In order to understand the manner in which the central bank determines the monetary policy we need to understand the basics of banking reserves and the role of banking in the creation of money. Lets understand this with the help of some fictional economy with no banking system where transactions are settled through cash or credit.
Cash trading happens when payments in our fictional economy is settled through cash and credit trading happens when transactions are settled through the exchange of goods. Lots of issues with these two methods of trading such as bad credit, theft, incentive problems and illiquidity. As the number of traders get larger it becomes increasingly difficult to manage cash and credit. Large payments become an issue, theft, counterfeiting and other issues encourage financial service providers with opportunities to manage cash and charge fees.
Thus the warehouse bank is born in our fictitious economy. In exchange for service fees these warehouse banks manage money and keep them secure. They accept cash deposits, safeguard money, allow cash withdrawals, authenticate money and most importantly allow the transfer to portions of deposited cash rather than transferring cash itself. Now the concept of checks are born in our fictitious economy.
Suddenly the fictitious economy is spawning new banks when other financial wizards realise the profitability of the warehouse banking business. From a monopolistic banking scenario the economy now has multiple banks with each bank issuing their own checks. A new problem now arises.
Lets give some names to all these entities to avoid confusion. What if Yuri from Metrocity, our fictitious economy needs to pay Shaun a certain amount of money? In the monopolistic scenario this was easy as the check would have been written on the same bankâ€™s check.
However now Yuri bankâ€™s in MetroBank and Shaun banks in MegaBank. If Yuri writes Shaun a check from Metrobank for an amount of $1000 how would Shaunâ€™s bank encase it? Shaun could go to Metrobank encash the cheque, carry the cash to Megabank and deposit the amount. This becomes very inconvenient for Shaun. A new facility called the clearinghouse is now borne in the economy.
A Brief History of Clearing Houses
Just a brief snippet of clearinghouse history – In London, To make matters convenient for customers banks began to send â€œwalking clerksâ€ to other banks to collect payments on behalf of their customers. Hundreds of clerks would walk all over the place with hoards of cash making the business very risky. The clocks however devised a smart way to reduce the number of walks. They all met in a coffee shop exchanged checks with one another and settled net balances only.
In 1770 banks established an official meeting place for clearing checks. By the 1850 banks in England were settling deposits at the bank of England rather than cash.Â This is an important point to note. In our fictitious economy banks settled their deposits with a central bank rather than with cash. This meant that there was now no exchange of cash and only changes in balances with the central bank. The first clearinghouse established in New York was 1854.
Returning to Metrocity, the banking system now advanced to a state where cheques were settled in the net amounts in clearinghouses. So at the end of the day if Metrobank owed Megabuck $3 million in checks and Megabank owed Metrobank $4 million in checks. The net settlement is for Megabank to pay Metrobank $1 million. Now Megabank could defer this payment for the next day settlement or pay in cash. The risk for Metrobank is that Megabank could go bankrupt thereby causing a loss to Metrobank plus the physical movement of cash is also risky.
The government of Metrocity therefore decides to open Centralbank. Centralbank now keeps a running balance of all bankâ€™s deposits so all Centralbank would need to do is adjust the balance of Metrobank with a $1 million credit and Megabuck with a $1 million debit. Banks need to deposit some cash with Centralbank in Metrocity as reserves. Centralbank determines the reserves bank need to maintain.
Next we understand the banking innovation that resulted in the formation of the fractional reserve bank and how a fractional reserve bank functions.