Template:M intro banking bank capital

You will often hear people sagely intone that “bank capital is expensive”. Everyone else in earshot will sagely nod as if this wisdom is ingrained in every graduate from their first moment behind the counter — who knows? Maybe it is — but it took JC a couple of decades to clock on to it, so it is worth rehashing.

Some basic concepts to bear in mind:

Firstly, “bank capital” is the difference between a bank’s assets — the investments it makes — and its liabilities — the amounts it owes its depositors and others from whom it borrows. Prudential regulation requires the bank to maintain an amount of bank capital. (You hear people saying the bank has to “hold” an amount of capital but this is a bit of a mischaracterisation: in fact, the bank must just manage the difference between the value of its assets and the value of its liabilities. It has “asymmetric” credit risk here, in that if borrowers to whom it has lent go bankrupt it will lose money on its investments, but if lenders and depositors from whom it has borrowed go bankrupt the bank still owes it the money. That is the main reason banks have to maintain a minimum “common equity tier one ratio”: as a buffer against those credit losses.

A bank is a kind of transformer: it takes short-term liabilities and converts them into long-term assets.

Secondly, prudential rules require banks to keep a fraction of the deposits they receive “in reserve”. They are not allowed to lend them out as long-term assets, but must either sit on them or put them on deposit at the central bank.

Third, money is a wasting asset. Sitting on cash is necessarily inefficient because it is in the nature of money to lose value over time. One of the primary functions of the financial system is to keep money moving as fast as possible. It goes without saying, if you are sitting on money you are not earning anything with it. Putting cash with the central bank is the next worst thing to just sitting on it: while central banks do now pay interest, they don’t pay much. Here is a section from the Bitcoin is Venice opus:

Cash, on this view, is a tokenised, abstract, accountable unit of trust. It is a measure of indebtedness. Not specific indebtedness, to an identified person, as arises under a loan, but disembodied, abstract indebtedness in and of itself. This is quite an odd concept. Loans are expressed in monetary units, but are not monetary units themselves: they are contracts to pay and later return monetary units. The monetary unit itself — cash — is the subject of a particular class of contract called a loan. Cash is weird stuff. A banknote is not an asset, but an anti-asset: something that has a negative value in and of itself, and which, therefore, only generates value when you give it away. I can discharge a private debt I owe by transferring away my public token of indebtedness — cash — to the lender. We can see there that to hold cash, and not use it to acquire capital, discharge debts, or create indebtedness in someone else, is wasteful.

There is an important distinction here between holding cash, physically, and putting it in the bank.

When, and while, you hold cash physically, for all intents and purposes, the money is withdrawn from the financial system. It is disengaged. You have an “indebtedness” to yourself. It cancels out. It is meaningless. Worthless. Valueless. If you are robbed of physical cash it only creates a (negative) value when it is taken away, because it deprives you of the value you could have created by giving it away to someone else, in return for an asset.

So holding cash in person is a non-investment. It is to take capital out of the market. Since the value of capital is a function of the time for which it is productively engaged, a capital instrument you have disinvested should progressively waste away. So it does. Cash in your wallet, relative to a capital asset in productive use, must depreciate over time. That is the consequence of inflation. It has nothing really to do with central bank policy or fractional reserve banking: they may affect the rate of wastage, but they do not cause wastage. Cash itself necessarily wastes away.

This is why cash in your wallet is different to cash in the bank. Cash in a bank account is invested: with the bank. You have given away your token of abstract indebtedness to the bank in return for actual private indebtedness for which the bank credits you interest — okay, not much — as a return for your investment, and promises to pay you an equal amount of cash when you ask for it.