Commercial banking theory (which is, essentially, bank of issue theory) is relative easy to understand, once we remove the mystique that surrounds money. A bank — any bank, including banks of deposit as well as banks of issue — is essentially a clearinghouse for the exchange of promises. The function of a bank is to substitute the bank's good word for that of an individual borrower, and transfer these generalized promises that the bank stands behind between debtors and creditors.
At its simplest, a commercial bank operates in this fashion. A prospective borrower has something with a present value. This can be anything from an accumulation of existing wealth, such as inventories, or a sound proposal that will (if all goes as expected) generate inventory — and thus income when sold — in the future. As every finance major in college knows, the future stream of income from a capital project, whether industrial, agricultural, or commercial, has a "present value."
How this present value is determined is more of an art than a science, and one expert in the process will typically give between three to five present values in his or her opinion as to the expected actual present value. No one knows the future, of course, so as long as the opinion is based on the best data that can be gathered and the valuation expert is reasonably competent, his or her opinion is as good as anybody else's.
In any event, the prospective borrower cannot, realistically, go around to everyone in the economy, convince all the people with whom he or she will be dealing of the present value of the project. It is even more unrealistic to convince them all again to accept his or her individual promise to deliver wealth on demand to settle all the individual debts that will be incurred to bring the project to fruition. That is, to carry out the project, the prospective borrower would have to borrow the labor of some people, the raw materials of others, and so on, and pay them when the project starts to generate income.
Instead, the prospective borrower goes to a bank of issue, or commercial bank. He or she then only has to convince one individual, the bank's loan officer, of the present value of the project, and convince the loan officer to accept his or her promise to deliver wealth to the value of what is borrowed, plus a fee for being allowed to use the bank's good name, at such time as the project generates sufficient income.
After the usual bargaining (the borrower always believes the value of his or her project to be higher than the banker does), the borrower and the lender agree on the present value. The bank creates a demand deposit or prints notes in the amount of the lien it takes on the future income to be generated, and hands the checkbook or notes over to the borrower.
The borrower spends the money thus created (hopefully in ways that will generate the income needed to pay back the loan and make enough other profit to justify the effort), and begins making profits. A portion of the profits are used to make the debt service payments, which means payments of principal and interest on the loan.
When the bank receives the payments, it cancels that portion of the payment that represents principal (the original loan amount), and puts the rest into a revenue account to meet its own expenses and generate a profit for the bank. It's important to note that only the money that was created is canceled. The money that represents a charge over and above the original amount of the loan is not canceled, but reenters the economy as the bank pays its expenses and distributes dividends to its shareholders. The bank cancels no more money than it created in the first place. The amount over and above that collected by the bank as revenue reenters the economy, just as it would for any other business, whether to meet the bank's expenses, reinvest as retained earnings, or pay out profits.
Strictly speaking, none of this is by its nature usurious — but it can result in usury. That is what we will examine in the next posting in this series.
THE Global Justice Movement Website
This is the "Global Justice Movement" (dot org) we refer to in the title of this blog.
