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«Abstract This master thesis explores profit opportunities for the banking system due to banks power to create deposit money. Generally, extremely ...»

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Profit opportunities for the banking system due to

deposit money creation and potentials of a sovereign

money reform

Lino Zeddies1


This master thesis explores profit opportunities for the banking system due to banks power to

create deposit money. Generally, extremely little research has been done on this issue and

this thesis is trying to fill this gap and analyze, discuss and if possible quantify the different

channels for profit for the banking system at large.

Potential profit channels under investigation include firstly, exceptionally cheap funding through deposits for banks, secondly implicit government guarantees and subsidies due to unsafe bank deposits and the too big to fail problem, thirdly profits linked to the formation of asset bubbles and fourthly potential gains through creative accounting to disguise losses and to overvalue assets.

It is found that these profit channels constitute a source of extensive income for the banking system and thereby might offer an explanation for the striking levels of profit and income that the banking and financial system exhibits.

As these profit opportunities for banks could be interpreted as an inappropriate subsidy for the banking system, central aspects of a so called sovereign money reform, proposing to end banks deposit money creation, have been outlined. A discussion of potentials and criticism concludes with an overall promising assessment for the reform.

Master student at the department of Economics, Free University Berlin; Email: lino.zeddies@gmail.com Table of Contents Table of Contents

Table of Figures

1 Introduction

2 The current monetary system and money creation

2.1 The origin of money

2.2 Money creation in theory

2.3 Money creation in practice: The fractional reserve system

2.4 Money - terms and definitions

3 Problems and criticism regarding the monetary system

3.1 Excessive complexity

3.2 Danger of Bank Runs, need for deposit insurance, moral hazard

3.3 Ineffective monetary control

3.4 A growth imperative

3.5 Increased inequality and general indebtedness

3.6 Impaired seigniorage for the government and illegitimate banking privileges... 17 4 Banking sector income and profits

4.1 Banking and Finance industry key data

4.2 Employee income

4.3 Shareholder income

5 Profit opportunities for the banking system due to deposit money creation................ 23 5.1 General Considerations

5.2 Exceptionally cheap deposit funding

5.3 Implicit subsidies due to systemic importance

5.4 Profits linked to the formation of asset bubbles

5.5 Profit creation through creative accounting

5.6 Summary of results and further considerations

6 Potentials of a sovereign money reform

6.1 Background and evolution

I 6.2 Functioning

6.2.1 Institutional modifications

6.2.2 The mechanics of money creation

6.2.3 Implementation and making the transition

6.3 Discussion of advantages and criticism

6.3.1 Reduced complexity

6.3.2 Safety of deposit money and prevention of bank runs

6.3.3 More effective control of the money supply

6.3.4 Distributional effects and government income

6.3.5 Reduced growth imperative

6.3.6 General insecurity and risk of reforming the monetary system

7 Conclusion


II Table of Figures Figure 1: The currency/deposit ratio in Switzerland.

Figure 2: Balance sheet demonstration of the deposit money creation process.................. 10 Figure 3: The two monetary circuits

Figure 4: Money – terms and definitions

Figure 5: Monetary aggregates in the Euro area

Figure 6: Monetary aggregates in the US.

Figure 7: Total Banking Assets in the U.S. and Euro Area.

Figure 8: Development of net interest vs. non-interest income for banks in the U.S. and Germany.

Figure 9: Banking profits (income after tax) in the U.S. and Germany.

Figure 10: Total Wall Street bonuses, 2000-2014.

Figure 11: Return on Equity for financial institutions.

Figure 12: Overview of different channels for profit opportunities for the banking system.

Own representation.

Figure 13: Total liabilities of German banks (excluding Deutsche Bundesbank) as of December 2014.

Figure 15: Annualized funding advantage for German banks.

Figure 14: Interest rates on bank liabilities for German banks.

Figure 16: IMF estimates for implicit banking subsidies.

Figure 17: Relation and causation of deposit money creation and the formation of asset bubbles.

Figure 18: Development of housing prices.

Figure 19: Average total equity to total assets for banks in different countries.................. 38 Figure 20: No liquidity frontier for the banking system.

Figure 21: Using a Special Purpose Entity to inflate profits.

Figure 22: Overview of different profit channels, their main beneficiaries and profit estimates.

Figure 23: The sovereign money system: one monetary circuit.

Figure 23: Overview of functional modifications of a sovereign money reform................ 53 Figure 24: Comparison of a bank balance sheet pre- and post-reform.

Figure 25: Flexibility of the monetary system.

–  –  –

Whereas most mainstream economists use to neglect the institutions of money and debt for their concept of a dichotomy between nominal economic variables (money, prices, inflation) and real ones (output, capital, employment), economic history and recent events proved them fatally wrong. Since 1970 there have been 147 banking crisis with devastating consequences for economic prosperity and well-being (Laeven & Valencia,

2012) and the enduring financial crisis of recent times has highlighted the importance of the monetary system and the financial industry for the functioning of the whole economy. Unfortunately, the architecture of the financial system at present does not seem to serve the needs of our society. There is regular boom and bust, overshooting debt and many banks are so big that they have to be rescued by the government in case of failure, ridiculing the economic principles of a market economy. These costs for public bank rescue programs are particularly huge and shortly after the outbreak of the financial crisis in 2008 totaled already €5 trillion or 18.8% of GDP for the 11 major industrialized countries (Faeh et al., 2009).

At the same time, banks are profit machines for their shareholders and employees. Bank managers receive exceptionally high levels of income and bonuses, often ranking them highest among all income groups and about a quarter of all dividend payments in the U.S.

accrues in the financial industry (U.S. Dept. of Commerce, 2015). It seems that banks have acclaimed a position of great power and importance, with business and government alike depending on their credit.

A crucial explanation surrounding these issues might be the power of banks to create deposit money. While the government and the central bank are in charge of the creation of cash (coins and bank notes), the greatest part of a modern economies’ money supply is made up by the money in bank accounts. These deposits though, are not created by some public institution but instead by private banks. Whenever a bank grants a loan or buys up assets from a non-bank, new deposits come into existence (McLeay, Radia, & Thomas, 2014). And whereas the public sector derives some income, or “seigniorage”, from the creation and emission of coins and banknotes, there is no seigniorage for the public from the money in bank deposits. While this clearly implies a huge foregone income for the public, it should be wondered if instead it is the banking system that receives some kind of profit from its power to create deposit money. This is the topic and central research question of this thesis.

Historically, the term seigniorage defined the income that came to the seigniore, the sovereign or king, due to the creation of new coinage. This income was based on a markup on the metal value that the coins contained in relation to the nominal value of minted coins. As new coins would be spend into circulation by the sovereign, this seigniorage would directly contribute to public income and historically represented an important source of government revenue (Zarlenga, 2002). With the evolution of the monetary system, eventually paper money emerged, which featured much lower production costs compared to coins. However, paper money is usually only lent into circulation so that there is no seigniorage in the original sense but what Huber (2014a, p. 87) terms an “interest-seigniorage” due to the regular interest inflow. A similar interest seigniorage accrues for the central bank due to the lending of central bank reserves to commercial banks but there is no seigniorage for the public on the creation of deposit money. Quite a few authors state that instead banks receive seigniorage income from the creation of deposit money and that this would imply huge illegitimate gains for the banking system. For instance Huber and Robertson (2000, p. 79) speak of “special banking profits” and Doorman (2015, p. 18) writes that “[…] all the benefits of the privilege of creating money (with a technical term, seigniorage) end up with the aforementioned small group of people: bankers, traders, and bank shareholders.” But while it seems apparent, that the power to create money is connected with great privileges and profit opportunities, the mechanism behind this is much more complicated and indirect than the government seigniorage due to the creation of cash. As banks cannot just create and spend deposit money as they wish, there is certainly no seigniorage in the original sense. Also, there is only limited interest seigniorage from lending money because deposits also receive some interest. Concerning this, Sauber and Weihmayr (2014, p. 904) go so far to argue that there is no seigniorage for banks at all as every bank asset requires funding in form of a liability and as competition between banks should eliminate any extra profit. But even if there is no seigniorage in the usual sense, it seems premature to preclude that there is no gain from the privilege to create money at all. Instead, there might be more complicated and indirect channels for profit, some “quasi-seigniorage”.

Despite an increasing interest by economists in recent decades in the topic of money, banks and financial markets, astonishingly, the question if there is a seigniorage for the banking system has been severely neglected. Some potential benefits for the banking sector through their power to create money have been explored on partially or indirectly but apart from considerations at some detail by Huber (2014a) and Glötzl (2011) and a few quick remarks from other authors, not a single comprehensive scientific treatise on the issue could be found.

This thesis is meant to fill this gap and provides a comprehensive discussion and analysis on profit opportunities for the banking system due to its power of deposit money

creation. Potential profit channels that are examined include:

 The opportunity of exceptionally cheap funding through deposits  Implicit government subsidies and guarantees due to the too-big-too-fail problem  Profits linked to the formation of asset bubbles  Potentially illegitimate gains through creative accounting to disguise losses and to overvalue assets.

The research question is limited to profit channels that can be linked to banks’ power to create deposit money and would not exist if banks were mere intermediaries of savings.

Generally, compared to the traditional concept of a seigniorage, the channels implying a quasi-seigniorage for banks are rather indirect and complicated and pose some room for discussion and interpretation.

The research question is not posed on a specific country but for the monetary system in general as it is functioning in pretty much all countries in the world as of today.

Therefore, examples will cover various developed countries depending on data availability and eligibility but mostly covering Germany, the UK and the U.S., for these countries are important economies with institutions that are representative for many other countries.

Evidence for considerable quasi-seigniorage for the banking system would provide a part of the explanation why banks are so profitable for shareholders and employees. At the same time though, it would hardly seems justified that the banking sector should receive an income that is equivalent to a “free lunch”. Any positive findings would therefore imply some good reason for respective financial reform.

In general, the concern of this thesis is to be seen in a wider quest for understanding and improving the functioning of the monetary and financial system. As the financial crisis and its enduring impact have highlighted the need for fundamental financial reform, banks’ power to create money is seen by some scholars as the underlying structural problem of the financial system. For instance, it is argued that pro-cyclical money creation by banks and a lack of direct control of the money supply by the central bank enabled the formation of financial bubbles as a major cause of the financial crisis, that the fractional reserve system leads to insecurity of bank deposits and the danger of bank runs, eventually resulting in expensive government bail-outs and that it causes general overindebtedness and growing inequality due to the impaired seigniorage for the government (Huber, 2014a). Therefore, potential illegitimate quasi-seigniorage profits for banks might represent only one problem among many others.

Given these problems and the findings of this work, this thesis concludes with an exploration of potentials of monetary reform, precisely of a sovereign money reform.

Sovereign money reform is proposing to take the power to create money away from private banks and, instead, confer it to the central bank and democratic control. This should eliminate any quasi-seigniorage for the banking system and transfer all seigniorage income to the public so that it can serve the greater interest of all people.

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