Interbank Movement of Funds & Lending Capacity of Banks

In this article we will understand the complexity of interbank movement of funds. Without understanding this complexity, which is an outcome of inconsistent accounting practice of banking system, we cannot understand the banking.

Interbank movement of funds in Gold-Standard Banking

In order to understand the banking, the complexity of interbank movement of funds must be understood properly; without this one cannot understand the banking. To understand it properly we will understand as to how it evolved over a period of time in all the three eras of the banking (1) in bank-notes system alone i.e. when bank-deposits were not invented (2) in bank deposit system and (3) post clearing-house and central-banking system.

1. Interbank Movement of Funds in Purely Bank-Notes Banking System

In its early days banking was solely dependent on issuance of bank-notes alone, the idea of bank deposits was not invented. In that era each bank issued bank-notes (1) against gold deposit and (2) for making the loans. In this era no bank converted other banks’ bank-notes into gold; when bank-notes holders had to convert their bank-notes into gold they had to go to bank-note issuing bank only. During this era of banking there was hardly any interbank movement of funds.

2. Interbank movement of Funds in Bank-Deposit System: Pre- Clearing House Era

Interbank movement of funds started after invention of “bank-deposits” only. How the “bank deposits” moved from one bank to another? To facilitate the interbank movement of “bank-deposits” each bank opened its account with every other bank of economy. In other words, if there were 10 banks in the economic system, each bank would open its account with remaining 9 banks and each bank would have the account of remaining 9 banks. Now consider two banks of economy; bank ABC and bank XYZ.

2 (A). Movement of Funds from Deposit Account

Now suppose if an account holder of bank ABC gave a cheque of Rs.5000 to an account holder of bank XYZ, how the payee (i.e. the receiver of the cheque) would get the money?  The payee (i.e. the receiver of the cheque) would deposit this cheque into his own bank and his bank (i.e. bank XYZ) would present that cheque to bank ABC “over the counter” (since there was no “clearing house” system till then). When bank ABC received this cheque from bank XYZ it would debit the account of its customer and credit the account of bank XYZ with it and would inform (advice—in banking parlance) the bank XYZ that its account has been credited by Rs.5000. On receiving this information/advice from bank ABC, the bank XYZ would debit the account of bank ABC with it by Rs.5000 and would credit the account of his customer i.e. the account of the payee.

2 (B). Movement of Funds from Loan Account

In case of interbank movement of funds on account of loans, similar procedure was followed. If the borrowers’ deposit account was with lending bank itself; the lending bank (suppose it is bank ABC) would simply debit the loan account of borrower and would credit his deposit account. But what if the deposit account of borrower was not with bank ABC? In this case the bank ABC would debit the loan account of borrower and credit its banker’s cheque account (i.e. one of its own internal accounts) and would hand over that banker’s cheque to the borrower. The borrower would deposit the banker’s cheque in his account with bank XYZ and bank XYZ would, in turn, present that banker’s cheque to bank ABC over the counter and bank ABC would debit its own banker’s cheque account and credit bank XYZ’s account. Bank XYZ would, in turn, debit the account of bank ABC maintained with it and credit the account of the customer. 

3. Normal Practice and Mutual Understanding among the Banks in Case of Interbank Transactions in Pre-Clearing House Era

Now one can see that after the deposit/fund has moved out from bank ABC to bank XYZ, the bank XYZ has increased its deposit-liability (of converting the deposit into gold) by Rs.5000 whereas bank ABC has shed-off its deposit-liability by the same amount; so how the bank XYZ would be compensated for its enhanced liability? It is the credit balance of Rs.5000 in deposit account of bank XYZ with bank ABC which is the offsetting factor. Alternatively, one can also say that it is the debit balance of Rs.5000 in account of bank ABC with bank XYZ that will be the compensating factor for the increased deposit-liability of Rs.5000. Since bank ABC is under obligation to convert its bank-deposits into gold therefore, bank XYZ would include its “bank-deposit” with bank ABC into its asset portfolio; thus compensating the enhanced liability with equivalent amount of asset.   

As a matter of practice bank XYZ would hardly ask bank ABC to convert its “credit balance” into gold; it will leave its credit balance as such because next day it could well face a scenario wherein some of its own bank deposit might go to bank ABC. For example, if next day or so a depositor of bank XYZ gave a cheque of Rs.5000 to a customer of bank ABC, the reverse process would happen and its credit balance with bank ABC would come down to zero. Or if some more deposit moves out of bank XYZ to bank ABC its deposit account with bank ABC would go into a debit (or negative) balance. That is why the bankers’ account with each other used to be like that only i.e. sometimes any bank’s account with any particular bank was in credit balance and at other times in debit balance and so on; it kept on changing on daily basis.

It was in this way that banks facilitated interbank movement of funds. It is re-emphasized that bankers would hardly ever ask (except in case of extreme emergency) the fellow bankers to convert their credit balances into gold because this mutual arrangement among bankers was to facilitate the interbank operations, not for demanding the gold from one another on account of interbank transactions. If the banks would have started demanding gold from one another on account of interbank movement of funds the entire banking system might have gone bust; we will understand this in following pages.

 The respective accounts of banks with each other were the mirror image of each other; i.e. each bank would easily know its position with other bank just by looking at other banks balance with it.  For example, if bank XYZ’s account with bank ABC had a credit balance of Rs.6000 then bank ABC’s account with bank XYZ would be having a debit balance of Rs.6000 and so on.   

4. Interbank movement of Funds (Bank-Deposit): - Post- Clearing House & Central Banking Era

Post central bank era, the interbank transactions are done through clearing house which is conducted by central bank of the system. In this system, instead of opening their accounts with one-another every bank opens (1) its own account with central bank and (2) central bank account with it. In this case too most of the process remains the same except presentation of cheque; let us understand it in brief.  

Suppose that a customer of bank ABC gives a cheque to Rs.5000 to a customer of bank XYZ. In this case bank XYZ does not present the cheque to bank ABC “over the counter”; instead, the bank XYZ handovers this cheque to “central bank” and central bank, in turn, passes on this cheque to bank ABC. On receiving the cheque from central bank, bank ABC debits the account of its customer and credits the account of central bank with it by Rs.5000 and informs the central bank about this. Then central bank debits the account of bank ABC and credits the account of bank XYZ with it and informs bank XYZ of the same. Thereafter bank XYZ debits the account of central bank with it and credits the account of its depositor/customer. In case of movement of funds from loan account, analogous process is followed.

5. Interbank Movement of Funds in Post Clearing House System: The Anomaly 

Although, the interbank movement of funds in “post-central bank & clearing house era” is an extremely simple process as explained above but there is an anomaly into it that has made it extremely complex process; its overlapping with reserves requirement of the banks. As already explained, the post-central bank era the commercial banks were made to transfer and maintain their entire reserves portfolio (i.e. gold and gilt-edged securities) with central bank of the system and central bank would give equivalent amount of credit to commercial banks. The tangle in this case was that interbank transactions happened through the “reserves accounts” of commercial banks with central bank of the system. To understand it properly let us consider a case involving two bank, bank ABC and bank XYZ and the central bank of the system.

Suppose that bank ABC and bank XYZ have total liability (i.e. deposit) of Rs.1000000 and Rs.1500000 respectively and the statutory reserves ratio is 10%. Statutory reserves ratio the “minimum” reserves ratio that banks are legally bound to maintain with central bank; they cannot go “below” that prescribed minimum ratio otherwise they undergo hefty fines and penalties. This “reserves” with central bank was kept in form of gold and/or gilt-edged securities. In this case (i.e. at 10% reserves ratio) the “minimum required reserves” for bank ABC and XYZ would be Rs.100000 and Rs.150000 respectively. But banks invariably keep some “excess reserves” with central bank over & above their prescribed minimum. The importance of keeping the “excess reserves” will be clarified in following pages. But here, for the sake of convenience, let us suppose that banks have not kept any “excess reserves” with central bank. Now the position of the banks will be as follows

Particulars	Bank ABC	Bank XYZ
A. Total Liability (Deposits)	Rs.1000000	Rs.1500000
B. Reserves (Gold and/or Gilt-edged securities)	Rs.100000	Rs.150000

Table-1

Now suppose a customer of bank XYZ gives a cheque of Rs.10000 to a customer of bank ABC. Now this cheque would be deposited into bank ABC and bank ABC would present this cheque to bank XYZ through central bank (i.e. via clearing house) and after receiving the cheque from central bank, the bank XYZ would debit the account of its customer and would credit the account of central bank by Rs.10000 and would inform central bank accordingly. Central bank would debit and credit the “reserves accounts” of bank XYZ and bank ABC by Rs.10000 respectively and thereafter bank ABC would debit and credit the central bank’s and its customer’s by Rs.10000 respectively and final position would be as under    

Particulars	Bank ABC	Bank XYZ
A. Total Liability (Deposits)	Rs.1010000	Rs.1490000
B. Reserves	Rs.110000	Rs.140000

Table-2

In this case the deposits of bank ABC and bank XYZ have increased and reduced by Rs.10000 respectively i.e. the liability of bank ABC and bank XYZ to convert the bank-deposits into gold has increased and reduced by Rs.10000 respectively. In other words, the bank from where the deposit is moving -out is shedding off its liability by Rs.10000 and the bank where the deposit is moving-in increasing its liability (of converting deposit into gold) by Rs.10000. Now we can easily understand that the bank from where the deposit is moving out seems to be in advantageous position because its liability (to convert the deposit into gold) has come down by Rs.10000. Similarly, the bank where the deposit is moving-in seems to be in disadvantageous position because its liability has increased by the same amount. That is why, to offset this, the central bank moved equivalent of gold (i.e. reserves) from account of bank XYZ to that of bank ABC by respectively debiting and crediting their reserves accounts with it.

On the face of it, it looks a fair practice but there is some anomaly/inconsistency into this; something doesn’t add up. In our example the reserves ratio is 10%; it means that banks’ deposits (or liabilities) are backed by only 10% of gold (or gold equivalent i.e. gilt-edged securities). In other words, a deposit of Rs.10000 is backed by gold worth Rs.1000 (i.e. 10% of deposit amount) only, not Rs.10000. Therefore, when a deposit of Rs.10000 moved from bank XYZ to bank ABC then, logically, the central bank should have debited and credited their respective reserves accounts by Rs.1000 (i.e. 10% of moved deposit) only not by Rs.10000 (i.e. by full deposit amount). In other words, the payee bank should have been compensated only upto the extent of 10% of moved-in deposit in form of gold (i.e. reserves) not upto the extent of 100% of gold. But the central bank compensated the payee bank by full amount of moved-in deposit! One can wonder as to what is the logic behind this abnormal practice?

6. An Inconsistent Accounting Practice  

As already explained that a policy of r% reserves ratio meant that bank had only r% gold-backing for its liabilities (i.e. deposits). But banks recognized this reality in case of “in-house dealing” only, not in case of dealing with “external entities”. Let us understand it in some details.  

When it came to dealing with “external entities” (e.g. their borrowers, in court of law etc.) the accounting & legal practices of the banks never acknowledged the true meaning of reserves ratio (i.e. the fact that only r% of their liabilities were backed by gold). In their dealings with “external entities” the banking system always maintained that all its bank-deposit/bank-notes are equivalent to (or backed by) gold. Therefore, the entire accounting & legal practice of the banking had evolved on this assumption only i.e. bank-deposits/notes are equivalent to gold. Therefore, when it came to transaction between “two different banks” (every bank is an “external entity” for every other bank) any deposit transfer from one bank to another was bound to be treated in this way only; i.e. by assuming that entire bank-deposit as “equivalent” to the gold. That is why the central bank compensated the payee-bank (i.e. the bank where the deposit is moving in) with equivalent amount of gold (i.e. reserves) by debiting the reserves account of payer bank. If this abnormal or anomalous practice was/is not followed the entire accounting system of the banking would collapse.

Now remember the case of pre-central bank era, when banks carried out interbank movement of funds by opening the account with one-another. In that case the debit/credit entries in their respective accounts (on account of interbank movement of funds) were left as such; they were not settled immediately i.e. banks didn’t ask for equivalent amount of gold from each other. They did so because each bank knew that if they were to ask for conversion of their balances with one-another into gold, banks might not have been able to do so because bank would have been demanding to convert their “entire balance” with one another into gold instead of only upto the extent of its real backing of gold (i.e. upto its reserves ratio). This would have led to wipe out of a significant portion of reserves portfolios of many banks.   

But in post-central banking era the interbank transactions are settled immediately by debiting/crediting the reserves accounts of commercial banks with central bank, that is why this anomaly. But one may think that why post-central bank clearing house phenomenon took this seemingly “unwise & impractical” step of immediate settlement of transaction? It is so because by the time this practice started (i.e. by the time clearing houses came into existence) the overwhelming portion of reserves was formed by “gilt-edged securities” instead of gold itself. Therefore, anytime any bank felt the drainage of its reserves on account of interbank transactions it could have easily replenished the same by selling/discounting its gilt-edged securities to/with central bank of the system.         

Now let us see absurd fallouts of this anomalous accounting practice by the banking system.

Compare the Table-1 and Table-2 above. In Table-1 the reserves ratio of both the banks is exactly 10% each i.e. 10% of their liabilities are backed by the gold (or its equivalent) but in case of Table-2 (i.e. after transfer of bank-deposit of Rs.10000 from bank XYZ to bank ABC) bank ABC’s reserves ratio has gone upto 10.89% whereas the reserves ratio of bank XYZ has come down to 9.40% which is less than its minimum required reserves! It is so because a deposit transfer of Rs.10000 also entailed a transfer of reserves of same amount in same direction as well. However, if a deposit transfer of Rs.10000 would have been entailed by a reserves transfer of Rs.1000 only (i.e. 10% of moved amount) then both the banks would have maintained a reserves ratio of 10% irrespective of volume of deposit moved in or moved out of the banks. Although the combined reserves ratio of both the banks put together is still 10% because total deposits and reserves of bank ABC and bank XYZ are still Rs.2500000 and Rs.250000! 

Now we can also find out the maximum amount of “existing deposit” that can be transferred from one bank to another. As per statutory requirement, the banks’ reserves should not go below their minimum prescribed percentage of their total liability (i.e. deposits) otherwise bank might face some hefty penalties from central bank. Therefore, a bank can afford to transfer its deposit to other banks only upto the point wherein its excess reserves goes to zero. In other words, the maximum deposit that a bank can transfer to other banks is roughly equal to its excess reserves.  

7. Lending Capacity of any Individual Bank: The Gaffe of Banking Accounting System

Now we will see the real absurdity of this practice of banking system by enquiring about the “maximum lending capacity” of any individual bank and of banking system as whole. To understand this let us take a case wherein bank ABC and bank XYZ have total liability (i.e. deposit) of Rs.1000000 and Rs.1500000 respectively and the minimum statutory reserves ratio is 10%. In this case the “required minimum reserves” for bank ABC and XYZ would be Rs.100000 and Rs.150000 respectively. But the banks do keep not only the “statutory required reserves” with central bank but also some “excess reserves” with central bank for their smooth day-to-day functioning. The importance of keeping “excess reserves” will be understood in following pages. Let us assume that banks ABC and XYZ have “excess reserves” of Rs.10000 and Rs.15000 respectively; in other words, each bank has actual reserves of 11% of their liabilities whereas the minimum required reserves is 10% only. Therefore, the final situation of both the banks would be as follows: -

   

Particulars	Bank ABC	Bank XYZ
A. Total Liability (Deposits)	Rs.1000000	Rs.1500000
B. Required Statutory Reserves	Rs.100000	Rs.150000
C. Excess Reserves	Rs.10000	Rs.15000
D=(B+C). Actual Reserves	Rs.110000	Rs.165000

                       

Table-3

7 (A). Lending Capacity of any Individual Bank: Loan Proceeds Ending Up in Lending Bank Itself

Now we will see an interesting case regarding “lending capacity” of any bank. In case of Table-3 above the excess reserves of bank ABC and bank XYZ are Rs.10000 and Rs.15000 respectively. So how much of “additional loan” can they make at 10% reserves ratio? Theoretically, at r% reserves ratio any bank can make additional loan upto 100/r times its excess reserves; therefore at 10% reserves ratio both the banks can make additional loan upto 100/10=10 times their excess reserves. But banks can do so only if entire proceeds of the additional loan (i.e. additional deposit created out of new loan) end up in lending bank itself. If this is to be the case, bank ABC and XYZ can create additional loan and deposit of Rs.100000 and 150000 respectively (which is 100/10=10 times their “excess reserves” of Rs.10000 and Rs.15000 respectively). After creating that much of additional deposit the excess reserves of both the banks get exhausted because at 10% reserves ratio the excess reserves of Rs.10000 and Rs.15000 end up becoming the “backing” of newly created deposits of Rs.100000 and Rs.150000 respectively. In other words, the “excess reserves” of both the banks end-up becoming their “minimum statutory reserves” for the additional deposit created out of loans; although the actual reserves of both the banks remain the same i.e. Rs.110000 and Rs.165000 respectively. The end result of above process is shown in table-4 below.     

Particulars	Bank ABC	Bank XYZ
A. Total Liability (Deposits)	Rs.1100000	Rs.1650000
B. Required Statutory Reserves	Rs.110000	Rs.165000
C. Excess Reserves	Nil	Nil
D=(B+C). Actual Reserves	Rs.110000	Rs.165000

Table-4

The above case of Table-4 is of wherein the entire process of lending and resulting deposit creation ends in “lending bank” only. It is a reflection of the fact that when entire lending and deposit creation process is the “in-house matter” of a single bank, the accounting practice of banks reflect the true meaning of reserves ratio i.e. the fact that at r% reserves ratio a bank can make new-loans upto 100/r times its “excess reserves”.

7 (B). Lending Capacity of any Individual Bank: Loan Proceeds Going to Other Bank(s)

But what about the case when proceeds of the loan go to some other bank? Let us go to Table-3 once again and see what happens if loan proceeds of lending bank go to other bank(s). If loan proceeds (i.e. deposit created on account of loan) go to some other bank(s) the lending bank also loses equivalent amount of its reserves (i.e. gold or gilt-edged securities) to payee (i.e. deposit receiving) bank. Therefore, in this case, the maximum lending capacity of any bank is upto the extent of its “excess reserves” only because if bank ABC makes a loan of more than Rs.10000 its “actual reserves” goes below its “minimum required reserves”. Similarly, if bank XYZ makes a loan of more than Rs.15000 its “actual reserves” comes down below its “minimum required reserves”. Therefore, in this case it appears that any bank’s lending capacity is upto its “excess reserves” only.

After going through both the scenarios, one can clearly see the inconsistency of the banking system’s accounting practice! We can clearly see that as long as the loan proceeds end up with lending bank itself it had to cover its newly created liability by only r% (r is the reserves ratio) of the real asset (i.e. gold reserves) but as soon as it had to transfer this liability to any other bank (i.e. to an external entity) it had to cover it by 100% of real asset (i.e. gold reserves)! It is only here that gaffe of banks’ accounting system gets clearly visible!

7 (C). Lending Capacity of any Individual Bank: The “Infinite Series”   

Let us assume that there are only two banks in economic system; bank ABC and bank XYZ. Let us suppose that bank ABC and XYZ, are making the loan simultaneously and loan proceeds of one bank end up with another bank and vice versa.  

We go to table-3 once again and assume that both the banks make maximum possible amount of loan. Since any bank cannot go below its “legally required minimum reserves”, therefore in that case any bank can make new loan only upto the extent of its “excess reserves” only. In this case bank ABC can make a maximum loan of Rs.10000 and bank XYZ loan of Rs.15000. Now since the proceeds of loan made by both these banks go to each other, the following transaction will take place.

In this case bank ABC makes a loan of Rs.10000 but its proceeds (as well as equivalent amount of reserves) go to bank XYZ. Therefore, the resulting situation will be that bank ABC will not have any excess reserves left and bank XYZ will receive additional deposits and reserves of Rs.10000. But at the same time bank XYZ has also made a loan of Rs.15000 whose proceeds (as well as equivalent amount of reserves) go to bank ABC therefore bank ABC receives additional deposits and reserves of Rs.15000. The final situation will be as follows

Particulars	Bank ABC	Bank XYZ
A. Total Liability (Deposits)	Rs.1015000	Rs.1510000
B. Required Statutory Reserves	Rs.101500	Rs.151000
C. Excess Reserves	Rs.13500	Rs.9000
D=(B+C). Actual Reserves	Rs.115000	Rs.160000

Table-5

Now once again bank ABC and XYZ have the “excess reserves” of Rs.13500 and Rs.9000 respectively and they can make further loans of Rs.13500 and Rs.9000 respectively and if loan-proceeds keep going to “other banks” then we have an infinite series, but the end result of this infinite series will be same as that of Table-4 i.e. both the banks put together creating new loans and deposits worth Rs.250000 (i.e. =25000x100/10). One must note it that in table-4 the excess reserves gets exhausted in a “single shot” whereas in case of teble-5 the excess reserves exhausts in an “infinite series” of ever decreasing amounts. The example of table-5 is that of only two banks in the system, but the scenario is the same even in case of multiple banks in the system as banks keep receiving deposits and reserves from other banks.  

Therefore, theoretically we can say that the lending capacity of any bank is between its excess reserves to 100/r times its excess reserves (r being the reserves ratio) depending on how much of the loan proceeds remain in (or moves out of) the lending bank. However, if we look at the consolidated banking system i.e. if we merge all the banks of system then the lending capacity of that consolidated merged bank will always be equal to 100/r times its excess reserves. In other words, the total lending capacity of banking system as whole is always equal to 100/r times the excess reserves of banking system as whole.   

Interbank Movement of Funds and Lending Capacity of Banks: - Post Gold Standard Era

In post gold standard era, the interbank movements of funds are done in exactly the same manner as above, the only difference being that now entire reserves of the commercial banks are formed by gilt-edged securities only; gold has gone out of equation. As explained above, it is so because despite abandoning the gold-standard banks still follow the gold standard era accounting norms and practices as if nothing has changed. Needless to say, that this is the main reason why modern-day bank accounting practices don’t make any sense at all. If one has to make any sense of modern-day banking accounting practices, he has to imagine as if gold standard is still in force; then every accounting norm and practice of banks will start making sense to him.

8. Why Banks Attract the Deposits from Other Banks

It has already been explained in this book that banks don’t make the loans out of their deposits; instead they create the deposits out of thin air to make the loans. Therefore, one can wonder as to why the banks attract the deposit from one another by paying interest? The answer is the accounting anomaly of interbank movement of funds as discussed above. 

It has already been explained that whenever banks lose/gain any amount of deposits they also lose/gain equivalent amount reserves as well because interbank movement of funds also entails a parallel movement of reserves too. In other words, if a deposit of Rs.10000 is transferred from bank ABC to bank XYZ, then a “reserves” of Rs.10000 is also transferred from bank ABC to bank XYZ. Therefore, the basic idea behind attracting the deposits from other banks is to attract the “reserves” that accompanies the deposits, not the “deposit” per se. The reserves that banks get on account of attracting the deposit help them in further lending; let us understand this through an example.

Suppose bank ABC attracts a deposit of Rs.10000 from any bank; along with this deposit bank ABC also gets the reserves of Rs.10000 that will help bank ABC in lending. If the entire loan proceeds of loan are to end up with bank ABC itself then at 10% reserves ratio bank ABC can make new loans upto Rs.100000. But even if the entire loan proceeds go to other bank then bank ABC can make loan worth Rs.10000. Therefore, depending on how much loan proceeds remain in the bank, the banks can make new loan between 100/r times the attracted deposits to just upto the extent of attracted deposit (r being the reserves ratio). Important thing to note here is that when bank makes the loan on the basis of deposits attracted from other banks, it is only the concomitant reserves that gets utilized in making the loan, the deposits remains there is the bank itself.       

Even if any bank fails to attract new deposits from other banks, it can still make the loans. In that case it can enhance its reserves by getting some of its gilt-edged securities discounted with central bank. Therefore, to enhance its reserves any bank has two options (1) discounting its gilt-edged securities with central bank and/or (2) attracting the bank-deposit from other banks. But whenever there was any shortage of reserves for banking system as whole it can be increased by only selling the securities to central bank by the banks. 

 When banks increase their reserves by discounting (i.e. selling) their gilt-edged securities with central bank, it comes at a cost; they no longer earn the interest income on these securities because after selling them to central bank the interest on those securities is earned by central bank. But when banks increase their reserves by attracting the deposits from other banks, they incur a different type of cost; the interest on deposits. Comparatively, enhancing the reserves by attracting deposits is a cheaper alternative therefore, given the choice, banks prefer this way for enhancing their reserves.

Interestingly, if interbank movement of funds is to be entailed by only r% (r being the reserves ratio) of reserves movement (which is a logical thing to do) instead of 100%, then attracting/losing the deposits from/to other banks will become a no profit/no-loss case for the banks. In that case the only way to enhance the reserves will be by selling the gilt-edged securities to central bank.