<p>Commercial banks face stringent market and regulatory constraints in their lending. This limits the amount of credit that they can issue.</p>
<p>For clarity, as I think you have the loan issuance process slightly confused, below is a stylised balance sheet example of a commercial bank making a loan. The bank purchases a financial security (signed promissory note promising to pay back the loan at a later date or schedule with a given amount of accrued interest) from a borrower with newly issued bank credit. Both the bank and the borrower's balance sheets expand in both directions (new assets and liabilities for each), leaving the net change in financial equity zero for all involved. <a href="https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf" rel="nofollow noreferrer">See Mcleay et al. 2014</a></p>
<p><a href="https://i.sstatic.net/lGPBoLE9.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/lGPBoLE9.png" alt="Stylised balance sheets for loan issuance" /></a></p>
<p>What doesn't happen is Bank A shifts funds from some other account in order to credit up the balance of their customer. Bank A simply issues new credit unilaterally - balanced by acquisition of the customer's issued credit IOU (their promissory note). But because the bank's credit is far more readily accepted throughout the economy than the customer's credit, the bank charges interest for compensation for holding the customer's lesser credit.</p>
<p>Most borrowers wish to make a purchase with their new bank credit from Bank A. This therefore often results in a transaction occuring with someone who banks at a different bank, B.</p>
<p>Bank A debits back down your recently enlarged deposit account and sends a payment instruction electronically to Bank B for them to credit the seller's account. This is the payment clearing process and can happen in seconds.</p>
<p>However, Bank B now has increased liabilities but no new assets and Bank A has fewer liabilities but no change in its assets. Bank A therefore must settle the payment with Bank B. You've described inter-bank settlement accounts but this settlement process is increasingly ultimately done via reserve accounts at the central bank. Below is more stylised balance sheets illustrating this process. Overall (both clearing and settlement), Bank A's balance sheet contracts and Bank B's balance sheet expands. The central bank's liabilities (reserves) simply shift in composition.</p>
<p><a href="https://i.sstatic.net/DddSsUA4.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/DddSsUA4.png" alt="Stylised balance sheets for transactions between customers at different commercial banks" /></a></p>
<p>For the stability and functioning of the financial and payment systems, settlement <strong>must</strong> occur between the banks.</p>
<p>If Bank B simply allowed its liquid liabilities (incoming customer deposit balances) to increase without a corresponding increase in its liquid assets, it would quickly become insolvent. Banks are not charities. They are not in the business of helping each other out.</p>
<p>If Bank B goes in negative equity, it will no longer be able to settle withdrawal requests or outward transactions of customers as certainly no other Bank would be stupid enough to allow Bank B to offload liabilities to them without demanding debt settlement. Customers would lose confidence in Bank B and shift their custom to competing banks, resulting in a bank run and bankruptcy. Of course, if this occurs across the economy, the central bank as lender of last resort can always re-capitalise the banking sector in bail outs (often with a few token bankruptcies (eg. Lehman Brothers in 2008)) but in a functioning competitive banking sector, banks face this insolvency threat.</p>
<p>The regulatory regime of our monetary systems also prevents such scenarios occuring. All financial obligations must be adhered to, otherwise confidence in the payment system itself would likely have large macroeconomic effects on the real economy and people's lives. The central bank plays an active role in regulating the banks and continuously ensures there is sufficient liquidity in the system to successfully conduct all payment requests (millions every day).</p>
<p>You mention overnight inter-bank lending. This does occur when Bank A doesn't have sufficient reserves for settlement and must acquire funds at the inter-bank rate. However, the key constraint on bank lending to customers is monetary policy of the central bank. Their administered rates (IORB, Overnight Reverse Repurchase (ON RRP) facility, and discount rate) force banks to increase the rate they pay on their own liabilities to customers (customer bank deposits and savings accounts) as otherwise other banks and wholesale depositors could arbitrage at the IORB rate and make free money.</p>
<p>For clarity, if the central bank pays 5% on bank reserve deposits held by them but Bank A keeps the interest paid out to customers on their deposits at 0%, then Bank B could offer 2.5%, attracting customers away while also bringing with them the corresponding reserve balances from Bank A. Bank B is now still making a free arbitraged profit of a 2.5% spread. But quickly, other banks would bid up their savings rates to attract customers for the same reason and naturally, via this market competition for customers, the arbitrage option closes. The end result is that customer deposits are remunerated at a rate roughly equal to the rate the central bank pays on reserves. In order for the banks to still make a profit, they must apply a mark up on their loan rates to once again generate a positive interest rate spread. These loan rates can not rise too high since, once again, a competitor would offer lower lending rates and attract customers away. <a href="https://research.stlouisfed.org/publications/page1-econ/2020/08/03/the-feds-new-monetary-policy-tools" rel="nofollow noreferrer">See the St Louis Fed on new monetary policy tools for more details</a></p>

CC BY-SA 4.0
2024-06-04T15:47:18.930Z
2024-06-04T15:47:18.930Z
Jamie Smith
<p>The way I understand the current banking system is:</p>
<ul>
<li>Banks make money primarily by writing loans and then collecting interest</li>
<li>When I go to a bank A and take out a loan for 500$, they take my account and simply add 500 to that number. (which is how the vast majority of money is created)</li>
<li>They then tell Bank B to write -500 to the account they have at that bank.</li>
<li>Rinse and repeat</li>
<li>Now the day is over and all the debts have to be paid back. If a bank has received deposits that day, they use those first to pay back their debts. If there's still debt left after, they take out yet another loan with either another bank or the fed at a certain rate, presumably at a lower rate than I got. This is called overnight lending</li>
<li>They only limit on how many loans they can give out is the default rate and the loan interest rate. If too many people default on their loans or if the interest rate is lower than the overnight lending rate, they make no profit.</li>
</ul>
<p>My question is, why do banks even bother with the effort of the overnight settlement? A bunch of negative numbers on a balance sheet isn't really gonna hurt them that much. Why don't they instead just give out as many loans as they can at whatever interest rate and let the debts to each-other just get as high as they want. Or even better, since no actual money is exchanged, why not loan money from themselves? Somewhere in the bank there is a negative account on which the bank pays interest to itself?</p>

CC BY-SA 4.0
2024-06-04T12:45:08.303Z
"*why not loan money from themselves*" is your question basically "is banking regulated in any way, or can they write themselves a check for 1 trillion dollars without any legal consequences"?
Giskard
CC BY-SA 4.0
2024-06-04T13:06:55.007Z
So the answer to my question is "because the goverment says so"
user2741831
<banking><central-banking>
Why do Banks care about settling their debts at the end of the day?
user2741831
# Why do Banks care about settling their debts at the end of the day?

(Asked by: username_0 on 2024-06-04)

The way I understand the current banking system is:

* Banks make money primarily by writing loans and then collecting interest
* When I go to a bank A and take out a loan for 500$, they take my account and simply add 500 to that number. (which is how the vast majority of money is created)
* They then tell Bank B to write -500 to the account they have at that bank.
* Rinse and repeat
* Now the day is over and all the debts have to be paid back. If a bank has received deposits that day, they use those first to pay back their debts. If there's still debt left after, they take out yet another loan with either another bank or the fed at a certain rate, presumably at a lower rate than I got. This is called overnight lending
* They only limit on how many loans they can give out is the default rate and the loan interest rate. If too many people default on their loans or if the interest rate is lower than the overnight lending rate, they make no profit.

My question is, why do banks even bother with the effort of the overnight settlement? A bunch of negative numbers on a balance sheet isn't really gonna hurt them that much. Why don't they instead just give out as many loans as they can at whatever interest rate and let the debts to each-other just get as high as they want. Or even better, since no actual money is exchanged, why not loan money from themselves? Somewhere in the bank there is a negative account on which the bank pays interest to itself?

**Tags:** banking, central-banking

> **Comments:**
> **username_1**: "*why not loan money from themselves*" is your question basically "is banking regulated in any way, or can they write themselves a check for 1 trillion dollars without any legal consequences"?  
> **username_0**: So the answer to my question is "because the goverment says so"  

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## 1 answers

### Answer by username_2 on 2024-06-04. Score: 1 | Accepted answer

Commercial banks face stringent market and regulatory constraints in their lending. This limits the amount of credit that they can issue.

For clarity, as I think you have the loan issuance process slightly confused, below is a stylised balance sheet example of a commercial bank making a loan. The bank purchases a financial security (signed promissory note promising to pay back the loan at a later date or schedule with a given amount of accrued interest) from a borrower with newly issued bank credit. Both the bank and the borrower's balance sheets expand in both directions (new assets and liabilities for each), leaving the net change in financial equity zero for all involved. [See Mcleay et al. 2014](https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf)

[![Stylised balance sheets for loan issuance](https://i.sstatic.net/lGPBoLE9.png)](https://i.sstatic.net/lGPBoLE9.png)

What doesn't happen is Bank A shifts funds from some other account in order to credit up the balance of their customer. Bank A simply issues new credit unilaterally - balanced by acquisition of the customer's issued credit IOU (their promissory note). But because the bank's credit is far more readily accepted throughout the economy than the customer's credit, the bank charges interest for compensation for holding the customer's lesser credit.

Most borrowers wish to make a purchase with their new bank credit from Bank A. This therefore often results in a transaction occuring with someone who banks at a different bank, B.

Bank A debits back down your recently enlarged deposit account and sends a payment instruction electronically to Bank B for them to credit the seller's account. This is the payment clearing process and can happen in seconds.

However, Bank B now has increased liabilities but no new assets and Bank A has fewer liabilities but no change in its assets. Bank A therefore must settle the payment with Bank B. You've described inter-bank settlement accounts but this settlement process is increasingly ultimately done via reserve accounts at the central bank. Below is more stylised balance sheets illustrating this process. Overall (both clearing and settlement), Bank A's balance sheet contracts and Bank B's balance sheet expands. The central bank's liabilities (reserves) simply shift in composition.

[![Stylised balance sheets for transactions between customers at different commercial banks](https://i.sstatic.net/DddSsUA4.png)](https://i.sstatic.net/DddSsUA4.png)

For the stability and functioning of the financial and payment systems, settlement **must** occur between the banks.

If Bank B simply allowed its liquid liabilities (incoming customer deposit balances) to increase without a corresponding increase in its liquid assets, it would quickly become insolvent. Banks are not charities. They are not in the business of helping each other out.

If Bank B goes in negative equity, it will no longer be able to settle withdrawal requests or outward transactions of customers as certainly no other Bank would be stupid enough to allow Bank B to offload liabilities to them without demanding debt settlement. Customers would lose confidence in Bank B and shift their custom to competing banks, resulting in a bank run and bankruptcy. Of course, if this occurs across the economy, the central bank as lender of last resort can always re-capitalise the banking sector in bail outs (often with a few token bankruptcies (eg. Lehman Brothers in 2008)) but in a functioning competitive banking sector, banks face this insolvency threat.

The regulatory regime of our monetary systems also prevents such scenarios occuring. All financial obligations must be adhered to, otherwise confidence in the payment system itself would likely have large macroeconomic effects on the real economy and people's lives. The central bank plays an active role in regulating the banks and continuously ensures there is sufficient liquidity in the system to successfully conduct all payment requests (millions every day).

You mention overnight inter-bank lending. This does occur when Bank A doesn't have sufficient reserves for settlement and must acquire funds at the inter-bank rate. However, the key constraint on bank lending to customers is monetary policy of the central bank. Their administered rates (IORB, Overnight Reverse Repurchase (ON RRP) facility, and discount rate) force banks to increase the rate they pay on their own liabilities to customers (customer bank deposits and savings accounts) as otherwise other banks and wholesale depositors could arbitrage at the IORB rate and make free money.

For clarity, if the central bank pays 5% on bank reserve deposits held by them but Bank A keeps the interest paid out to customers on their deposits at 0%, then Bank B could offer 2.5%, attracting customers away while also bringing with them the corresponding reserve balances from Bank A. Bank B is now still making a free arbitraged profit of a 2.5% spread. But quickly, other banks would bid up their savings rates to attract customers for the same reason and naturally, via this market competition for customers, the arbitrage option closes. The end result is that customer deposits are remunerated at a rate roughly equal to the rate the central bank pays on reserves. In order for the banks to still make a profit, they must apply a mark up on their loan rates to once again generate a positive interest rate spread. These loan rates can not rise too high since, once again, a competitor would offer lower lending rates and attract customers away. [See the St Louis Fed on new monetary policy tools for more details](https://research.stlouisfed.org/publications/page1-econ/2020/08/03/the-feds-new-monetary-policy-tools)


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