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Wednesday, August 18, 2010

More Detail on the Proposed BOE Act - Part Eight

Note: This is the eighth part of a series filling in details of the Proposed Bank of England Act on which I posted seven articles here from July 31st to August 3rd. Bill Totten

Making Loans

Unlike the current system, the process of making loans after the reform is very mechanical, with no scope for money creation.

In the post-reform banking system, a bank will only be able to make loans using money from one of the following sources:

(a) the money that bank customers have given to the bank for the purposes of investment (specifically, the money that bank customers have used to open Investment Accounts)

(b) the bank's own funds, for example from shareholders or retained profits

(c) any borrowings from the Bank of England (when permitted).

In contrast with the current system, all money in Transaction Accounts (which would currently be held in 'current' accounts) is 'off limits' to the bank's loan-making side of the business.

The Investment Pool:

Each bank will hold an account at the Bank of England, known as the Investment Pool. This account will be held at the Bank of England. All loans will be made from this account, and all loan repayments will be paid back into this account.

Filling Up the Pool:

When a customer opens an Investment Account, the behind-the-scenes transaction will actually involve money being taken from the customer's Transaction Account and transferred into the bank's own Investment Pool.

(Recall that the customer's Investment Account is really just a customer-friendly way of representing the investment contract made between the bank and the customer).

How Banks Would Make Loans:

When the bank wishes to make a loan, it will effectively transfer the amount of the loan from its Investment Pool into the borrower's Transaction Account. To do this, it will need to instruct the Bank of England's computer system to transfer the amount of the loan from the bank's Investment Pool into the bank's Customer Funds Account, and update its internal records for the borrower's Transaction Account.

How Customers Would Repay Loans:

When a customer wishes to make a repayment on the whole or part of a loan (or when the bank regularly takes its deposit), money will be transferred from the customer's Transaction Account back into the bank's Investment Pool.

How Banks Would Repay Customers' Investment Accounts:

When an Investment Account reaches its maturity date or notice period, the bank transfers the money that it owes to its customer from its Investment Pool into the customer's Transaction Account.

Worked Example: Making a Loan:

Let's look at a worked example, starting with a customer who wishes to invest some money.

1. The customer decides to invest GBP 1000 in an Investment Account with the same bank that he normally uses for his Transaction Account. He chooses the account type and agrees to accept the terms and conditions of the account.

2. The bank then transfers GBP 1000 from this customer's Transaction Account into the bank's Investment Pool. At the same time, it creates a record of an Investment Account of GBP 1000, belonging to the customer, and records details of the maturity date, interest rate paid and so on. The Investment Account does not hold any money - it is simply a user-friendly way of representing this investment.

3. The bank now has GBP 1000 in its Investment Pool Account at the Bank of England, which it can use to fund new loans.

4. A different customer applies for a loan of GBP 1000. The bank makes this loan by transferring GBP 1000 from the Investment Pool into the bank's Customer Funds Account and increasing the borrower's Transaction Account balance by GBP 1000 in its internal records.

(Note that in the example above, the figure of GBP 1000 is used for simplicity. There is no need for the amount of a loan to match the amount of an individual investment - the GBP 1000 loan could just as well have been funded by five people investing GBP 200 each. On a bigger scale, there would be thousands of investors and thousands of loans.)

Note the Major Change:

Note that in all these transactions, every time the balance of one account is increased, the balance of another account is decreased by an equal amount. In other words, money can only be moved from one account to another.

This is in direct contrast to the current loan making process, whereby the borrower's account is credited with the amount of the loan but the original depositors are never told that their money is 'on loan'. It is impossible under this reformed system for new money, purchasing power or 'credit' to be created within the banking system as a result of the loan-making process (or indeed any other process).

Inter-Bank Lending

Interbank lending in the post-reform system is very simple. If Bank A wishes to lend GBP 1 billion to Bank B, it simply instructs the Bank of England's clearing system to transfer GBP 1 billion from its own Operational Account to the Operational Account or Investment Pool of Bank B. The legal contract or agreement dictating how and when the loan will be repaid is a matter for Bank A and Bank B to arrange between themselves. The Bank of England will have no interest in, or record of, which bank owes what to who. It will only record the amount of money in each of the banks' accounts at any one time.

As with loans to the general public, a bank may only make a loan to another bank using:

* Funds in the bank's Investment Pool

* The bank's own capital (retained profits, shareholders' funds, et cetera)

Consequently, with interbank lending, it is impossible for both banks to use the same money at the same time. If the money is with Bank A, it can't be used by Bank B. Clearing between the two banks would be instantaneous and final, and no money creation would take place at any point in the process.

Bill Totten


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