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Tuesday, August 17, 2010

More Detail on the Proposed BOE Act - Part Seven

Note: This is the seventh 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

Three Accounts at the Central Bank and The Payments System

We now look at the bigger picture and explain how the payments system works in the post-reform economy. Understanding the payments system is a pre-requisite for understanding how loan making and investment will take place in the post-reform banking system.

It is important to understand that money - at least, 97% of it - now has no physical form. It is merely numbers in computer systems. With that in mind, it should be remembered that unless you are referring to physical cash, money is never actually 'kept' or 'stored' anywhere. It is only recorded in one computer system or another.

This is important because our reform requires some subtle changes to the computer systems used in the banking network, and these changes are easily misunderstood if the nature of money itself is misunderstood.

Bank Of England Holds All Digital Money

Firstly, all digital money (other than cash and coin) would be 'held' in a central computer system under control of the Bank of England. This would replace the computer systems currently used by the bank clearing houses in the UK (in fact, the same technology and software, with a few adaptations, could probably be used).

Each Bank Would 'Bank' with the Bank Of England

In the same way that you or I might hold personal bank accounts with HSBC or Nationwide, HSBC and Nationwide (and every other bank) would in turn hold accounts with the Bank of England. Each individual bank would have three main accounts:

1. The Customer Funds Account

This is the account in which all of each bank's Transaction Account funds are held. When a payment is made to a Transaction Account holder by someone at another bank, the balance of this account will increase. When a Transaction Account holder makes a payment to someone who uses a different bank, the balance of this account will decrease.

2. The Investment Pool Account

This is the account that the bank uses to receive investments from customers, receive repayments from borrowers, make payments back to Investment Account holders and make loans to borrowers.

3. The Bank's Operational Accounts

This is the account where the bank can hold funds for its own purposes - retained profits, own capital, money to pay staff wages et cetera.

Each of these accounts may be split into sub-accounts to help the bank manage and segment its own funds

Individual Banks Manage Individual Customer Accounts

While the Bank of England would hold the real 'money' (in digital form), it would not hold any information on individual customers or customer accounts. This would be the responsibility of the individual banks.

The three accounts at the Bank of England would be huge 'pots' of money. Legally, the money would belong to the banks (with the exception of the Customer Funds Account, where it would belong to the individual customers).

For its Customer Funds Account, each bank would record the amount of this money that is owned by each and every one of its individual customers, and the transactions made in and out of each customer's account. As a simplistic example, a bank's database may look something like this:

- Mrs K Smith: balance GBP 546.21
- Mr W Riley: balance GBP 1942.52
- Mr J Heath: balance GBP 26.78

The Investment Pool Account is money that technically belongs to the bank, so the bank would not have corresponding records to divide this pool up between customers.

However, each bank would need to keep records of all its 'contracts' and agreements, both to Investment Account holders and to borrowers.

For borrowers, it needs to know:

* the amount lent
* the agreed interest rate
* the date of monthly repayments
* the quantity of repayments to be taken, and so on.

For each Investment Account, the bank will need to have a record of:

* the amount invested
* the date the investment was made
* the maturity date or minimum notice period
* whether the minimum notice period has been exercised
* the interest rate agreed

Making Transactions Between Accounts

Understanding the following is not essential to understanding the wider reform. However, an understanding of the following will dispel a few misconceptions and misunderstandings about how the reform works.

In the present day, money is simply information. Consequently, we need to look at computer systems to understand how the monetary system will work.

The first thing that must be understood is that, under the new system, a commercial bank will have no more power to create money than you have the ability to log into your internet banking and choose your own account balance. Since all real digital money will be held in the Bank of England computer systems, the Bank of England gets to determine how the commercial banks can interact with this money. As a result, they can ensure with 100% certainty that it is impossible for money to be created by anyone other than the Bank of England's issue department, even in digital form.

A Worked Example: Payment Between Two Accounts

Imagine that a customer, Jack, banks with HSBC and pays using internet banking to transfer GBP 400 in rent to his landlord.

1. Jack logs in to his internet banking and fills in the landlord's account number and sort code, the amount he wants to pay, and clicks 'Make Payment'.

2. If the landlord banks with HSBC, then HSBC will simply adjust its internal records to reduce the balance of Jack's Transaction Account by GBP 400, and increase the balance of the landlord's Transaction Account by GBP 400. The payment has now been completed and cleared within fractions of a second. The balance of HSBC's Customer Funds Account at the Bank of England remains unchanged, since this was an internal transfer within HSBC.

However, if the recipient (the landlord) is at another bank, say Barclays, then HSBC must:

1. Reduce the balance of Jack's Transaction Account by GBP 400.

2. Send a message (via the computer system) to the Bank of England. The message, in plain English, will read something like this: Transfer GBP 400 from our Customer Funds Account (CFA) to Barclay's CFA. Tell Barclays that the payment is for account number 295283742, on behalf of account 192384192 ('Jack Smith'), with the sender's reference 'Here's the rent ...'

3. The Bank of England will then decrease the balance of HSBC's Customer Funds Account by GBP 400, and simultaneously increase the balance of Barclay's Customer Funds Account by GBP 400 (in other words, it will transfer GBP 400 from HSBC to Barclays).

4. The Bank of England's computer system will then send a message to Barclays that will read, in plain English, something like the following: You have received a payment of GBP 400 for Customer Account Number 295283742. The payment was sent from HSBC Account number 192384192 ('Jack Smith'), with the sender's reference 'Here's the rent ...'

5. The computer systems at Barclays' would then update their own customer account record by increasing the balance of the landlord's Transaction Account by GBP 400.

The entire process outlined above could be done in less than thirty seconds, and the funds would have 'cleared' instantly and be immediately available to the landlord for making payments to other accounts.

(For those with little experience of computer programming, the above may sound complicated, but in reality the technology behind this process is simpler than the technology that allows you to order a book at - just a little more heavy-duty to handle billions of transactions a day!)

With an understanding of the post-reform payments system, we can now look at how loans will be made after the reform.

Bill Totten


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