What happens if Robert goes and spends the new bank-created money with a shop that has a bank account with a different bank, let’s say Lloyd’s, if this happens, then Lloyds will want to see 10,000 pounds of real money from Barclays. Barclays would then need to transfer 10,000 pounds of central bank reserves to Lloyds to settle the transaction.
Note: From the point of view of Lloyds receiving a transfer of 10,000 pounds in central bank reserves into its accounts at the Bank of England is just as good as Barclays pulling up in a truck and dropping off 10k pounds in cash. However, it’s much more convenient for the banks to have electronic central bank reserves than to carry around all that cash.
This process of banks making payments between themselves is called interbank settlement, and it’s really important to understand it because it’s crucial to the way that banks have been able to gain control of the entire money supply. First, let’s look at the simplest example of an interbank settlement with just two banks and two customers.
Robert, when he receives his loan, goes straight into a DIY store and spends 10 thousand pounds on everything he needs. He goes to the checkout and pays using his Visa debit card.
Here’s a simplified version of what happens behind the scenes.
First, the DIY store’s debit card machine automatically contacts Visa and says, please charge 10000 pounds to this card number that Visa’s computer systems then dial up Barclay’s computer systems and say Robert’s trying to spend 10000 pounds and his debit card.
Is that OK?
Barclays computer system checks the balance of the account and says yes and then reduces the balance of Robert’s account by ten thousand pounds. Now, Visa’s computer system contacts Lloyds and says, I’m sending you 10,000 pounds for the DIY stores account. Lloyds then updates the balance of the DIY store by 10000 pounds. However, importantly, when the owners of the DIY store log into their Internet banking, they see two figures. One says account balance and the other says available.
Now for the next couple of days after Roberts comes into the shop, the account balance will be 10000 pounds higher than the available balance. The 10000 pounds that Robert has spent isn’t available to the DIY store for them to spend just yet.
Why?
Well, behind the scenes, Barclays needs to settle with Lloyds. When Lloyds gets the message that someone has spent 10000 pounds in the DIY store, it updates their account balance and then calls Barclays to say, ask them to send the money. Barclays could settle with Lloyds by delivering the ten thousand pounds in cash, but in reality, this is just a hassle for both banks that have to find somewhere to store all the cash in a van with security to transport it.
So instead, Barclays will settle by making a 10000-pound transfer from its reserve account to the Bank of England to Lloyds’ reserve account to the Bank of England. Once Lloyd’s gets the 10000 pounds in its account, the Bank of England, then it will update the available balance in the DIY stores account. Now, this was a simple example that involved just one payment between two bank customers, Robert, and the DIY store, only two banks are involved, but in the U.K. right now, there are around 50 million people with bank accounts.
Some of these people make more than one electronic payment a day and there are over 50 different banks.
Every day, over 60 million transactions are made between bank accounts in the U.K. through several different payment systems, including Visa, MasterCard, direct debit, and online bank transfers. If banks had to go through the whole hassle in the example with Robert, every time someone bought a sandwich from a supermarket using a debit card, it would get very messy very quickly. But there’s a clever way of simplifying the whole thing massively. It’s called multilateral net settlement when you have a lot of individuals and businesses making payments to each other. That’s a lot of money flowing between the different banks. So what the banks do, especially with fellow banks, which manage direct debits and the type of bank transfers that you make via Internet banking is this.
First, they put all the payments into a big computer database without actually moving any real money, cash, or central bank reserve then at the end of the day or every few hours, they run a process to cancel out as many of the payment flows as possible.
For example, Imagine a customer at Lloyds sends his rent of three hundred fifty pounds to his landlord’s account at Barclays. But on the same day, a customer, Barclays, sends his rent for £100 to his landlord, who happens to be at Lloyds. The two payments almost cancel each other out. So after canceling out or netting, in the official jargon, the only money that needs to be moved is 50 pounds from Barclays to Lloyds because there are millions of payments being canceled out by the system.
The amounts that need to be transferred between the banks at the end of the day are usually just a tiny fraction of the total value of the payments made and this is why even though in 2007 RBS customers had nearly 700 billion pounds in its customers accounts, about itself only had 17 billion pounds that it could use to make payments on behalf of those customers, this 17 billion was more than enough for the total netted payments that it would need to make at the end of the day. This netting-out effect means that a bank only needs to have a very small amount of available money compared to the total amount that they owe to customers at any particular time.
They know that any payments they make to other banks are likely to be canceled out by payments coming back to it. On some days, the bank customers will spend more than they receive, and at the end of the day, the bank must pay some of its money across to other banks to settle these payments. But on other days, customers will receive more in salaries and other income than they pay out, and the bank will end up receiving money from other banks at the end of the day. Over time, the total amount of money needed by the bank doesn’t change much. The only time that they would need all the money that they owe to their customers is if customers were to panic and ask for their money back at the same time. This is what happened to Northern Rock in the U.K. and Wachovia in the US, and it can destroy a bank very quickly.
This process is what gave rise to the term fractional reserve banking because banks only need to keep enough money to repay a fraction of their customers any time. We talked about the central bank reserves that banks keep in their accounts of the Bank of England, these reserve accounts don’t store cash, just electronic central bank reserves. It’s important to note that although central bank reserves are created by the Bank of England, they’re still just numbers in a computer system. These numbers are just stored on a file very similar to an Excel spreadsheet, and we could create a billion of them in the time it takes to type out the number of screens.
The 150 billion pounds of central bank reserves are no more tangible than the numbers on the screen, and in fact, the entire record of balances of the central bank reserves scheme will take up less space on the Bank of England’s computer hard drive than the average song on an MP3 player. Now, the computer system that records all these central bank reserves is referred to by the Bank of England as the real-time gross settlement processor or Artigas processor.
Now, real-time gross settlement isn’t as complicated as it sounds. A settlement simply means that it’s a system that banks can use to settle their payments to each other. In other words, it’s a way for them to transfer money to each other. Real-time gross settlement means that any payment instructions sent to the computer system are processed immediately. If a payment of 100,000 pounds is sent to the system, 100,000 pounds will be transferred automatically. This is, in contrast, a multilateral net settlement that we discussed just before in the article where all the payments are queued up, canceled out against each other and only the final net difference is transferred.
When a payment is put through, the Artigas processor is considered to be final, it’s also considered to be risk-free if one bank owes money to another bank. There’s always a small chance that it won’t be able to pay the other bank. But once the money arrives in the central bank reserve account, then the deal is finished because holding central bank reserves is just like holding cash.
It’s the safest asset you can have.
So at the end of the day, the multilateral net settlement payment systems will cancel out all the smaller payments between different banks and then they’ll tell the real-time gross settlement processor how much of the net difference is owed between the banks should be. The Artigas system will then transfer the central bank reserves from the banks that owe money to the banks that are owed money.
