Commercial Banking & the Money Supply
Commercial banks largely confined themselves to taking deposits from industrial, commercial & wealthy individual capitalists. They make short-term loans to businesses & discount commercial paper held by industrial & commercial capitalists.
Perhaps their most important function is to provide a payments mechanism through the creation of credit money. Through fractional reserve banking, they create a large quantity of credit money on a much smaller base of legal-tender “hard cash.”
Nowadays, legal-tender money consists of paper money not convertible into gold issued through the central banks, along with fractional coins made of base metals.
The legal-tender paper notes & coins, along with the legal obligations of the central banks to pay off the commercial bank deposits in the central banks in legal-tender cash on the demand of the commercial banks, forms the “monetary base” of “hard cash” that backs up the much larger quantity of commercial bank-created credit money.
The overwhelming mass of the “money supply” the economists talk about consists of commercial bank-created credit money, & not the legal-tender token money.
In the past, commercial banks did not as rule make consumer loans nor did they advance mortgage loans to homeowners. Indeed, as a rule only capitalists had dealings with the commercial banks. Consumer bank loans were the function of saving banks & mortgage companies. They couldn’t create credit money through checking accounts.
Although now most savings bank & mortgage companies have gone, the survivors can now issue checking accounts & so create credit money. The distinction from saving banks has now gone.
Investment banks are quite different from commercial banks. They do not take deposits & issue bankbooks. The core business of an investment bank is to underwrite new issues of stocks & bonds. The funds collected can then be used to arrange mergers & organize new & larger corporations. They also reorganize bankrupt corporations that are not liquidated.
Although they do not issue mortagages, they have been involved in the “securitization” of mortgages. Instead of holding on to the mortgages, the direct lenders sell them to an investment bank at a certain markup. Once they have done this, the direct lenders no longer care whether the mortgage is ultimately repaid, they have made their profit. Hence the subprime mortgages prior to the 2007 credit crunch.
Derivatives are securities or other financial “instruments” whose value is based on—derived from—other securities. Some derivatives, such as put & call options, have been around for years. But developments in computer technology enabled financial “innovators” to come up with new, often highly complex, derivatives such as mortgage-backed securities & credit default swaps.
Once enough mortgaged home buyers began to default on their mortgages, it was the weaker investment banks that had bought the mortgages & the capitalists who had bought the “derivative” securities created by the investment bankers who were dragged down.
Investment banks does not take deposits, they raise cash by issuing short-term promissory notes called commercial paper.
In the panic of 2008 they couldn’t sell any commercial paper.
Bear-Stearns & Merrill-Lynch were saved from complete collapse only by being forcibly merged with J.P. Morgan Chase and Bank of America, respectively. Both are heavily involved in commercial banking & so have a deposit base. Lehman Brothers was forced to declare bankruptcy in September 2008 & was liquidated.
The Banking Act of 1933 (Glass-Steagall)
This required that a banking institution be either a deposit-taking bank or an investment bank. If a banking institution decided to function as an investment bank, it would be forbidden to take deposits.
The idea behind this reform was that a run on the commercial banks would paralyze the whole system of bank-created credit money.
It was the huge wave of failures of mostly small commercial banks that caused the U.S. “money supply” to contract by one-third between 1929 and 1933.
The act also created the Federal Deposit Insurance Corporation (FDIC). The idea is that deposit-taking banks would purchase deposit insurance from it. Each bank that belongs to FDIC pays into this insurance fund. Up to a certain amount of the banks’ deposits ($250,000) are insured by this fund.
It is the responsibility of the FDIC to determine whether its member banks are solvent or not—that is, to determine whether or not its assets—mostly loans & discounts—exceed its liabilities—mostly deposits. If a bank is judged insolvent, the FDIC is supposed to shut it down. The FDIC either arranges a merger with another, solvent bank, or if this can’t be arranged, it runs the bank itself for a transitional period while the failed bank is being liquidated. In the event of liquidation, the FDIC pays out of the insurance fund the full amount of the bank’s deposits that fall within the limit that is insured by the fund.
Before FDIC, depositors knew that they could & likely would lose a part, and maybe all, of their money if their bank failed. They would therefore avoid putting their money in banks that had a reputation for reckless or speculative behaviour. But once depositors knew that they would always be able to access their funds even if the bank failed, they would no longer be so picky. Bankers who were previously restrained would be free of this constraining influence. Therefore, more speculative behavior would be expected under the FDIC insurance system than without it: Moral hazard.
The Cyclical Movement of Credit & Banking
During the economic boom phase of the industrial cycle, credit increasingly replaces cash.
This means that industrial production will sooner or later expand faster than the supply of money material—gold bullion.
The replacement of cash transactions by credit transactions is a symptom of the ongoing overproduction. It is a sign that production is developing beyond the limits allowed by the capitalist relationships of production. Either capitalist relations of production must be abolished—or a crisis of overproduction will break out that will reduce production back down to the narrow limits that capitalist relations of production are adequate for.
Eventually, there is a banking & credit crisis, & credit contracts. Overproduction comes out into open in the form of huge mountains of unsold commodities piling up in warehouses, evaporating order books for the industrial capitalists, the dumping of unsold commodities at prices below their values. Industrial production plummets as commercial capitalists slash orders or suspend them altogether for a time, workers are laid off, & wages are slashed below the value of labour power.
As economic activity declines & the general price level falls, the economic system returns to a cash basis. The fall in the general price level reduces the amount of money that is necessary to circulate the now reduced total mass of commodities. The production of money material—gold bullion—becomes increasingly profitable.