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Bank income and spending

February 20, 2018

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

For example they 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 (= assets – liabilities, also known as net assets, or net worth), while bank interest received represents at least a temporary increase in equity. That temporary increase in equity enables a commercial bank to spend in order to accommodate its many costs – including such things as interest paid to depositors, shareholder dividends, government tax, salaries and overheads – and to acquire new investments.

Bank equity is not money 

Bank equity may be visualised in terms of some combination of (a) loan securities, (b) investment securities, and (c) reserves. The loan and investment securities are bank assets, and also liabilities of the borrowers and/or security issuers. Reserves are also bank assets.  However none of these assets are directly matched by bank liabilities.

One should be aware of the difference between an operating account (which does not contain entities which can function as money) and a transaction account (which always deals with money). In order for something to function as money, it requires a marketplace of players who have access to it, who accept it, and who 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. 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 should also recognise that commercial banks have no need for bank credit money and do not store it. Banks can create or destroy credit money by simply 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 suppose. 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.  Bank lending and spending also effectively transfer reserves between banks. We have used a broad definition of the word “reserves” in this explanation, which can embrace such things as (i) cash held in bank vaults and tills (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, while the last may be thought of as a component of “broad” state fiat money.

Reserves held within the banking system are not part of the money supply and are not interchangeable with bank credit money. We have a dual monetary system consisting of state fiat money (banking 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 never mix. Members of the public and non-bank businesses have no access to banking reserves. Banks never lend or spend their reserves into the real economy – never. The line is never crossed. Bank reserves created by the central bank remain 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 uses part of its income 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, we arrive ultimately at a first transaction in which a dealer purchased a newly created security from either (a) a corporation, (b) a government agency, or (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.  And in particular the return of reserves to the government will have facilitated government spending and/or lending into the real economy.

The various operations described above 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 that the portion of bank income which is held in the form of “retained earnings” or “retained profit” represents a withdrawal of money from the real economy, thereby appearing to justify (at least in part) the claim by advocates of the “debt virus hypothesis” that money needs to be created specifically in order to accommodate the interest paid to banks for the loans they advance. However this claim may 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 are part of a bank’s equity. Those assets overwhelmingly take the form of purchased Treasury securities.  This is because, as mentioned previously, banks prefer not to hold on to more than a very minimal level of reserves, and to retain only the estimated cash (coins and notes) required for the immediate requirements 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, thereby facilitating 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 more 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 will occur, 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 many 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 transactions 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 creditary reserves).

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.

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.

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.

Repayment of interest using currency (coins and banknotes)   The borrower will withdraw 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 two transactions 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.

John Hermann


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