🏦 Banks Have A Secret Superpower
They can create money out of thin air. When you save Re. 1 with a Bank, the bank lends Rs. 5.4 against it. But, the US wants to stop this. Why? ReadOn!
What if we told you that banking as you know it could change forever? What if we told you that money as you know could change forever?
Sounds crazy? But that’s exactly what Joe Biden’s candidate, running for the head of the Office of the Comptroller of Currency (OCC) of the United States, is proposing.
A world where banking is reimagined.
The Present
Banks are like match-makers of the financial world.
They take deposits from people who have excess money. And they give it to people who are looking to borrow. They pay low interest to the depositors and collect high interest from the borrowers. This margin is how banks earn. Pretty simple?
If only things were so simple in reality.
Say you have Rs.10,000 in your piggy bank. But then you came across this piece on inflation by ReadOn.
A realisation dawns upon you: your cash might lose its worth over time. You won’t be able to use your money to buy as many things in the future as you can now. So you decide to deposit this money with a bank.
This money becomes the bank’s liability. The bank owes you this money.
Now, the bank knows that you won’t withdraw this entire amount of cash anytime in the near future. But to be safe, they keep a small amount in reserves and lend the rest to a lady, Ms. Dhanvati. This is where the magic happens.
When they lend the amount to Ms. Dhanvati, they create a liability, where they have to release this amount to Ms. Dhanvati as a loan. And they also create an asset. Ms. Dhanvati will have to repay this amount to the banks in the future.
The loan amount is deposited in Ms. Dhanvati's bank account. Now banks realized that Ms. Dhanvati also won’t use this entire amount in one go. So they decide to corner a small portion and lend the money to someone else. And the process repeats again and again with different customers.
This way,
The amount of loans extended by bank > the cash deposits it receives.
The amount of money being used in the economy > the cash in circulation.
(Yes. In India, the cash in circulation as on October 2021 was just 14% of the total money supply! The money multiplier was 5.4 in 2020-21. That is for every one rupee deposited with banks, banks could lend Rs. 5.4).
Banks are the only institutions in the world with the power to create money out of thin air. And this process of creating money on money is called the “Money Multiplier.” It can go on and on.
But not forever.
If banks were to lend without any restriction, or with very low restriction, they could go bankrupt.
You see, more and more people will have money in their bank accounts. This increases the possibility of more people demanding to withdraw cash from their accounts (called Bank Run). But banks won’t have sufficient cash to honour all their demands. How could they? All they did was pass entries to create more money!
Now a failure to repay could result in a possible collapse.
So banks are required to corner sufficient amounts of cash, to be able to meet this obligation. But even then, the mechanism is not full-proof. There have been cases of Bank Run in the near past (like this one in China).
This process of money creation also risks the economic trail of a country. There is a risk of inflation, job losses, and slowing down of economic activities. Imagine the power that banks have. They can make or break the economy.
To reduce this power of banks, the Central Bank has to keep pulling strings in the background.
The Central Bank is like a joker walking on a tightrope. One wrong step and the entire economy can come crashing down. They try and introduce rate-cuts, rate hikes and many more super jargon-heavy mechanisms to just control this delicate economic balance. Often, the Central Bank is at the mercy of banks to quickly implement its policies.
This system of banking has continued for a long long time.
But Ms. Omarova thinks differently.
Ms. Omarova is the candidate for the head of OCC in the US, one of the most important bodies for regulating banking.
According to her, the power of banks to take deposits from people should be taken away, altogether! She argues that this “making money out of thin air” function of banks should go away, and they should only exist for efficiently allocating money to companies and individuals for different needs.
If that happens, here’s what the future will look like:
A New Future for Banking
If you can’t deposit money with banks, then what will you do with it?
Deposit it directly with the central bank.
Now the central bank won’t have to walk the tight-rope anymore! they will have the power to control money on their own.
The new discussions around a Central Bank Digital Currency (CBDC) makes this idea sound more real than ever. Every citizen will have a digital wallet with the central bank. and every citizen will get interest directly from the central bank.
But to give you interest, the central bank will have to earn money.
So, what will the Central Bank do with your deposits?
Ms. Omarova proposes that the Central Bank of US (Fed) can invest this amount in a proposed entity called National Investment Authority (NIA). NIA is a theoretical concept for now. But it will be like a public infrastructure agency for the US. With Fed's investment, NIA will become a body that is funded by the public to build infrastructure for the public.
But that’s not the only use case. The Central Bank can also lend this money to banks.
Yes. Banks won’t become extinct (if that’s what you were thinking). They will still have the function to borrow money and lend money (without the super-power of money multiplication that they currently enjoy).
The Real Implication
If this vision comes alive, it will change the very fabric of the United States. The centre will get the power to handle public money. The centre will take over the handling of infrastructure. The poster child of a capitalist economy won’t remain capitalist anymore.
Now contrast this with where India is headed with asset monetization. The handling of public assets is being transferred to private players (reverse of the direction the US is taking). And that’s fair too. The efficiency that private players in India can bring in, is something that the bureaucrats have not succeeded at.
At the end of the day, a society has to keep changing and keep rebalancing its act. Any one system cannot continue for too long. Because no system can be flawless and perfect. With the passage of time, the flaws become more and more troubling. And change is the only way to weed out those flaws. Change is the only constant.
Until next time...
Want to understand Money Multiplier in detail? Check out this video!
Share this via WhatsApp or Twitter with your friends and help them declutter news from noise! See you tomorrow :)
If you are coming here for the very first time: Don’t forget to join us on WhatsApp to get daily updates! 👇