Banking: -The Facts and the Fiction

In our text-books banks are described as financial intermediary i.e. they borrow the money from one set of people and lend the same to another set of people. Before going into further details about this, let us have a look at some famous quotes about banking by some prominent historical figures.

Terrorism, war & bankruptcy are caused by the privatization of money (i.e. banking), issued as a debt and compounded by interest.

             Napoleon Bonaparte 

I sincerely believe the banking institutions having the issuing power of money are more dangerous to liberty than standing armies.

Thomas Jefferson (former US President) 1816

You are a den of vipers and thieves. I intend to rout you out, and by the eternal God, I will rout you out.

Andrew Jackson (US President): To delegation of bankers discussing the Bank Renewal Bill, 1832

History shows that the money changers (i.e. bankers) have used every form of abuse, intrigue, deceit and violent means possible to maintain control over governments by controlling the money and the issuance of it.

James A. Madison; former US President

It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning

Henry Ford; 1903

Banking was conceived in iniquity and was born in sin. The Bankers own the earth. Take it away from them, but leave them the power to create deposits, and with the flick of the pen they will create enough deposits to buy it back again. However, take it away from them, and all the great fortunes like mine will disappear and they ought to disappear, for this would be a happier and better world to live in. But, if you wish to remain the slaves of Bankers and pay the cost of your own slavery, let them continue to create deposits.

Sir Josiah Stamp, President of the Bank of England in the 1920s

In fact, this is not even an exhaustive list of such negative comments/observations made on banking system, it is just illustrative one; a small size book can be written just by putting such negative quotes about banking.  One can wonder as to why these people had such negative views about the banking system and why no text-book of banking & economics has dealt with such negatives views by such prominent figures? If these statements about banking have even a grain of truth then how come our text-books depict banks something like an innocuous entity i.e. merely an intermediary between depositors and borrowers? If banking is really what our text-books tell us (i.e. a financial intermediary) then the statements made by these historical figures carry no weight at all and they must be dismissed as lunatics or so. But these people, as we know, were topmost figures in their respective fields, one of them—Sir Josiah Stamp—was the topmost banker of the world at his times. In this paper we will see as to (1) how the banking came into existence as so-called gold-standard banking, (2) how it got transformed into modern day post-gold standard banking.

Beginning of the Banking: - The So-called Gold Standard Banking

Beginning of the banking can be traced to the practice of European traders to keep their money (i.e. gold/silver) with some depositories for the sake of safe-keeping it. These depositories, in turn, issued a receipts/promissory-note to their depositors guaranteeing them that they could retrieve their gold—whenever they wanted so—on presenting those receipts/promissory-notes to them. Later on, these receipts/promissory-notes came to be known as bank-notes/currencies. Since using these receipts/bank-notes for settling the transactions among the traders had several advantages over using actual gold therefore over a period of time these receipts became quite a popular form of settling the transaction among the traders. But for providing this service the depositories charged some fee for that. Almost all such depositories were owned by the Jews because it was only the Jews who dealt in money matters. In fact, since generations these Jews were basically the money lenders (i.e. the usurers, as they were known in Europe) only; the safe-keeping of others’ money by issuing receipts became an “additional profession” for the Jews. Later on, they mixed these two professions into one that had monumental consequences!      

Over the period (probably since early 17^th century), the owners of these depositories slowly realised that in order to meet their commitment—of handing over the gold to their depositors when they presented these receipts to them—they needed a maximum 10% to 20% of gold that was deposited with them; rest 80% to 90% of gold always remained with them. Realizing this, the depositories started taking an undue advantage of the situation. They started the fraudulent practice of issuing the hoax receipts/promissory-notes/bank-notes—as debts. As explained above that by that time receipts/bank-notes issued by the depositories had become quite a convenient and popular mode of settlement of transaction among the traders therefore the Jew money lenders also started giving loan in form of these receipts/bank-notes only instead of giving the loan in form of actual gold. The traders who used to take the loan from these Jews had no objection in taking those receipts as debt instead of actual gold; because these receipts/bank-notes were readily accepted as “money” in the market. That is why, after they started the practice of issuing hoax receipts, instead of charging their depositors for safe keeping of their money, these depositories started paying interest on deposit. Therefore, it was a win-win situation for both, the lenders and the borrowers. Whenever any merchant approached these depositories for loan they simply gave him the receipts/bank-notes of the loan amount.

Needless to say, that those depositories did not had any gold in their vaults to back these receipts since whatever gold they had in their depositories they already used to have had receipts issued against that. Since people did not know about it (at least in initial phases), they accepted these un-backed receipts like genuine ones and it was accepted at the face value in markets as well. The bankers knew that—under normal circumstances—only a fraction of receipts issued by them will be presented to them for payment, therefore even if some of these un-backed (hoax) receipts were also to be presented to them for payment they could have easily honoured these receipts.

In essence the issuance of the hoax (un-backed) receipts was creation of money by banks since the receipts/bank notes issued by them were readily accepted as money in the market. It is important to note here that whereas the receipts/bank-notes given to “depositors” were not the creation of money—since they were created in lieu of the gold kept in the vaults of the banks—but receipts/bank-notes given to “borrowers” was “creation of money”—as there was no gold in vaults of the banks to back these receipts/bank-notes—they were just created out of thin air!

The Reserves

The main governing principal of the banks was the availability of gold in relation to receipts/bank-notes issued by them; this was known as reserves. In gold standard times the term reserves was used to imply the availability of “gold” with commercial banks in relation to the total volume of receipts issued by them. For example, if the actual availability of gold with any bank was 10 kg. and the bank had issued receipts/bank notes worth 50 kg. of gold then the reserve ratio was said to be 20%. In this case bank had 20% backing—in form of gold reserves—for the bank notes issued by it. If bank had issued the bank notes worth 100 kg. of gold—on the basis of 10kg. of gold—then the reserve ratio was said to be 10%. In other words, at r% reserves ratio, r% of total receipts issued by the bank were to be genuine ones and (100-r) % were to be hoax; thus at 5% reserves ratio 5% of the total receipts would be genuine and 95% would be hoax; at 10% reserves ratio, the ratio of genuine and hoax receipts would be 10 to 90 and so on.

The Secret Behind Success of Banking

The merchants who took those loans—in form of (un-backed) bank-notes—from depositories invested it in exorbitantly profitable trade with eastern nations/colonies. In other words, they used these bank-notes in buying the goods from their local markets and then they sold/resold these goods in eastern nations in exchange of gold. In other words, what they got in exchange for their goods in Asian/African markets was real gold; not the bank-notes. During the usual course of time these traders used to earn sufficient money—in form of Gold—from the Asian/African nations that enabled them to repay their entire loan along with the interest—in form of Gold! Note it that the debt was taken/given in form of “hoax receipts/unbacked bank-notes” but it was repaid in form of “actual gold”. This was the most extraordinary aspect and the very essence of the “gold-standard banking” i.e. the issuance of debt in form of hoax (un-backed) receipts and its repayment in form of actual gold!

Now, just think of the big-picture of the whole scenario; the loan that was issued in form of hoax receipt was repaid in form of actual gold and this activity kept swelling the gold deposit with the bankers! As gold deposit with banks kept on swelling, they used to issue more and more loans (through hoax receipts, of course) and this activity kept on going unabashedly like a growing spiral! As a result, the volume of gold with banks as well as hoax receipts issued by them kept increasing phenomenally.  

Interesting thing to note here is that banking system was under compulsion to keep expanding, it could not have stopped expanding; the day it stopped expanding it was bound to collapse! The very future of banking depended upon “sucking the gold” in ever increasing volumes; from wherever it could, the day this was to stop the banking system was bound to collapse. 

That is why after beginning of this innovative fraud, the bankers, instead of charging money from their depositors for safe-keeping of their gold, started offering them some interest on their deposits—an incentive to attract as much gold as possible! More the gold with any depository the more the hoax receipts it could have issued. Now the depositors too were getting a part of the booty—the interest on their deposits. It was a win-win situation for everyone; the depositors as well as debtors.

Inclusion of Loans/Securities into “Reserves Portfolio”

After sometimes—for enhancing their lending capacity—banks invented a new excuse; they started considering some of the loans/securities as parts of their reserves. If the banks had made loans to some very highly reputed merchant/trader/firm whose loan were considered very safe by the banks, then these loans were also counted as part of the banking reserves. The logic behind this was that these loans were “almost guaranteed” to get repaid (in form of gold, of course). Therefore, whichever bank had such loans/securities in its assets, it took these securities as good as future inflow of gold and after applying some discount (to get the present value of future gold inflow) on it these loans were included in reserves portfolio of the banks. That is why these bonds/securities were (and still are!) referred to as gilt-edged securities.

The loan given by banks to their respective states (i.e. governments) too were considered extremely safe as it was assumed that the state can repay any amount of loan just by taxing the people. Therefore, only within a very short period the governments bonds/securities (the governments usually took the loans through issuance of bonds only) became the most acceptable form of bonds to be considered as part of reserves.

Invention of Bank Deposits

Gradually, as the banking became more widespread the practice of making the loan through issuing the "bank-notes" (that were basically the promissory notes issued by the bankers) was gradually replaced by making the loans by creating the deposits in banks' ledgers. For example, if someone took the loan of Rs.10000 the bank would credit his deposit account by Rs.10000 instead of giving him bank-notes worth Rs.10000.  Similarly, if someone deposited gold worth Rs.10000 in the bank then bank would credit his deposit account by Rs.10000 instead of giving him bank-notes/promissory notes worth Rs.10000. Like bank-notes these bank deposits too were convertible in gold on demand of deposit holders. In other words, bank deposits too were as much of a liability for bankers as bank notes/promissory-notes. After invention of bank-deposits the printing of bank-notes by the banks became a different type of administrative decision; based on “liquidity preference” of economy i.e. what fraction of money supply was demanded in form of bank-notes. Let us understand it in some details.

Suppose any bank (or banking system as whole) had created total deposit of Rs.10000 in accounts of its customers. Some of the depositors would have liked to withdraw some cash against their deposits. Assuming that on an average, depositors wanted 30% of their money in form of bank-notes, in that case the bank would print bank-notes worth Rs.3000 and give it to their depositors after debiting (i.e. reducing) their deposit account by Rs.3000. Note it that there is no change in liability of the bank even now though the composition of liability has changed. Previously its entire liability of Rs.10000 was in form of bank-deposits now it is in form of bank notes (Rs.3000) plus bank deposits (Rs.7000). As the banking and financial system kept getting more and more advanced and sophisticated the proportion of bank-notes as a fraction of overall money supply kept on declining.

Emergence of Central Banks

In the initial phase of banking every bank issued/printed its own bank-notes. Due to this there used to be several types of bank notes in every country and this was a source of great confusion and chaos. To overcome this confusion, in 1793, the British parliament passed a law which forbade other banks to issue/print bank-notes and the sole right to issue the bank-notes was entrusted with Bank of England. Other banks were allowed to make loan only by the way of creating the deposits whereas Bank of England could have made the loan in both the ways i.e. by printing the bank-notes as well as by creating the bank-deposits. Remember it that Bank of England too was initially a commercial bank only; it was only much later (in early 20^th century) that it became full-fledged modern-day central bank.

If other banks wanted cash, they had to get it from Bank of England only. For this, every commercial bank opened its account with Bank of England and deposited their gold with bank of England and Bank of England credited their accounts with equivalent amount of bank-deposit. When any bank wanted to get some cash from Bank of England that bank would draw the cash from Bank of England by getting its deposit account debited in the same way as commercial banks’ customers get the cash from banks by getting their accounts debited.    

After knowing these aspects of gold-standard banking, can anyone say that banks were/are “financial intermediary”? Is it not the absurdity of highest degree to explain the Gold Standard banking as a financial intermediary? Interestingly enough, explaining the banking as a channel in the "gold-standard" era was a lesser degree of absurdity in comparison to describing the modern banking system as a financial intermediary!

Evolution of Modern Banking From Gold Standard Banking

We have already seen as to what the so-called gold standard banking was. Its central concept was reserves ratio i.e. relationship between how much gold a bank had and how much bank-money (i.e. bank notes/bank-deposits) it had created. For example, if a bank had 10 kg of gold and it had a policy of keeping its reserves ratio at 10% then this bank could have created bank money worth 100 kg of gold. If bank was to change its policy to keep the reserves ratio at 5% then it could have created bank money worth 200 kg of gold and so on. As already explained that after a while, in addition to gold, the bank started to include some of their best quality loans (i.e. the gilt-edged securities) in their reserves portfolio because these loans were considered as future inflow of gold.

In such scenario, if banks had to increase their lending capacity without decreasing their reserves ratio, they had to

1.      Increase their gold stock by attracting more gold-deposit and/or by getting their existing loans (that were issued in for of bank notes/bank-deposits) repaid in form of gold. Post Central Banking scenario the bank had to deposit these golds into central banks.  

2.      Simply make an internal accounting adjustment by including some of their good quality loans in their reserves portfolio even before those loans were actually repaid in form of gold. Post central banking scenario such loans/bonds had to be kept with central bank after getting them discounted.

Gradually, as baking system kept on expanding the volume of bank-money (i.e. notes/deposits) kept on increasing and soon it far surpassed the volume of actual money (i.e. gold) in economies/markets. Consequently, the repayment of bank debts (that were issued in form of bank notes/deposits) started happening form of bank-money (i.e. notes/deposits) itself instead of actual gold. In other words, their debtors started repaying more and more of their loans in form of bank-money itself instead of gold. This trend increased substantially after advent of industrial capitalism because the bulk of the “debt recovery” started happening from domestic markets itself. The crux of the issue is that gradually more and more of the bank issued debt started getting repaid in form of bank issued money (i.e. bank notes/deposits) only, instead of actual gold itself.

Further after, the so-called gilt-edged securities started forming larger and larger portion of the reserves portfolio of the banks instead of actual gold itself. In other words, 10% reserves portfolio no longer meant that banks had 10% backing for their liabilities (bank notes/deposits) in form gold; instead 10% reserves meant a mixture of (1) gold and (2) gilt edged securities and the gilt-edged securities started forming bigger and bigger portion of reserves. In other word 10% reserves ratio actually meant that banks had less than 10% backing for their liabilities (i.e. bank money) in form of gold and this ratio kept on declining over the period of time. 

Abandoning of Gold Standard           

Therefore, when the pretense of so-called gold-standard was finally dropped in the wake of great depression what all that was done was to

• Officially announce that banks will no longer convert the money issued by them in gold,
• Gold was no longer the part of reserves of the commercial banks and gilt-edged securities alone formed the reserves of commercial banks with central bank of the system and
• Banks/Central Banks stopped printing the gold-content on bank notes.

In other words, except discontinuing the practice of printing the gold content on bank notes nothing changed, everything remained the same; banks continued to include the so-called gilt-edged securities in their reserves portfolios to enhance their lending capacity.     

Banks’ Accounting Norms and Practices

Almost all the accounting practices or accounting norms of the banking system came into existence during the early phases of the gold-standard banking and these accounting norms and practices had some justification behind them. For example, the loans (or the securities) were considered as assets by the banking system because—in early phases of gold standard banking—they were repaid in the form of gold i.e. they were the future inflow of gold (an asset). On the other hand, bank-notes or bank-deposits were the liability of banks because they were merely a token issued by the banks in lieu of the real money (i.e. the gold); not the real money in itself, and issuing bankers were under obligation (theoretically, at least) to redeem these bank-notes/bank-deposits into gold (i.e. the real money) as and when their holders demanded so. That is why the bank-notes or bank deposits were the liability (i.e. obligation) on the bankers. Likewise, some of the top-quality loans—that were almost guaranteed to be repaid in form of gold—were termed as gilt-edged (i.e. as good as gold itself) securities and were included in reserves portfolio, in advance, i.e. even before they were actually repaid in form of gold. Whereas the gold—already an asset—was already the part of their reserves.

Now consider the following: -

• After abandoning the gold-standard the bank money (i.e. bank-notes/bank-deposits) itself has become the ultimate form of money, it is no longer any token for any real form of money (like gold) but still bank-notes/bank-deposits are considered as liability by the central banks/commercial banks! Needless to say, that it is an absurdity.  
• Similarly, the loans and advances are not going to repaid in form of gold or any other kind of real asset but still they are considered as asset; this too is an absurd and meaningless concept.

• Similarly, the so-called gilt-edged securities too are not going to be repaid in form of gold or silver but still they are called the gilt-edged securities and are included in reserves portfolio of the banks!

• Moreover, after abandoning the gold standard there is no need for any concept of reserves and reserves ratio (i.e. so-called C.R.R.) because after abandoning the gold standard banks don’t need to keep any real physical asset (like gold) as reserves to back the money issued (i.e. bank notes/deposits) by them. After abandoning the gold standard, the bank-notes and bank-deposits themselves have become the ultimate form of money, they are no longer any token for any real form of money like gold; hence they do not require any kind of backing by any real physical assets. 

Therefore, we can clearly see that the accounting practices developed by the bankers in the early phases of gold-standard banking were logical and justified. However, after abandoning the gold standard the justifications on which the accounting practices of the banks were founded, no longer remained justified. But still, the accounting practices of the banks have remained the same without any alteration as if nothing has changed and this is the biggest reason behind utter confusion when people try to understand money, banking and finance through modern day text-books.