The Aba community was working very well with all citizens having an increased lifestyle with no disputes. Well mostly anyway. Due to the increased productivity, Aba increased in size and had added another 4 farms and in total were producing more than they could consume in total.

Again at the community meeting on Sunday in the discussion on life and the universe, they got around to talking about whether they could sell their excess production to another community or indeed whether there was similar communities to trade with. A few wise heads and youngsters volunteered to go on a trek to see what they could find.

The posse of Aba citizens walked for days and eventually came across another community of similar size but as they would find out a different community in important ways.

The new community that we’ll call Gol, produced goods other than agriculture. They produced woven clothes not just animal hides for clothing. They also had this fantastic useful contraption called a horse and cart that the Abaites desperately wanted. The Aba people thought that the Gol community would be ideal to trade with.

Abaites and Golites people started to discuss how they could trade. Abaites explained Abacoin to the Golites but were met with blank stares. The Golites explained their Money system. The Golites had discovered yellow stones on their land that when melted down produced a shiny metal that they called gold. Gold was very pretty but did not seem to have any practical uses except for decoration as it was too soft. However, Gold was available in limited quantities on Gol land so the people had mined the gold and produce physical coins that were called Golcoins. The Golites used Golcoins as money in the same way that the Abaites used Abacoins.

In trading for new goods the Abaites wanted to pay with Abacoins and the Golites with Golcoin. What to do?

Firstly they decided to agree an exchange rate. As Aba and Gol communities were about the same size and appeared to have about the same standard of living, it seemed sensible to make 1 Abacoin equal to 1 Golcoin.

The Golites said that they could maintain the value of Golcoin because they controlled the limited supply of Gold and it was not in demand for much else so the amount of Golcoins could be controlled.

The Abaites had a very different system but had a clever solution. The young Abaite that controlled the abacus technology had a method that he said was foolproof. The abacus would be used to calculate the trading of Abacoins between the Abaites and the Golites. In addition to the normal record keeping, the Abaites would create a block half way to between the two communities that records all the Abacoin that has been issued. Addition to the block there would be chains that record all the Abacoin transactions and who owns the Abacoin. The brilliance came from the extra step that required all the wise heads from both Gol and Aba to be present when ever there was a transaction or change in Abacoin issuance. These wise heads  would memorise the block and chain at that time so that if anyone tried to change the block and chain wise heads on both sides would know ensuring that the record was always accurate.

The Abaites and the Golites would argue about what was the best system but they all agreed that both were practical solutions even though one was based on a shiny useless metal and the other on simply substantiated record keeping.

The problem with control of the abacus and record keeping just got worse.

How do banks work and how Too Big to Fail banks are carried by citizens

If we keep the explanation to the basics, it’s not difficult to understand how banks work in a digital age. It’s not a mystery like aspects of quantum physics, and banks are not run by groups of high functioning geniuses. However, I have heard the President of the USA, Prime Ministers, leaders of old-world companies and new-world companies make public statements where they clearly have no idea how banks work.

Banks operate completely differently from other businesses or companies. Banks have a highly geared balance sheet. What is meant by that? As previously discussed, Megabank earns Money income by lending Money (asset) and borrowing Money from deposits (liabilities). The difference between the interest cost of the deposits and the interest received on the loans is income, generally referred to as the net interest margin. The bank also receives money through the issue of shares (capital). Capital takes any losses before deposits. So if a bank loses money through overspending or losses on the loans that it has made, its equity capital is supposed to protect the depositors against loss.

All simple enough, except that Megabank is highly geared, as in the amount of capital is small relative to the size of its assets and liabilities. Let’s keep it simple. Megabank has a ratio of total assets to equity capital of around 15 to 1. That is Megabank has on average, $1 of capital to protect from losses for every $15 of loans. This ratio demonstrates the sensitive nature of Megabank’s balance sheet. A low capital ratio also enhances the ability to easily ramp up lending and therefore Money creation by not having to raise very much capital as Megabank grows. But the downside is that only a small percentage of loans need to go bad before Megabank is in big trouble, with the risk of destroying depositors Money.

The high gearing of Megabank’s balance sheet is not the biggest systemic issue, even if that could be described as high risk. The higher the gearing ratio, the less capital Megabank needs to raise to increase lending, and the less protection that is provided to depositors and the government that supports those depositors. Share capital is allocated against loans, not just to directly protect depositors against loss but to temper bankers against having lending spiral out of control and making far too much Money that the economy can’t manage to repay from future productive income. Simply, very highly geared bank balance sheets that grow excessive lending, with little capital constraints, create too much Money and are an economic threat in themselves as they drive up asset prices and turn low-risk loans into high-risk loans.

These Money creation risks are so important that it would not be an unreasonable assumption to think that the nature of Megabank’s balance sheet should be totally transparent, which it is not. But before discussing transparency, let’s discuss bank liquidity, an equally important matter.

When Megabank lends Money (assets), it lends for different periods of time. For home loans there are terms of 25 years or more. On the other side of its balance sheet (liabilities) Megabank does not exactly match the duration of its borrowing in the form of deposits. In fact, Megabank has a large portion of its Money deposits as short term that can be withdrawn by Depositors on little to no notice. If Megabank were to have a large withdrawal of Money, it would need to sell assets or loans quickly, otherwise it would have insufficient Money and therefore a liquidity crisis even if it has sustained no actual losses. Actually, in our assumed single bank world, Megabank can’t have a liquidity crisis as it holds all the Money, and any withdrawal of Money must be matched by a deposit. However it could certainly happen to one of the divisions of Megabank in the real world.

Normally a liquidity crisis precedes a debt loss crisis, but in our digital world it can happen very quickly. This was demonstrated recently in 2023, when middle ranking US banks went down in a matter of days. What started as a liquidity crisis rapidly evolved into a debt loss crisis. Liquidity risk is addressed by regulators or Central Banks, requiring banks to hold a stock of liquid securities like government bonds or AAA mortgage-backed securities.  These can be easily sold or placed with the Central Bank to provide a bank with money that is not available from other sources. The US in 2023 clearly showed that this is not a fool-proof system.

So to Rule 8:

Rule 8: Banks operate differently from other businesses; they are highly leveraged with only a thin layer of capital to support losses and constrain lending, thereby ensuring that the Money creation system sits on shaky foundations. Banks also carry liquidity risk from depositors withdrawing Money quickly and on mass that the bank can’t meet and can’t fund within the banking system

How do banks have the ability to create Money? Its been described in previous chapters that banks create Money when they lend. This process is simple and fast in a digital banking world and it is a responsibility that banks have that lies at the foundations of economies. Yet is rarely discussed.

Prior to the digital world, if a bank loaned a citizen money in the form of cash notes from its safe, no Money is created as that process was just a reassignment of those cash notes. However, at some past point a bank cheque was invented. If a bank issued a borrower with a bank cheque and that borrower used the bank cheque to purchase a house where the bank cheque was deposited in a bank by the seller, then Money was created. In a digital world, the bank cheque is obsolete with Money creation being instantaneous and on all loans no matter what form or purpose.

No other institution or corporation can create Money by borrowing. They can borrow and create IOUs, loan securities or bonds but not fungible Money like Megabank creates when it borrows. Loans to Megabank in the form of deposits is Money because its fungible across all banks and citizens down to the cent, allowing it to be used in all Money transactions. An absolute necessity for any economy.

Banks are central to the Money-making process, are unique from other institutions or organisations, and need to be transparent and fully accountable to citizens.

Let’s get a little more complex on how much loss protection for depositors, in the form of capital, Megabank must hold as stipulated by the regulator APRA’s, rules. The large banks within our Megabank do not have hard rules from APRA on the amount of equity capital that must be held to protect depositors against loss of their Money. Rather, under international standards that APRA generally adhere to, the large parts of Megabank can use what is known as the Internal Risk Based methodology. Under this methodology each large bank creates its own methodology to calculate the risk on its balance sheet (loans, derivatives, operations etc) and uses that risk calculation so that capital is determined and allocated on a risk adjusted basis. There are parameters set by regulators but each bank under the Internal Risk Based method has a different calculation and algorithms. Sound sensible? That is very much an open question. There are both difficulties and unintended consequences.

The first thought that should come to mind is that to compare banks, or indeed inform all stakeholders of the risk calculation and capital adequacy, the Internal Risk Based methodologies should be fully transparent. I have analysed the international standards for banks, and those standards effectively agree that transparency is required. I have also read the disclosures of Megabank and all its parts, plus the disclosures of many large international banks and the results were less than satisfying. In all cases where Internal Risk Based methodologies are used there is not sufficient disclosure of the algorithms and assumptions under the calculations made to understand the risk and how the calculations were made. This non-disclosure of capital calculations is very important for all citizens.

Banks are valued on the basis that the higher the sustainable return on equity, the more valuable the shares. Therefore, it should be no surprise that the large parts of Megabank that use Internal Risk Based methodologies have smaller capital requirements than smaller banks that don’t have the same rights and must therefore use fixed capital allocations set by the regulator and international standards that unsurprisingly require higher capital requirements. Consequently Megabank’s large divisions have a lower cost of capital and a competitive edge over its smaller rivals that significantly distorts the origination of loans in Megabank’s favour. We allow Megabank to self-regulate to gain market advantage without proper disclosure.

There is even more to this inequitable banking tale, and that is the doctrine of ‘Too Big to Fail’. Too Big to Fail is where an organisation, usually a bank or insurance company, is so large that the economy simply cannot withstand that organisation failing and so must be rescued by regulators and government if it has a debt or liquidity crisis. It is also referred to as ‘socialising losses and privatising the gains’.

This was highlighted in the financial crisis of 2008 and 2009, and even with the talk and regulatory changes in the intervening 15 years, not only has nothing changed, if anything Too Big to Fail is even more entrenched in western economies the world over. This was recently demonstrated in Switzerland with Credit Suisse.

 The market and all citizens are fully aware of the Too Big to Fail, even if not by name, as they gravitate more and more to larger banks, especially when things look troublesome. Too Big to Fail banks have a huge advantage over their competition but only because of the support from citizens buying into the doctrine.

Megabank’s large divisions market advantage is diabolical, leading to Rule 9:

Rule 9:  Megabank’s large divisions operates without proper disclosure and is granted special capital status by the regulator that gives it competitive advantages and too much Money creation powers. These large banks also enjoy special status of Too Big To Fail where management can excessively reward themselves but rely on the citizens to bail them out if they overreach in lending and Money creation.

Before leaving the topic of banks, I need to point out another unintended consequence of the established doctrine of Too Big to Fail. My use of Megabank to describe the banking system as one bank is not just for dramatic effect. On a day-to-day basis, banks and the Central Bank act as a single treasury department, so that not just the whole Money system balances, but that each bank’s balance sheet does not have an excess of Money, or more importantly, a deficit of Money. All banks normally work together effectively to keep the system working and Money flows happening, where and when required.

However, when things get tough, the vultures become apparent. Too Big to Fail banks now understand that because of their status, when there are liquidity issues with a bank in their system, deposits in the system will gravitate either to Too Big to Fail banks and not their smaller competitors, or randomly distributed across all banks. In these cases, it is not in the interests of Too Big to Fail banks to recirculate those increased deposits. Recirculating would assist the bank where the run is occurring by depositors, and by keeping Money liquidity flowing through bank lending to a liquidity-challenged bank, it would probably survive. Rather it’s in the interests of large banks to do nothing voluntarily and wait for the smaller bank to collapse. In those circumstances, due both to their privileged position and the fact that they have the Money, Too Big to Fail banks can buy the assets of the failed bank at a discount, and likely with government support. These so called ‘bank rescues’ continue to embed the concept of Too Big to Fail and concentrates the banking system into fewer and fewer hands that stifles competition.

I’m not defending badly managed banks that get themselves into liquidity and credit loss problems. But circumstances, recently in 2023 in the USA and Switzerland, demonstrate that rescuing depositors and borrowers in failing banks results in big costs to citizens and big gains to Too Big to Fail banks. That’s not to criticize the assistance provided to depositors and borrowers, but if citizens are paying directly and indirectly through Too Big to Fail, then a more equitable solution is needed so that these costs are paid for by the beneficiaries, i.e. Too Big to Fail Banks and their management.

Rule 10: The banking Too Big to Fail doctrine is being further entrenched as bank failures occur with large banks and their management benefiting. Without proper Money compensation from Too Big to Fail banks to the citizens, via the government, banking becomes increasingly less competitive and more reliant on citizens to support the banking business models at insufficient cost to those banks and inequitable excess returns to management.