Recently, discussions about a public bank in Santa Fe have increased. This note addresses skepticism expressed about the utility of a chartered public bank. Chartered banks have a marvelous, some say almost magical, way of creating money in the economy by advancing bank credit (lending). Serious students of banking have understood the process for decades. Yet, many grasp neither the process nor its importance.
The process relies on our understanding of money as an IOU (I owe you). The issuer of an IOU makes a promise to redeem it by exchanging the IOU for some specific thing of value. A coat check ticket is an IOU that is redeemed by returning your coat. A grocery store coupon is an IOU that is redeemed at the checkout counter as a payment on your grocery bill. Dollars issued by the federal government are IOUs that circulate as money and may be redeemed only for other dollars or as payments on your tax bill.
Your bank deposit is an IOU from the bank that promises to redeem the deposit in dollars. You can have cash or, should you write a check, the bank will decrease your account balance and increase the balance of the recipient’s account. If the recipient’s account is at another bank, the Federal Reserve Bank provides the clearing service to make the transfer from one bank to another. Nowadays banks record balances on electronic spreadsheets (ledgers) and transfers occur by electronic means.
When any chartered bank advances credit, two events occur. First, the bank accepts a promissory note (IOU) committing a borrower to pay the principal plus interest. Second, the bank increases the balance of the borrower’s bank account by the amount of the principal. The entire loan process is an exchange of promises that creates money where none existed before.
Redemption begins when the borrower writes a check to make a withdrawal from the new account balance. The bank must find the funds with which to redeem its promise. Purposefully, the banking system allows a bank to borrow funds from other banks in the federal overnight funds market at a low interest rate. That rate is near the federal funds rate that the Federal Reserve Bank recently increased to 0.75 percent.
A bank may have excess funds if it takes in more deposits than it loses in withdrawals on a given day. Excess funds are available for lending to banks that come up short of funds at the end of the day. Having set the price of money, which is the funds rate, the Fed has the responsibility to supply all the money demanded by the banking system
Here is the important advantage of a public bank that the city owns. Like any chartered bank, a public bank can access funds at the low Federal Reserve Bank rates rather than at private bank rates. And bank profits go to the owners, the city rather than private investors.
Of course, bank operations are much more complex than the essentials outlined above. Bank regulations are numerous and limit the amount a bank may lend to some multiple of owners’ invested capital. For small banks that multiple is over eight and depends on loan risk, which is small for city projects. Also, banks need plenty of deposits to allow ready access to funds needed for daily operations. And deposits bring with them assets deposited at the Federal Reserve Bank that the bank may invest in safe treasuries or other government assets.
Finally, because it does not need to satisfy the investment desires of private investors, a public bank can be a super-safe depository for public funds.
