CPA Moenga Elvis
Banks Are Determinants of the Performance of an Economy
The role of banks in both local and global economies has increasingly come into sharp focus with a number of banks most recently Silicon Valley Bank (SVB) failing. SVB is the biggest US Bank to fail since the 2008 financial crisis and the second biggest ever. The failure of SVB mainly emanated from a bank run occasioned by liquidation of long-term US government bonds at a loss beyond which its capital could offset.
It therefore behooves of us to question, what really is the role of banks in the economy? Over the years banks have moved from being intermediaries to being key players and determinants of the performance of an economy through their ability to increase money supply when they lend. At law, the word deposit is meaningless, since essentially when you give money to a bank this money is simply a loan to the bank. In Kenya, the Banking Act defines “banking business” as such—
(a) The accepting from members of the public of money on deposit repayable on demand or at the expiry of a fixed period or after notice;
(b) The accepting from members of the public of money on current account and payment on and acceptance of cheques;
(c) The employing of money held on deposit or on current account, or any part of the money, by lending, investment or in any other manner for the account and at the risk of the person so employing the money;
Banks borrow from the public. On the flip side, banks therefore don’t lend money but are in the business of purchasing securities. When you go to your local bank to apply for a loan or mortgage, you sign an offer letter and a security is created known as a promissory note (a written, legally binding financial instrument that outlines a borrower’s promise to repay a specific amount of money to a lender. It is a type of debt instrument used for borrowing and lending purposes) which is what the bank has ideally purchased.
What banks do is thus very different from what has been taught in schools for decades and a misrepresentation of facts as they are in practice. The simplistic narrative that banks give loans from existing customer deposits is a nullity. When a loan is issued to a customer the bank does not transfer any money from within or without the bank, you essentially find the money in your account. This is because as defined above deposits are essentially a record of what banks owe the public, now it also owes you money and its record of what it owes you is what you think you are getting as money.
Let’s take an example of your typical salaried employee. When the employee is paid a salary into their bank account, the bank recognizes the following entries in its books from an accounting perspective:
Dr Cash deposit
Cr Customer deposit
(To recognize a “borrowing”/liability from the customer)
When it issues a loan to the same employee;
Dr Loans and advances to customer
Cr Customer deposit
(New fictitious deposits created in the books as loans aren’t advanced from existing deposits and no one has deposited any new money)
In this way, banks create/increase money supply by inventing these claims on themselves through fictitious deposits which are traded from bank to bank within the entire banking ecosystem. Granted, once global economics shifted from a commodity backed currency to a fiat currency, we essentially are in the business of trading debt. However, the ability of banks to create money through lending can have a positive effect in the economy if it spurs creation of goods and services and technological advancement, what is termed as productive lending as opposed to speculative/unproductive lending.
The danger of unproductive lending is twofold; the increased money supply by banks creates inflation something that Central Banks already keep an eye on and is widely understood and controlled through the Consumer Price Index (CPI Index). The often-unchecked aspect of lending that is a gray area is on where the money is actually going to.
When a good chunk of bank credit is lent to unproductive sectors such as financing consumption (car loans, financing extravagant lifestyles of the masses) and speculative ventures typical with real estate investments in Kenya, there results in a corresponding surge in asset prices to match increased money supply leading to asset booms and bubbles which eventually go bust resulting in bank failure and a systemic crisis where large banks are involved.
All in all, the financial intermediation theory of banking (that loans are given from existing deposits) and the fractional reserve theory (that banks keep excess reserves from which they lend from) fade in comparison to the credit creation theory (money is created from nothing- ex nihilo). Empirically, the latter has been proven and tested. The Basel regulations of banking are thus a band aid that fail to address the credit creation reality of banks since they still treat banks as financial intermediaries.
In his Theory of Credit Macleod (1891) put it this way: “A bank is therefore not an office for “borrowing” and “lending” money, but it is a Manufactory of Credit.” It then follows that banks need to be held to a higher standard as manufacturers of money as their actions have an effect on prices (increased money supply leads to inflation). If banks create currency faster than the rate at which goods are being produced, their action will cause a rise in prices which will have a perhaps disastrous effect (Withers (1916, p. 47)).
In conclusion, in addition to the various frameworks in place such as CAMEL (Capital adequacy, Asset quality, Management quality, Earnings and Liquidity) and prudential guidelines there is need for the Central Banks and Deposit Insurers to double down on not just asset quality but also the productivity to which credit is being advanced. It is high time we stopped viewing banks as traditional intermediaries and more as significant contributors to money supply (credit creation) and overall economic growth.