Short & Simple 3 – Safeguarding Monetary Institutions and Banking

It was seen in parts 1 and 2 that government, as our collective agent, is able to use its currency to attract some workers and resources to the public sector. This enables it to carry out important functions. One of these functions is to shape and regulate the monetary and banking system.

Having established the currency, the government is responsible for ensuring that funds denominated in its unit of account are sufficiently accessible. Otherwise, there will be disruptions to the economy, as people struggle to meet everyday needs.

Many modern governments have chosen to delegate certain monetary functions to the private sector. This is especially true when it comes to issuing the funds needed in the economy.

Although some funds enter the economy as currency when the government spends, most of the funds we use are issued by commercial banks and are in the form of commercial bank deposits.

We will look at how banks create these funds a little later in the series. For now, it is enough to know that they do this through lending. If we apply for a bank loan, and our application is successful, we will be provided with a new deposit, which we can spend.

It is worth reflecting on:

(1) the relationship between government and the commercial banks; and
(2) the promise banks make when they create a deposit.

(1) The government is the guarantor of the monetary system. When difficulties arise, the government can always step in, because it is the currency issuer.

Most currency is issued by the central bank, which acts both as the government’s banker and the bank for all other banks. The capacity of the central bank to provide currency to the banks is unlimited.

This clearly has the potential to create undesirable incentives in the banking system.

A private bank – like any private business – seeks profit. Its own private interests will not always align with society’s collective interest.

If some banks believe, for instance, that the central bank will always bail them out, no matter how foolish their lending behavior happens to be, the results can be destructive.

Government, being responsible for the integrity and smooth functioning of the financial system, needs to oversee and regulate banks and other financial institutions to ensure that their activities are serving public purpose.

(2) As we will see in a future installment of the series, banks lend by simultaneously creating a deposit. The borrower gets a new deposit in a bank account, but will need to repay the loan later.

A commercial bank deposit is not currency. It is a bank’s promise to supply the government’s currency to the deposit holder. Since the government is the sole issuer of currency, banks ultimately depend on government to obtain it.

Even so, banks do not need to have the currency at the time they make the promise. They just need to know that, as necessary, they will be able to get it.

The bank promises to provide the currency at par, meaning that each dollar of deposit is completely convertible into a dollar of currency.

With a current account or checking account, the bank is obliged to supply currency on the spot, whenever the deposit holder requests it. With a term deposit, the bank promises to supply currency at a future date.

To guarantee that deposit holders can always convert deposits into currency (up to some limit set by government), the central bank acts as lender of last resort.

This means that if a bank is short of currency and cannot obtain it from another bank, it can borrow from the central bank.

This makes deposits “as good as currency” for most purposes, up to the limit at which deposits are guaranteed by government.

For banks, however, there are terms attached when they borrow currency from the central bank, including an interest charge.

Banks that get into financial difficulties may also be subjected to greater regulatory oversight, or even dissolved.

To the extent the government guarantees deposits, it is to protect deposit holders, not reckless banks.

Of course, in reality, power and politics come into play, and irresponsible banks, especially if large, do not always pay the appropriate price for bad behavior. Possible policy responses include tighter regulation or public banking.

Ultimately, these choices are political and are meant to be determined in a democratic manner by society as a whole.