I am not an economist by any stretch of the word. And for a long time, I had no clue about basic economic subjects, everyday stuff really. Like where do banks get the money to remunerate my saving account. Or what is backing up the currency I use everyday, what is it that gives it value. Gold in a vault somewhere at the central bank would it seem. Or would it? I actually had no clue that I had no clue, things were working the way they were and there was no need to ask questions. Until I started asking myself questions. And I found out that understanding these concepts is important. I should have been taught that at school, very early on. Would you not agree?
So where do banks get the money to remunerate saving account? If you deposit money at the bank and the bank pays you interest on it, it must be getting the money somewhere else to pay you. It is in fact lending the money you deposited to people or institutions who need financing and making them pay interest on the loan. Car loan, housing loan, personal loan, you name it. The difference between the rate at which the bank remunerate your deposit and the rate it charges on the loans makes out its profit. Pretty simple right?
Here’s a mind twister then. Where does the bank store its money? In a vault you could argue, and you would be right to a certain extent. After all, automatic teller machines at any given branch of the bank dispense cash out of a secure mini vault. But the bulk of money at the bank disposal at any given time is digital. A number on an account in a given currency, and treated exactly as you would treat your money: most of it is sitting on an account at the bank, and very little in your pockets. Realizing this opens up a whole new dimension of questions you could ask yourself. If the accounts under your name are sitting at your local bank, then where are the accounts holding your local bank’s money? “At your local bank” sounds like a reasonable enough answer, but think again. If you want to check your balance, you would log into your bank online page, enter a username and password and access your account. It is not in an Excel file on your laptop. It is quite similar for a bank, its accounts are held at another bank, the correspondent bank. For instance, a European bank which domestic currency is the Euro has Euro accounts opened at the central bank, which are remunerated just like any other interest baring account. It may also have US Dollars accounts held at US correspondent banks or Pound Sterling accounts at a UK correspondent bank.
At this point, you might start to suspect how the United States can enforce fiscal policies like the Foreign Account Tax Compliance Act (FATCA) to actors who do not fall under US authority. Given that any bank in the world accesses US Dollars through a US correspondent bank, barring US financial institutions from engaging in business with a European bank for instance practically prevents the European bank from engaging in any economic activity which basis is the US Dollar. It cannot initiate payment instructions in USD to its US correspondent bank and cannot receive USD amounts on its account. Given the prominence of the US Dollar on international markets, such a bank is essentially prevented from operating all along.
But then, why do banks want access to foreign currencies like the US Dollar or the Euro in the first place? Another way of putting it is why do central banks keep foreign currencies reserves? One of the main reasons is to allow themselves the means to protect the local domestic currency. Here’s an example: the central bank of Lebanon was keeping the Lebanese Pound in a strict peg to the US Dollar since 1997, maintaining an FX rate of 1507.5 LBP per USD. To achieve this, whenever the FX rate moved out of the peg target rate in favor of the USD, the bank would pump US Dollars in the markets, providing a higher supply of this currency, thus reducing its price and bringing the FX rate back to the target peg value. A pure supply versus demand mechanism to make it simple.
If foreign currency reserves get scarce, the central bank can always try to scrub Lebanese Pounds out of the market in an effort to decrease supply of LBP, since it cannot increase the USD supply anymore. It does so by increasing the remuneration rate on LBP accounts it is holding. This incentivizes commercial banks operating in the Lebanese markets to put more Lebanese Pounds in their accounts at the central bank, and to trickle this policy down to their individual customers by increasing the rates at which they remunerate customer accounts in LBP. The difference between this rate and the rate at which the central bank remunerates the banks accounts in LBP makes the operation very profitable to commercial banks at the expense of minimal risk it would seem.
The downside of such a policy is that it does not provide incentives for commercial banks to finance the real economy. Instead of lending money deposited with them to entrepreneurs, potential house owners, or students in need of financing, they deposit it at the central bank and gets “free” remuneration on it.What actually happened in Lebanon was that commercial banks started offering remuneration rates of up to 18% on Lebanese Pound denominated accounts. This means that the central bank of Lebanon was offering commercial banks an even higher remuneration on their accounts. Obviously, no company or business yields net margins of 18%, and no individual can sustain a loan with such high interest rates, which meant that the banks did not have any incentive to finance businesses or sell mortgages, freezing the Lebanese economy in effect.
The Lebanese economy of the 2020s is a large topic which I will probably tackle in a separate post. One last question though: How is money created? Some say it is “printed”, which is also true to a certain extent. We do use bank notes and they have to be printed somewhere. But the bulk of created money is actually digital: the central bank being the sole actor in a country’s economy to have the privilege to create money, it does so by buying financial assets like sovereign bonds from commercial banks, and crediting their accounts with an amount of money coming out of thin air. As simple as that.
The takeaway of this story is to run whenever someone offers you interest rates which are too good to be true: they are not. Had Lebanese people learnt the mechanisms behind some of the facts above as kids and understood a bit better how an economy works, they would have probably avoided stacking all their net worth in LBP saving accounts to get 18% returns. Too good to be true.
In conclusion, I would like to make a case for basic economic education at schools, starting at a relatively young age because it would seem that many if not most people do not understand many of the economic concepts behind many aspects of every day life. Like the nature of money and interest rates or the basic operating model of a bank. And knowing that is of paramount importance, there’s just too much at stake.
You know how a car works, so why would you not know how a bank works?
Let the board sound