to be one reason for the lingering false view that money is inherently scarce. In addition, MSM is generally accepted as fact by economists of the "neoliberal" school, which has been the dominant school of economic thought in the post-WWII period. It's unclear if these economists, at least the early pioneers, knew better or intentionally sought to confuse and/or obfuscate the public about money. Consider the following from Nobel prize-winning economist Paul Samuelson, who in a 1995 documentary on John Maynard Keynes, said the following (emphasis added):

“I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires. We have taken away a belief in the intrinsic necessity of balancing the budget if not in every year, [then] in every short period of time. If Prime Minister Gladstone came back to life he would say “uh, oh what you have done” and James Buchanan argues in those terms. I have to say that I see merit in that view.”

How incredibly ironic it is that critics mock MMT by calling it the "Magic Money Tree" while at the same time praying at the altar of silly religious cults promoted by the likes of Samuelson, where the all-powerful "invisible hand" magically guides markets into optimal resource allocation and "equilibrium" states (FWIW Smith's invisible hand comment has been taken completely out of context over the centuries by economists and historians). 

At its core, money is a human invention. Economists generally define money as a medium of exchange, a unit of account, and a store of value. Money's abstract nature (you can't hold a "unit of account") means there is no limit to how much money can be created, just like there is no limit to how many inches can be used for measurements, or how many points can be scored in a sports game. A scorekeeper can't "run out" of points; a person can't "run out" of inches to measure a tree; and a sovereign nation that has control of its own currency can't "run out" of money.

That's not to say there aren't real resource constraints; in all three examples above, there are no doubt real limits to how many "units" are needed to "account" for each of those situations. But the fact remains that the units themselves are limitless.

Banking 101

What does this have to do with banks? Most people, including those on Wall St, believe in MSM which, following its logical conclusion, implies that banks must obtain deposits or find other sources of pre-accumulated scarce money in order to "fund" the loans they create. However, this is fundamentally untrue. As explained brilliantly in a 2014 article released by the Bank of England, banks don't accumulate deposits and lend them out; they create deposits when they make loans. See the graphic below:

Source: Bank of England

Consider someone taking out a mortgage. Let's say, for argument's sake, they borrow $750,000 from a bank to fund the purchase of a new home. The total purchase price is $1,000,000, so they will contribute $250,000 cash as their down payment.

In our modern economy, people don't generally keep $250,000 in cash laying around. Instead, the $250,000 is held in a Deposit account at a bank. In other words, the $250,000 of cash exists as a digital accounting ledger entry on a commercial bank's balance sheet. This reflects a credit relationship. The "money" is an IOU "due from" the bank and represents the Buyer's legal property and contributes to their net worth to keep the accounts in balance. Assets = Liabilities + Net Worth. When a deposit-holder demands cash, or orders the bank to transfer the "due from" IOU to another person's account (internally or at another bank), the bank is legally obligated to make good on that payment.

Here is what the home purchase transaction looks like, before during and after:


DURING (i.e. after the loan is made, but before the house transaction settles):


Note: this assumes both the Buyer and Seller hold their deposits at the Bank who created the loan. As we can see, there was no change in net worth for any party before, during, or after the transaction settles, but in aggregate there is more "money" than before, as the bank's deposits when from $250,000 to $1,000,000. How did this happen? The bank approved the loan and credited the buyer's account with $750,000, which along with the $250,000 cash already held was transferred to the Seller. The Seller holds $1,000,000 in a deposit account at the Bank. In exchange, the Buyer now owns the House, and the Bank has a $750,000 IOU from the Buyer. The Bank did not obtain this money from an already existing account - it created it ex nihilo.

The Finance Franchise

Why do banks have this special privilege of curating money out of thin air? The best explanation can be found in a fantastic 2017 Cornell Law Review article, which argues the relationship between commercial banks and the US government resembles a franchise arrangement: the government is the franchisor and issues a special license called a bank charter to its franchisees, the banks. The product they are selling is the full faith and credit of the United States, expressed as a form a fiat money called dollars. McDonalds franchisees procure Big Macs; US commercial banks procure dollars.

The privileged status of banks as public money franchisors gives them priority status versus other lending institutions. While non-bank lenders need to obtain scarce deposits to make loans (or other investments), banks do not have such constraints (they do have other limits and are heavily regulated, however). In fact, banks have exclusive legal rights to hold deposits, which themselves have special legal carveouts in that each deposit account is guaranteed up to $250,000 at 100c on the dollar by the FDIC. Deposits are a lower cost of funds than other forms of capital, including debt and equity. And they are critical for making payments and, therefore, to the proper functioning of the economy. This is why US government had to bail out the banks during the GFC, because the public's deposits were at-risk. Banks generally make money by charging interest on loans, less any interest paid on deposits and other debts, and operating costs.

The logic behind this "franchise" relationship is to distribute power and money-creation capabilities across all sectors and regions of the economy, rather than concentrating that power in a single entity. The profit the banks generate is their reward for promoting the nation's economic progress.

King Dollar

So what if banks have special licenses to print dollars? Why do people want to accumulate dollars anyway? There are myriad reasons for demanding dollars, but the most fundamental is simple: taxes. The US government's ability to levy taxes, fees, and fines is the primary driver for the public's demand for dollars. Taxes are a form of debt, and the US government demands dollars to be paid for tax debts. In fact, some have made the analogy of the dollar as a "get out of jail free" card. But dollars are useful for other debts, too. In fact, any dollar bill reads "THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE."  The US government will always accept dollars in nominal terms for the payment of such debts. And, it is actually illegal for the US government to default on its debt

You may have noticed that a dollar bill is labeled as a "Federal Reserve Note." The bills in your pocket are your assets; given the immutability of double-entry accounting, they must be offset with a corresponding liability. Indeed, as noted on its website, Federal Reserve Notes (i.e. the physical dollar bills people use to pay for goods and services) are in fact the Fed's liabilities. Your assets are the federal government's liabilities. A liability implies some sort of obligation. When the Fed issues dollars, it is creating an obligation to accept that dollar in its full nominal value for future payment. The dollar will eventually find its way back; taxes are typically due upon death. And like Ben Franklin said, there are only two certainties in life: death and taxes.

This is an important concept to understand - the US government's liabilities are the non-government sector's assets. There is a circularity in the sense that both the federal government and the non-government sector both simultaneously represent the People of the United States. So, they are essentially two sides of the same coin, just with different accounting identities (sort of like how the Bank in our above example had a $250,000 Cash asset and a $250,000 Due to Buyer liability). In a literal accounting sense, the assets and liabilities (including net worth) of the federal government, households, businesses, and municipalities net out to zero. Assets and liabilities must match for the accounts to be in balance. 2 - 2 = 0...Every. Single. Time.

Speaking of the Fed...

Commercial banks by law must be members of the Federal Reserve, the central bank for the United States. While "The Fed" has some characteristics of a private corporation, it is ostensibly a public institution and an agency of the US federal government. It serves as an intermediary between the finance arm of the Executive Branch, the US Treasury, and the commercial banks. Indeed, it is like a "bank for banks" and a "bank for the government." When the Treasury collects taxes, the cash is transferred out of the taxpayer's deposit account at their bank and into the Treasury's General Account at the Fed, because the Treasury by law can't draw on an account at a commercial bank. This cash is held on deposit at the Fed, and is called a "reserve." When "primary dealers" (usually subsidiaries of bank holding companies) purchase debt from the Treasury at auctions, by law they have to use cash reserves held on deposit at the Fed for payment. So in every way, the cash used for the purchase of the US government's debt is "paid for" by money created by the government.

The Fed can't lend money or purchase debt directly from the Treasury. If it wants to purchase the Treasury's debt as part of its monetary policy, it credits the seller's bank account with reserves in exchange for the debt securities.

The Fed is in charge of promoting price stability and full employment in the economy, for which it conducts monetary policy - mainly buying and selling the Treasury's debt securities, creating and destroying bank reserves in the process. Like deposits for customers, banks do not lend out reserves (although they can use them for payment with other banks that have accounts at the Fed). The real purpose of reserves is to ensure banks have sufficient liquidity to make payments as they come due. This is why QE isn't really "money printing" - it is more similar to a credit card company raising its customer's credit limit. A higher credit limit improves liquidity, and ensures payments can be made in a pinch, but doesn't necessarily lead to more spending or investment.

Putting it all together

So in summary, banks are part of an exclusive "government franchise" that gives them a license to print the government's money, which is always in demand because the government demands taxes and other payments, and promises to always accept its own currency as payment.

The general public, including Wall St sharks and FinTech CEOs, still believe in MSM and that banks need to obtain scarce deposits to fund their loans. This is fundamentally not true. Legally, banks should be considered as "structurally senior" to other lending and financial institutions, because they are essentially agents for the government who provide absolutely critical services for the overall economy. And, they have a lower cost structure because they can hold deposits, which the government guarantees.

Understanding these basic facts about how banking actually works can help us better understand money and the economy, and gives us a leg up against Wall St "experts."

Until next time,


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