Tuesday, 26 March 2013


                                  The current crisis in Cyprus reveals clearly features and faults of the banking system.
First, fractional reserve banking entitles banks to create new money by ‘leveraging’ their total liquid assets and cash deposits: for example, 100 euros cash can be used to create 1000 euros  loan; 1000 creates 10,000; 10,000 creates 100,000; 1 million creates 10million; and so on up to 1:90 when 1 million creates 90 million; or 68 million into 680million. It is not necessary for any bank to have the monies it creates in a loan as cash reserves.  We have to understand that investment/loan/commercial banks create money in this way. It is assumed that the sum of 1000 euros deposited by 1/10/1000/10000 customers will usually sit in the bank for an indefinite time, and will not be claimed by all customers at the same time. It is assumed that fractional reserve banking permits all banks to leverage cash reserves to create new money indefinitely as loans.

Second, a bank is free to use the money deposited as it wishes to create monies. It is a mistake for depositors to believe that the bank has any cash to hand at any time. It is a mistake for the bank customers to think that their money is available on demand. At the moment, Cypriot banks are being allowed to use cash reserves from the ECB to put into their cash machines. These banks do not have any cash of their own! All their money is to be found in their investment accounts.
 In fact, remember that the customers  have given their monies to the bank, and the bank only promises to pay back; it does not guarantee payment. The monies belong to the banks. In Cyprus, the two largest banks have refused to pay back in full, and have limited the cash withdrawals of all customers, and have locked down the accounts of the largest depositors preventing them from making any money transfers.  Millionaires, as well as millionaire funds, from Russia, Greece, UK, Germany, the Emirates, the USA, have been unable to reclaim their monies. They have been warned that their monies may not be available at all! But if available, will certainly be subject to a levy or tax.

Third, banks use cash deposits as collateral to make loans for investments such as housing and business and bonds and trust funds.  It has been reported that the banks in Cyprus had up to 68 billion euros in cash deposits on which they have undertaken to pay 5% interest.  It is probable that they have used these deposits to create anything from 680 billion [x10] to 6 trillion [x100] euros in loans and investments and will have commitments of 3.4 billion euros or more interest payments. Unfortunately, the investments have gone ‘bad’ and they have failed to meet their contracts. The demands to pay 5% interest have rendered the banks insolvent. In order to meet their commitments, the Cyprus government has applied for a Eurozone-loan.

Fourth, the crisis has come about in Cyprus, and elsewhere, simply because banks are able to make loans that far exceed their capital reserves.  They operate a fractional reserve banking system. They are not required to make sure that loans are secured by reserves in the Central Bank. A bank may make a loan to an enterprise or corporation or a government worth $2.5 million on the basis of $25000 collateral. There has been no attempt to secure the loan by bank reserves or company assets worth $2.5 million. Therefore, if the debtor goes bust, and defaults on the loan, the bank loses the money.

Fifth, an aspect of these negotiations and loan contracts is that all new monies are not cash, they are electronic digital entries. In our example, the $2.5 million is digital money, created by the bank as a debit on their balance sheet and entered as a credit on the debtors bank balance. The only cash or real money may be the $25,000, which is given to the bank as collateral.  However, the loan contract stipulates that the debtor will transfer the $2.5 million plus interest back to the creditor bank over an agreed period of time. This means that at the completion of the loan, @ 10% for 10 years, the bank does gain $25,000 plus $2.5 million plus interest of say, $6.48million.  The bank makes a lot of money, real or digital, on every good loan, but loses principal and interest on every bad loan. The banks in Cyprus have suffered from the consequences of ‘bad loans’.

Sixth, there was a time when all dealings were done with gold coins. It remains the case in times of crisis that most people trust only gold, and would prefer their wealth in the form of gold bullion. A recent visit to the Bank of England by Queen Elizabeth revealed the stores of gold bullion held in the Bank vaults, providing the base of the money system.  However, gold is not mobile. It is difficult to move about from person to person or bank to bank or country to country.
More recently money was  in the form of notes and coins. It was moved about by security vans and trains. It was always subject to attacks by bank robbers, and ‘great train robbers’. Publicly or privately, it was bulky. Nevertheless, people still think of money as notes and coins. Today, we see crowds of people queuing outside banks in Cyprus trying to get ‘their money’ out of their banks.
We are now part of a financial service in which gold or silver or copper coins and bank notes do not move between banks, corporations, nor governments. All dealings are done as digital electronic entries.  We have quickly accepted digital entries as ‘money’ while at the same time still thinking of coins and notes as ‘real money’. Bankers process digital money, their customers handle ‘real money’. Today, there remains a difference of perspective between bankers and customers.

Finally, we are involved in an economic system in which capitalists expect to be able to deposit their capital and profits in banks, and be paid interest for the privilege. In this system, bankers have noticed that their clients leave their monies in bank accounts for a long time. The bankers have taken ownership of the money and use it as the basis of loans and investments. In this way these deposits are made to work, and generate interest payments.

At the same time, during the development of the ‘digital world’, bankers have designed procedures whereby all their monies are digital entries on balance sheets, and trading books. Exchange deals and currency trading are digital transactions on screen. Loans and mortgages comprise digital entries and transfers on creditor and debtor accounts, that bear little relationship to the amount of cash reserves held in the bank and central bank.

This system operates on the assumptions  that no one will demand all their cash at the same time, and that everybody believes that their cash is present in the bank safe. In Cyprus at the moment everybody wants to demand all their monies ‘now’, and that they can go to the bank and collect it. As we have seen, neither of these actions is possible. We all have to confront the reality of banking as a digital procedure, whereby money is represented by digital entries on balance sheets. For example, the 68 billion euros that we are told are deposited in Cypriot banks are not there and not available on demand. They are digital entries, being used as part of investment and loan accounts. Money as ‘cash’ has to be printed and minted, and is normally in a bank only to meet daily requirements, available on demand. Today, Cypriot banks get their euros from the European Central Bank. If the ECB stops this service, then the banks will have no cash, and their customers will not be able to get their money!  It seems that the banking world is a world of mirrors in which nothing is quite as it appears!