Peter J Morgan
Peter J Morgan BE (Mech.), Dip. Teaching – professional forensic engineer, retired economics, mathematics and physics teacher
PART 4 of 18
When an EFTPOS payment or a cheque from a customer of one bank is deposited with a competing bank, not only is money transferred from the payer’s account to the payee’s account, but the payer’s bank owes the payee’s bank an equal amount of RBNZ notes and coins. To avoid the risk, inconvenience and expense of physically moving RBNZ banknotes around between banks, the RBNZ – and indeed all central banks, long ago created a second tier of money – unavailable to anyone except the banks and the central bank – called “reserves”, which nowadays are RBNZ electronic money. Several times during every business day, a computerised settlement process takes place to net-out these inter-bank debts, and after each settlement process each bank either owes one or more of the other banks, or is owed, some reserves. Hence the observation that “reserves follow deposits“.
Banks, therefore, need to hold some reserves, which they borrow from the RBNZ at an interest rate 50 basis points (a basis point is one hundredth of a percentage point, so 50 basis points are equal to 0.5 percentage points) above the Official Cash Rate (OCR), the OCR being the interest rate that, since 2006, the RBNZ pays on deposits of banks’ surplus reserves. If a bank doesn’t have enough RBNZ reserves and cannot borrow them from another bank at an interest rate below that which it would have to pay the RBNZ, that bank borrows them “on demand” from the RBNZ at the OCR + 0.5%. In practice, the RBNZ never refuses to lend reserves to a bank, but it might do so if a bank did not have the pre-specified collateral. Only financial institutions that meet the requirements of the RBNZ are authorised to hold electronic reserves – ordinary companies, trusts and people are not. That is, the existing monetary system is a two-tier one. The lower tier, for ‘we the people’ and our businesses and legal entities, consists of electronic bank-debt-money plus RBNZ notes and coins. The upper tier, for the RBNZ, banks and selected financial institutions only, consists of lower tier money, plus electronic RBNZ reserves. To satisfy their customers’ needs for them, banks buy notes and coins from the RBNZ, and pay with electronic reserves.
Because of the automatic, several-times-a-day system of netting-out reserves, the amount of reserves that any bank needs to borrow is only ever a very small proportion of the sum of the loans it has granted – hence the term ‘fractional reserve system’ (since replaced by the term ‘risk weighted lending system’), so despite the claims to the contrary by the governor of the RBNZ and the mainstream media alike, the magnitude of the OCR does not necessarily have much effect on any bank’s lending decisions or profits. This is proven whenever banks engage in a ‘lending war’ by lowering their mortgage interest rates despite there having been no recent cut in the OCR.
To ‘lend’ (i.e. create ex nihilo new money), banks first seek out willing and able borrowers, then grant their loans, and then, only if they need to do so, borrow only enough reserves for settlement with each other. So, the rate of money creation by banks depends not so much on the level of the OCR, but more on the willingness of potential borrowers to borrow, and the banks’ assessment of their ability to pay the interest charges and make the scheduled principal repayments, plus their reliability in doing so. When the RBNZ lowers the OCR, the mainstream media demonstrates its ignorance – or possibly complicity in hiding – as to what the OCR actually is by wondering aloud if the banks will “pass on” the cut in the OCR by reducing their mortgage interest rates. Another example, from an NZ Herald article reporting the cutting of the OCR to 2%, is the somewhat misleading statement that “Banks need deposits to help fund their lending”.
An explanation of the need for NZ banks to obtain deposits from overseas-domiciled customers:
When an ANZ customer is granted a $750,000 mortgage for the purchase of a house, and the ANZ customer buys a house from a Westpac customer, ANZ’s liability to pay the $750,000 in RBNZ notes and coins is transferred to Westpac, and ANZ must pay $750,000 in reserves to Westpac in the next round of automated “netting out”. If the Westpac customer, having sold his house, then decides to import a $400,000 boat from a UK boatbuilder who banks with Barclays, for the equivalent in UK pounds, he would go to Westpac and buy $400,000 worth of UK pounds. On the open forex market, Westpac quickly has to exchange $400,000 for its equivalent in UK pounds, and as a result the previous owner of those UK pounds then has, instead, a $400,000 deposit with Westpac. But that foreign-owned NZD deposit in Westpac might be simply an overnight balance, and no bank will want to fund itself for very long with a flighty overnight wholesale balance, so Westpac will try to replace that very short-term deposit with more secure funding, by for example issuing a three-year bond in the international market – long enough that it will count for the RBNZ core funding ratio, but also the sort of funding that will comfort the ratings agencies. (In practice, the bonds an individual bank will issue will often be in US dollars or Euros, then hedged back to NZ dollars, but for simplification purposes we can assume that NZ dollar-denominated bonds would be issued – that is the economic substance of the set of transactions.
Thus, individual New Zealand banks are always competing for “their share” of the foreign deposits resulting from their customers’ imports of goods and services. In particular, individual New Zealand banks try to lock-in longer-term foreign deposits (both from prudence, and from specific RBNZ regulatory restrictions). When global markets get more jittery generally, that flows through into higher interest rates that New Zealand banks have to pay to attract term deposits from overseas. This increases New Zealand banks’ costs of being in business, and necessitates an increase in the interest rates that they need to charge on the loans they grant – and have previously granted – to their customers. The banks generally say that the interest that they have to pay to attract term deposits from overseas represents their ‘funding costs’ – giving the impression, falsely, that they lend out their term deposits – the old ‘loanable funds’ deception.
The above two paragraphs could not have been written without the much-appreciated help and guidance of Michael Reddell, former Senior Economist at the RBNZ, former Head of Financial Markets at the RBNZ, and former Alternate Executive Director on the Board of the International Monetary Fund. The URL for Michael Reddell’s well-known blog on matters concerning the New Zealand economy and politics is www.croakingcassandra.com