Introduction
There are many considerations in establishing a public bank that must be answered. This paper addresses only financial issues.
A public bank like any other bank must have a state or federal charter. A bank, unlike non-depository, financial institutions, is allowed to accept deposits. The public bank then becomes part of the nationwide banking system but has a mission to serve the public rather than private investors.
As a member of the banking system a public bank will have an account at the Federal Reserve Bank (Fed). The Fed is a bank’s bank, and funds deposited there are called reserves. Banks also have securities accounts to hold Treasury bonds, and other government securities. Switching from reserves to securities and back occurs readily upon decisions by bank management.
Not only will a public bank return profits to the public owners, it will distinguish itself by maintaining low-risk operations. Without the need to satisfy investors with high profits, a public bank need not engage in the kind of high-risk operations and investments that can threaten private banks
Initially, A Public Bank for Santa Fe will loan to and accept deposits from its owner, the City of Santa Fe. When it becomes well established, the bank may participate with other banks and credit unions in loans to community development projects. And, it may accept deposits from other public institutions.
Owners of a public bank will be some government entity; municipality, county, state, tribe or a combination of them to amass sufficient assets and liabilities to operate profitably. To achieve its modest profit a bank must make loans, have deposits, and the owners must provide initial capital. We will briefly discuss each of these below and outline an hypothetical example. Also, we will take a closer look at “federal reserves.”
First, let’s briefly summarize what we have learned with our modeling efforts.
The Bottom Line
Our modeling suggests some minimum financial criteria for starting a public bank that can grow and thrive. Our numbers indicate that at start up the bank will need an opening loan portfolio of $40 million, $5 million in capital, and about $80 million in deposits. A community that does not have this minimum financial capacity might partner with another local public institution like a school district or a county.
Our analysis begins with considering income from loans. As interest rates change and we negotiate loan rates, we try to maintain an average “spread,” which is the difference between the rate our bank pays depositors and the rate the bank charges borrowers. If we can achieve a 3% spread, we will make $1.2 million on a $40 million loan portfolio. This is pretty close to a minimum amount for a staff of four people and a small office space. Some additional income will accrue from other investments
The $40 million loan portfolio implies minimums for capital investment and deposits. Needed capital investment should be, at least, $5 million. Federal regulations require owners to invest capital in amounts related to assets. And, deposits should be about twice the loan amount, $80 million.
These will be discussed further below. First, we will discuss the rudiments of federal reserves.
Federal Reserves
The idea of reserves is easy to understand, and paradoxically is easy to misunderstand. Simply, as stated above, reserves are a bank’s balance in its account at the Fed. Reserves can be thought of as a checking account balance. And, just as a deposit in a bank is a liability(1) of the bank and an asset of the depositor. So, federal reserve balances are liabilities of the Fed and assets of our public bank.
Reserve balances are often called more appropriately “clearing balances.” Their sole purpose is to connect all banks together so that as checks are cashed funds are transferred electronically from a sending bank to a receiving bank at the face value of the checks. When a check is written on one bank and deposited in another, the Fed decreases the reserve account at the originating bank and increases the reserve account at the receiving bank(2). The two banks then appropriately decrease and increase the accounts of their depositors.
Central banks around the world “clear” checks in this manner. The U.S. system processes trillions of dollars every day.
To be complete, reserves are the balance in a bank’s reserve account plus actual vault cash on hand. The balance of my bank account is my bank’s promise that when I write a check the bank will make reserves available so that the Fed can electronically credit them to the check recipient’s bank. When I receive a check, the reverse happens.
When a bank needs reserves it can borrow them from another bank or the Fed will create reserves on demand. As people write and receive checks to buy goods and services, reserves circulate around the banking system.
Only a few operations can change the total balance of reserves in the banking system. As discussed later, bank lending increases reserves, because it increases bank deposits. Likewise, repayment of loans decreases reserves, because it decreases bank deposits.
Also, other government monetary and fiscal operations beyond the scope of the present discussion change the quantity of reserves in the banking system.
Profit
No business, not even a public bank can endure without making a profit. Of course, income must cover salary, benefits, office space, and equipment for personnel. But, there is more.
Income must also pay for interest earned on deposits and loan losses. The latter occur when loans fail to provide the income originally anticipated. Although a loan to government is considered low-risk, it will underperform upon refinancing or early payoff. Loan loss provisions are both prudent and required by federal regulations.
We must not forget taxes on bank profits, unless the bank would qualify as a not-for-profit business. We expect that the public bank will be set up as the City of Santa Fe doing business as the public bank. That would be a tax-free arrangement.
In the course of doing business it may be necessary for the bank to take out loans which will add to operating costs. Debt service(3) on such loans is another addition to expenses.
Loans
The main money-making engine of a bank is its loan portfolio. A public bank has an advantage over other banks, because it doesn’t have to market itself to make loans. The government entity that founds the public bank refinances its debt through the bank. It might seem easy to just assume enough of the government’s loans to guarantee a good profit. But, we must consider other realities.
First, municipal or state bonds and some loans can be refinanced without penalty only on specific “call dates” that are written into the loan agreement. Generally, bonds cost more to issue than loans. So, it is often prudent to finance spending through loans.
Second, as discussed below, federal regulations use the bank’s capital(4) to limit the amount of loans a bank can issue. This differs from the view commonly held that regulatory loan limits are based on deposits.
Double entry bookkeeping requires four bookkeeping entries for a loan. For the bank, a loan deposit is a liability and the borrower’s promissory note(5) is an asset. For the borrower, the promissory note is a liability, and the new loan deposit is an asset.
Deposits
Deposits received by a bank are liabilities. Also, a deposit resulting from a bank loan is a liability. The distinction between them is that deposits received bring with them reserves as assets transferred by the Fed from the originating bank. When the bank lends, it does not automatically create reserves. But, when a borrower withdraws loan deposits by writing checks on the account, the bank must find and deposit reserves so the Fed can credit them to the receiving bank. These reserves must come from either the bank’s existing assets or borrowing.
Banks need deposits, because they are the most inexpensive way to acquire reserves. Other ways to acquire reserves are borrowing from money markets at less than 1% or from the Fed Discount Window(6) at 1% to 1.5%. Profits improve when a bank has abundant deposits. The more deposits we have the longer we can delay borrowing.
Strictly speaking, the Fed cannot loan its liabilities (reserves) any more than a bank can lend its liabilities (deposits). Instead, the operation is accomplished through Repurchase Agreements (repos) where the “borrower” (public bank) sells a government bond to the “lender” (another financial institution or the Fed). And, the borrower promises to repurchase the bond at the same price plus interest the next day or a few days hence.
Public banks have an advantage in acquiring deposits, because the existing government deposits from taxes and fees are immediately available. Again, the public bank does not have to incur the costs of marketing itself (give away toasters) to acquire deposits.
Capital
Core capital is what owners of a bank invest in the bank. Stockholders’ equity is the difference between assets and liabilities. Bank management invests financial assets in securities such as government bonds, municipal bonds, mortgage backed securities, and the unmentionable, derivatives. Core capital can grow by retaining some part of earnings.
Governments always have tight budgets. To find the millions of dollars to capitalize a bank will seem like a tall order. Even when the funds are found, it may be a tough sell to the taxpayers. However, the major selling point is this; banks make profits, and in a public bank profits go back to the people.
A bank leverages its equity to make loans and grow. For that reason, we consider core capital to be essentially an endowment that will grow and provide benefits far into the future.
As equity grows, the loan portfolio can grow, and the bank could offer lower rates. However, lower rates mean lower profits. As the loan portfolio grows, a given spread in interest rates will yield more income. Then management can consider lower rates. The choice depends on whether bank management gets more kudos for low rates or larger year-end returns.
Generally, federal regulations use Capital Adequacy Ratios to limit the amount of lending a bank can do. One such ratio is total capital to risk-weighted financial assets. The denominator of the ratio is the sum of assets, each asset is given a risk-weight multiplier of 0 to greater than 1. For examples, a government bond would have zero weight and would add nothing to the sum. A municipal bond might have a weight of 0.5, and a home mortgage a weight of 1. So, a bank with a lot of government securities would have a smaller denominator, hence a higher ratio. Higher is better.
According to present rules, the above ratio must be greater than 10% for a well-capitalized bank(7).
Another important ratio is (Tier-1 capital) to total assets ratio, called Leverage(8), which must be greater than 5%.
Tier-1 capital includes retained earnings in addition to core capital. Tier-2 capital includes long-term debt, and loan-loss reserves. In addition to limiting the amount of lending, capital is important, because it absorbs any bank losses.
The detailed Basel III rules and penalties for failing to follow those rules are complicated and beyond our present scope(9).
Day-to-Day Operations
During any business day multiple deposits to and withdrawals from the bank occur. At the end of the day a bank will have net deposits or net withdrawals. The latter means that reserves will be credited to the accounts of other banks by the Fed. During the day the Fed will allow overdrafts of a bank’s account. But, at the end of the day those reserves must be there or else!
If the adequate reserves are not on deposit at the end of the day, the Fed will supply them and charge a hefty penalty rate of interest.
To avoid overdrafts and penalties a bank must obtain reserves. Standard practice is for a bank needing reserves to borrow them on the overnight Federal Funds Market at the going Federal Funds Rate without collateral. Other sources of reserves are US government agencies, savings and loan associations or any financial institution having an account at the Fed.
When banks have excess reserves they may attempt to loan them in the overnight market. Currently, there are excess reserves in the banking system. This should make reserves easy to borrow but hard to lend, which might cause bank management to retain more reserves than needed or wanted.
Management of day-to-day operations involve how much to hold in reserves, what mix of securities in kind and in maturity to have, whether and how much to borrow and from whom. These decisions have an impact on profitability and require expert attention.
An Hypothetical Example
Let us look at a bank with $5 million in capital and $80 million in deposits of which $10 million. The capital should allow $40 million in loans. For simplicity, we will assume a single $40 million loan for 8 years at 4.2% interest with semiannual payments. With only $10 million in demand deposits, no reserves are required, but we put $1 million in as a place holder. The bank will have an initial balance sheet as shown in Table I.
Also, we used $200,000 of assets for computer and office equipment to get started.
Table II shows the situation immediately after the loan is made and deposited in the bank. Both assets and liabilities are increased by the amount of the loan. This is the operation whereby banks “create” money. Banks create most of the money in our economy by this simple operation.
Currently, the reserve balance required by the Fed is 3% of demand deposits in excess of $15.2 million(10). We regard the new loan deposit as a demand deposit. So, to comply with regulations some securities ($44,000) were converted to reserves. Table II shows shows this increase in reserves.
The next operation assumes that our borrower withdraws the whole $40 million loan deposit to build something wonderful for public benefit. When the $40 million in checks are deposited in other banks the Fed will decrease our Fed account by $40 million. We immediately convert $40 million from securities to reserves so that our Fed account is not overdrawn. In Table IV we show that the loan deposit has been withdrawn.
During the following year principal and interest are paid on the loan. Principal paid reduces the remaining loan balance, and interest both reduces outstanding interest due and flows to income. In addition we have income from investments in securities, 0.5% on reserves and about 1.5% on a mix of 2- and 5-year treasuries.
In Table III we tabulate our income, expenses, and net profit. These data are integrated into Table IV which shows our balance sheet after one year. We have assumed that when our borrower’s assets were drawn down to make loan payments additional deposits were made to maintain $80 million in deposits. Also, we show the $700,000 that the customer earned in interest.
The retained earnings are available as a dividend to the owners, as an increase to Tier-1 capital, or a combination of both options.
Finally, let us note from the balance statement in Table IV that we have about $50 million in assets against some $80 million in deposits. Whether or not that is adequate depends on the magnitude of withdrawals the depositor may take in the future. In the unlikely event, that the depositor would withdraw all funds on deposit, we would be short $30 million.
To decrease the margin between assets and deposits bank management might decide to shop for a long-term loan, which is a more expensive liability than a deposit. But, we expect additional reserves will be available in the overnight funds market.
Conclusion
It appears that public banks can find a niche in the national banking system by returning profits to the public rather than to private investors. Because they need not cater to private investors’ desires for profit, public banks can be very conservative in their investments. They promise to reduce borrowing costs for local public projects and provide funding at the time it is needed. Public banks will provide transparency and accountability to the public for bank decisions.
Footnotes
1) Liability is not a pejorative term, it just means that liabilities are a promise of something owed to the depositor.
2) See for example: https://www.federalreserve.gov/paymentsystems/check_about.htm
3) Principal and Interest borrower pays to lender.
4) Stockholders' equity.
5) Agreement to repay the loan.
7) We have chosen a more conservative 12.5%.
8) Leverage may be the most limiting ratio.
9) For example see: http://prod.davispolk.com/sites/default/files/Davis-Polk-Basel-3-Guide-for-Community-Banks.pdf
Tables
Table I Initial Balance Sheet
|
|||
Assets
|
Liabilities and Equity
|
||
| Cash reserves at Fed |
$1,000,000
|
Demand deposits |
$10,000,000
|
| Securities |
$83,800,000
|
Time deposits |
$70,000,000
|
| Loans | |||
| Loan loss allowance | |||
| Net loans | |||
| Bank premises and equipment |
$200,000
|
Equity |
$5,000,000
|
| Total |
$85,000,000
|
$85,000,000
|
|
Table II Balance Sheet After Loan Deposited
|
|||
Assets
|
Liabilities and Equity
|
||
| Cash reserves at Fed |
$1,044,000
|
Demand deposits |
$10,000,000
|
| Securities |
$83,756,000
|
Time deposits |
$70,000,000
|
| Loans |
$40,000,000
|
Loan deposit |
$40,000,000
|
| Loan loss allowance | |||
| Net loans | |||
| Bank premises and equipment |
$200,000
|
Equity |
$5,000,000
|
| Total |
$125,000,000
|
$125,000,000
|
|
Table III Income & Expense Statement
|
|
| Interest Income |
$2,165,883
|
Operating Expenses
|
|
| Salaries & Benefits |
$500,000
|
| IT Support |
$30,000
|
| Rent |
$500,000
|
| Interest on Deposits |
$700,000
|
| Loan Loss Expense |
$75,000
|
| Debt service | |
| Total operating expense |
$1,805,000
|
| Profit |
$360,883
|
| Taxes @ 15% |
$54,132
|
| Net Profit |
$306,751
|
Table IV Year After Loan Withdrawn
|
|||
Assets
|
Liabilities and Equity
|
||
| Cash reserves in Fed |
$1,000,000
|
Demand deposits |
$10,000,000
|
| Securities |
$49,185,254
|
Time deposits |
$70,700,000
|
| Loans |
$35,696,497
|
Loan deposit | Withdrawn |
| Loan loss allowance |
($75,000)
|
||
| Net loans |
$35,621,497
|
||
| Bank premises and equipment |
$200,000
|
Equity |
$5,000,000
|
| Retained earnings |
$306,751
|
||
| Total |
$86,006,751
|
$86,006,751
|
|
Bank References
Although not referenced in the text, the following references informed the above discussion.
McLeay, Michael, et. al., Money creation in the modern economy, Bank of England, Quarterly Bulletin 2014 Q1:
Coppola, Frances, Banks Don’t Lend Out Reserves, Forbes/Investing. January 21, 2014
Werner Richard A., How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit taking, International Review of Financial Analysis, Vol 36, December 2014, pp. 71-77
Bell, Stephanie, Can Taxes and Bonds Finance Government Spending?, Levy Economics Institute, Working Paper No. 244, July 1998
Wray, L. Randall, Endogenous Money: Structuralist and Horizontalist, Levy Economics Institute, Working Paper No. 512, September 2007
Fullwiler, Scott T, An Endogenous Money Perspective on the Post-Crisis Monetary Policy Debate, Review of Keynesian Economics, Vol. 1 No 2, Summer 2013, pp. 171-194
Fullwiler, Scott T, Modern Central Bank Operations - The General Principles, Warburg College: Bard College - Levy Economics Institute, June 2008
Wray, L. Randall, Modern Money Theory, Palgrave Macmillan, 2012, Chapter 3
A Nascent Text on Money & Banking, Eric Tymoigne, Associate Professor of Economics, Lewis and Clark College, Portland, Oregon
Mosler, Warren, Soft Currency Economics II, Valence Co. 1996
Many thanks for helpful suggestions and comments to Nichoe Lichen and Elizabeth Dwyer of the Brass Tacks Team for Banking on New Mexico. bankingonnewmexico.org
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