By MA Illiasu
I was discussing banking system with some curious-minded folks and a question came to mind; how do banks create money? And as expected, not all of them knew. The common knowledge was that banks do not create any money, they only issue out loans from the savings deposited with them by the people who’ll have no need of their money in a long period. But that’s that, a common knowledge. And I believe banking system operates on a knowledge much trickier than that.
Now let’s take for example as the Nigerian governments at several level suspends the lockdowns for a day or two, to allow people to bring in some long term or makeshift daily life stuffs. Three cases are bound to rise. One, people would rush and purchase all the needed stuffs ranging from food, drinks, sanitizing materials, medication, etc. A big number of those people have money deposited with Banks, and so would do those transactions by making a wire transfer to the sellers of those products and services. But there are people who wouldn’t do just that, and that’s where the second case would arise. Big number of those depositors would not only make a wire transfer, but would also withdraw massive portion of their money in cash, because not only do they need all those stuffs, they also need to be secured financially. And financial security in this regard revolves around having physical cash at disposal – against the lock down that restricts their movements to the Banks – in case an urgent need arises. What the Keynesian economists call precautionary purpose. But also there are people who would never make a wire transfer as if they do they’ll die, simply because they either don’t know how to do it, or because they don’t believe in such modern technological superstition – which is a cogent phenomenon in Nigeria. And that’s where the third case would arise. Those people would withdraw all the money needed to buy those commodities and the one they’ll need for precautionary purposes.
The important point to consider here is that, Covid-19 is a disease that makes people nervous and stocked with fear. And being nervous or afraid is a big factor that determines the need of money for precautionary purpose. Another important thing to notice is that, where the understanding of all the above three cases is limited, one could simply back oneself up with the knowledge of the drastic, heavy movement of physical cash in Nigerian economy. As oppose to the nature of foreign economies where there’s absence of that. And where the word “cash” is mentioned, Banks are brought into the picture. Likewise where physical movement is concerned, regular deposits and withdrawals are imminent.
Now let’s go back to the core of our initial discussion. How do Banks create money? The correct answer is that, “Banks create money out of nowhere.” As opposed to the common belief that Banks do not create any money, they only issue out loans using the money the public deposit with them. It may not sound logical, but it’s. How can one create money out of nowhere? The fact is that, if capitalism is a machine, then debt is the fuel. And it’s the iimportance of debt upon the market societies that makes it a phenomenon of regular enquiry, just like blood and oxygen to the sick and healthy alike. Those debts are equired mostly by entrepreneurs and households looking to buy houses or businesses looking to buy capital assets. And Banks as the entities that have its image protected by the consistent flow of public deposits, become the most trusted, and so, common source of loans. Therefore majority of times, entrepreneurs and other individuals in the economy are mostly indebted to the banks. Because it’s the banks that give out loans, and in return would charge interest, after an agreement that’ll be signed by all the parties involved. Entrepreneurs invest those loans in businesses and would not be able to pay back until an agreed period of time. Individual households also would invest those loans on buying houses which they won’t be able to payback until the agreed period.
From pragmatic sense of financial reality, when the number of loan requests are compared against the amount of deposits Banks get, the money deposited with the Banks would never be enough to satisfy all the loans enquired by the entrepreneurs and households. And any individual or organization with required elements needed, ranging from collateral to documentations, would never not secure loan from a bank, despite the fact that Banks don’t always have the required physical cash that’ll satisfy all the loan request. How do they do it? It’s a magic, which Yanis Varoufakis call “The black magic of banking ”. And it’s using that magic the bankers would “ create an anonymous money by writing a lot of zeros on a sheet paper or a long list of numbers on a computer that’ll represent physical cash, just like what we know of fiat cash in our mobile banking, which people would use normally like the physically cash.” With the hope that those entrepreneurs would payback on time, before trouble happen.The whole Black Magic depends on hope, and the optimism that everything is going to be alright. And the reason that ensures it works with the loan applicants and some few depositors alike is that they get their loans and withdrawals through a wire transfer and not in the form of cash. And wire transfer being acceptable as a medium of exchange, is all the people need in evidence to trust the method. But that trust would not last forever, because crises like the one being encountered currently that’ll force people to seek for cash amd not wire transfer, and business circle which the pandemic may cause is inevitable, and so, a crash is bound to happen.
Bankers can be seen as pragmatic practitioners by the way they handle their affairs. So risk averting and cautious. But they are the most legitimate risk-takers in the way they think, of any institution in an economy. That risk taking is what gas them into giving out loans that are ridiculously beyond their lending capacity. And such depends thoroughly on their depositors not needing physical cash, so as to keep brainwashing them and the loan applicants into believing they’ve all the cash they think they do. But in the event the depositors wanted withdrawal in physical form, they’ll have no choice but to give it to them. And that’s where they’ll get into a dilemma. Because they’ve loaned out so much money and more, with little to satisfy the people that would always need physical cash. So what’ll happen in an event like the one we may currently face; when people are nervous due to announcement of a lock down, so they would need much money for precautionary purpose, and all of them would be urged to withdraw at a time, while the bankers do not have that much money at their disposal due to loans they give out as well as the anonymous money they created that’s way beyond their deposit capacity using people’s deposit as a cover up. What exactly would happen?
Banks would be issuing people the withdrawals that’re far less than what they request for, to settle and comfort many people at a time. They’ll be encouraging people to use wire transfer and people would disagree. And that’ll make the matter even worse. Mainly because if you want to trigger trouble, upset a man that’s hungry. And people are hungry for cash. And that’s when the negativity would put the formula of “one to tell ten, ten to tell others” into full effect. Give it one day, and Banks would be having longer queues than a bag of millet has grains. Everyone would want to withdraw cash because there’s rumor suggesting banks are running out of cash . Even people who don’t need it would do so mainly because they finally get a clue that banks don’t have money. And they’re nervous because of Covid-19 and a lock down. The way I see it, that may mark the beginning of an inevitable financial crash that’ll last a long time until CBN intervene. While the CBN is dealing with bigger trouble than just the crash of financial system – that’s taking care of Nigeria’s emergency for Covid-19.
The entrepreneurs have already invested and can’t payback until an agreed period. Households have purchased houses and would not be able to payback until the agreed period. And to counter that, the collateral those economic agents submitted to the bank would be sold, but not entirely, because the buyers are rational – they’ll know that what make Banks sell in a panic is greater calamity than everything they can predict – and so would be reluctant to buy knowing they’ll lose the value of their money to crisis. And due to that, banks may get out of business. Some may liquidate and get taken over. And if people can’t get the money they deposit back, they can’t buy commodities. And if people can’t buy commodities, the entrepreneurs who take loans would lose their customers, and so would be unable to payback their loans come the agreed period. So in the long run, it’ll be a circle of depositors owing banks, and banks owing entrepreneurs, while entrepreneurs can’t payback. Summing up a crash.
After a crash comes the slump. Everyone owes everyone and no one can pay. Savers are told that their money has been lost, as the bank they deposited it in is bankrupt. Even those with money stashed away cut down, fearing an uncertain future. The recycling process on which the economy relies starts to go into reverse. More entrepreneurs lose their customers, cancel orders of new machinery and have to lay off workers. The fired workers cannot buy goods from the entrepreneurs who are still in business, pushing surviving companies towards the brink. Offices and factories close. Soon large numbers of workers, who would love to work, are unemployable, as employers, who would love to employ them, fear that the goods that they would produce will find no buyers.
Meanwhile, families cannot repay the loans with which they bought their houses. The banks confiscate their houses to sell them in a desperate bid to retrieve some of the missing millions. But with so many houses on sale and so little money in people’s pockets, rows and rows of sad houses remain empty and house prices collapse.
“Widespread insolvency. Mass unemployment. Wrath. This is the nemesis that follows hot on the trail of the bankers’ hubris.” – as asserts by professor Yanis Varoufakis. Its wretched vengeance falls indiscriminately and so affects the poor and the innocent above all. If you ask me of what I think of indefinite lock down that involves banks too, I’ll say the unprepared poor would suffer. But the hubris of banking would get exposed more, and that would come back and hang us all by the neck. The wiser counsel is to never involve banks in the lock down to promote sense of security among depositors. But with economic activities put on hold due to lack of movement, would businesses and households be able to payback their loans? Only time can tell.
MA Iliasu is a student of economics from Bayero University who takes pleasure in reading and writing. He writes from Kano.
The views expressed in this article are the author’s own and do not necessarily reflect the editorial policy of Sky Daily
