Moving Money - First Steps

I recently came across some notes I wrote several years ago when I was trying to understand how money moves around the banking system. Back then I struggled to find tutorials that covered the basics so thought I'd share my notes for those without a finance background who might be on the same journey. Please note I'm not a career banker so forgive me if my understanding is incorrect - feedback is very welcome!

In this first article I'll cover a simplified view of how money is recorded at rest within a bank and how it 'moves' from one bank to another. In subsequent articles I'll build on this foundation to describe how these 'moves' are executed in practice and progress to describe the cross-border 'movement' of money. Up front I'd like to acknowledge Richard Gendal Brown whose simple explanations of money movement in his series 'Thoughts on the future of finance' were particularly helpful for me.

Ok, intros over, here we go...

Single Bank Scenario

Let's start with the simplest scenario. Two individuals, Alice and Bob, open accounts with Bank A. Both deposit £100 in cash. Bank A staff take the physical notes and put them in their vault. In the vault the money isn’t kept in separate envelopes, labelled as belonging to Alice and Bob, it's held together as one lot of cash.

The bank's accounts now record the cash in the vault as an asset of £200 and a liability to Alice and Bob to repay them each £100. Note the bank doesn't promise to repay them the same physical notes they deposited, it simply agrees to settle its debt to them on demand. The balance recorded in Alice and Bob's accounts show a value of £100 each.

So imagine Alice wants to pay Bob £50. Bank A can simply alter the amount owed to Bob to £150 and at the same time reduce the amount owed to Alice to £50. Now we might say Alice 'sent' the money to Bob, but what Alice really did was to instruct Bank A to reduce the debt the bank owed to her and increase their debt to Bob by the same amount. The £200 in the vault doesn't change.

We have a mental image of an electronic bank transfer being the same as cash transfer, i.e. the physical movement from one person to another. However the numbered bills that Alice deposited didn't move and they no longer belong to her. At the point of deposit they became the property of the bank. From the bank's perspective the situation now looks like this:

Multiple Bank Scenario

Now let's imagine another individual Charlie who has already deposited £100 with her bank, Bank B. Bob wants to pay Charlie £50. One way is for Bob to ask his bank, Bank A, to reduce their debt to him and give him £50 in cash which he can then physically hand to Charlie.

Another way is for Bob's bank, bank A, to become a customer of Bank B and vice-versa. Let's imagine that both banks have a balance of £100 with the other bank. So Bank A has an asset that Bank B owes it £100 and a new matching liability that it owes Bank B £100, and vice-versa. The position now looks like:

Bob’s bank, bank A, can now send a message instructing Charlie’s bank, bank B, saying: “please reduce the amount of debt you owe me and increase your debt to Charlie by the same amount”. Again nothing really moves. Within Bank B one debt is reduced (the debt to Bank A) and another debt (the debt to Charlie) is increased. Within Bank A, the debt to Bob has been reduced but the £200 remains in the vault, untouched. Bank A's assets have correspondingly reduced by £50 as Bank B now only owes it £50 and not £100.

In executing Bob's instruction the amount of debt in our economy has reduced from a total of £500 (£300 in Bank A and £200 in Bank B) to £450 (£250 in Bank A and £200 in Bank B). Bank A's balance sheet has decreased by £50 and Bank B's has increased by £50.

Lending within a bank

Before we consider the next step it's worth a quick detour into lending as new debt (money) is created and recorded in a customer's account. Let's imagine Alice wants to take out a loan. Bank A agrees and increases their debt to her by £50 to £100. Her balance now shows £100 and she agrees to deposit £10/month for 5 months to repay back the loan.

This process is so commonplace that we barely notice what happens, but it's quite remarkable. Bank A created new debt (or we might say new money) out of thin air. It increased Alice's balance, in much the same way you or I could create debt by writing an IOU on a piece of paper. There is a crucial difference however. In the bank’s case this debt is very transferable, whereas an IOU that I write is unlikely to be trusted by someone who has never met me.

Central Bank Scenario

Returning to our simple payments ecosystem we need to consider what happens when we have lots of banks, not just two in our example. Do they all maintain mutual debts (accounts) with each other? This would be very inefficient as it would require every bank to monitor and maintain the accounts they hold with every other bank to ensure they have sufficient funds to allow payments to be made on their behalf.

We will come back to this when we consider cross-border payments, but within a single currency/jurisdiction there is another option. We can use the services of a central bank that all the individual banks maintain accounts with. This institution can hold a single account for each member bank and accept instructions to transfer debts between them.

Let's reset our scenario so we have just simple cash deposits at Banks A and B.

Now let's imagine Bank A and Bank B physically take £50 out of their vaults and send the cash to the central bank. The central bank now has a debt of £50 to each recorded as a liability in their accounts. These central bank accounts (or debts) have a special name, they are called 'reserves'. For the purposes of this simplified example reserves can be considered a closed system, i.e. the total amount of reserves remains the same as banks make payments between themselves. The balances of individual banks vary day-to-day but the net amount is unchanged.

Let's see how this works.

We revisit the process of making a payment from Bob to Charlie. Bob tells his bank to reduce their debt to him by £25 and send a message to Charlie’s bank to increase their debt to Charlie by £25. To balance the books between the banks the central bank needs to reduce its debt to Bob’s bank by £25 and increase its debt to Charlie’s bank by £25.

Bank A now has a reduced asset with the central bank and a correspondingly reduced liability to Bob. Bank B has an increased asset with the central bank and a matching increased liability to Charlie. The central bank's overall position hasn't changed, as we discussed above, but the balance of its liabilities has. It now has an increased debt (or liability) to Bank B of £75 and a lesser debt of £25 to bank A.

There is a drawback to this centralised process. To execute this transaction, Bank A now has to instruct not just Bank B but the central bank as well. These three parties, the originating bank, the central (or settlement) bank and the beneficiary bank all have to make matching changes. We will see in the next article how these messages are coordinated and these adjustments are achieved in practice.

So this completes our first article. We have arrived at the point where we can make payments through a central bank without the physical movement of cash between banks or the necessity for banks to hold accounts with each other. In the next article we will look at the messaging between the banks and the central bank that makes this possible.