how bank loans work, page-16

Hippo

"Banks create deposits "out of nothing" when they make a loan.”

This is an internet myth.

Banks must have actual cash, and the central bank (RBA) knows the instant the don't have it.

As pointed out in the RBA article I referenced above, licenced banks either have an exchange settlement (ES) account with the RBA or have another bank act as clearing agent for them.

The purpose of an exchange settlement account is to settle interbank obligations, settlements with the government and purchases and sales of specie and currency notes. Balances in ES accounts are used to settle all AUD payments between all banks (domestic and overseas) and the government agencies (like Treasury) who bank with the RBA.

When a bank writes a cheque or generates an electronic transfer (for a loan or asset purchase) the cheque or transfer obligation is "presented" for payment by the receiving bank to the bank generating the cheque or transfer. The first bank has to settle in cash from its exchange settlement account. If there are no funds in the ES account, the settlement fails and the bank is in breach of the conditions of its banking licence. (As you can imagine, that is serious sh*t!)

So how does a bank get a positive balance in their ES account to meet settlement on the outgoing loan or asset purchase if they can't create the cash out of thin air?

The most common way is to take a deposit. (That involves the bank getting someone else to lend them money.) When a bank takes a deposit they receive a cheque or electron transfer which they present to the bank issuing the cheque or originating the transfer. That bank pays up by a transfer of funds to the first bank's ES account from their ES account.

In banking terms Exchange Settlement cash is the same as actual money (given that banks can only buy notes and coins with ES cash)!

The notion that the RBA would alow banks to create balances in their RBA clearing accounts by fiat is ludicrous.



Afterthought: Once you understand the relationship between central banks and clearing banks, it does not require much imagination to figure out how QE works at a practical level. Central banks don’t have to print currency notes to create liquidity. They simply generate exchange settlement ledger items!)

Cheers