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1. How is money made using Fractional Reserve Banking?

2. The Morality of Money Lending – past and present.

3. Taking responsibility for personal debt.

This opinion piece aims to offer a better understanding of how a great portion of the money in our economy is “lent” into existence as well as looking at the changing morality of money lending activities over time and finally focusing on the importance of taking personal responsibility for debt.

Looking at each one separately now:

Fractional Reserve Banking

The world as we know it would not function without money. Money is an essential human creation and everyone uses it. Money has a powerful influence on our lives and we have an emotional connection to it. Money keeps us awake at night and motivates us to work hard during the day.

We can’t live without money, yet few people can precisely tell you what it is and how it works. Defining money is surprisingly difficult as it does not just comprise of paper currency. In Australia, physical cash accounts for less than three per cent of “broad money” (i.e., the amount of money held by households and companies in bank deposits and currency).

Nowadays, very few of us are paid in cash. Our salaries and wages are credited to our bank accounts which is one of the reasons why 97 per cent of broad money exists in bank deposits. This form of electronic money can’t be physically held as it is intangible numbers in a ledger.

These numbers are accounting entries and banks produce a large percentage of them when they create new money by lending money. As counterintuitive as it sounds, most money is lent into existence. Banks and other financial institutions create new money whenever they extend credit.

Banks are in the business of selling credit. Money is created as evidence of debt. Credit and debt are the same thing, seen from different points of view. Money is a debt instrument, not a debt itself. Thus, the amount of money in our economy is a function of debt.

This debt is created when a government borrows from its central bank. It is also created when individual citizens of a sovereign nation go into debt by taking out loans from banks and other financial institutions through the mechanism of Fractional Reserve Banking.

When a bank makes a loan to a customer, the proceeds are deposited to an account in the name of the borrower or in the name of the person/s from whom goods or services (e.g., car, holiday) are being purchased. Regardless, new credit money is created and this increases the money supply.

However, only a fraction of the new credit money which is deposited is kept in reserve to meet withdrawals. The rest is invested by banks in loans to other customers (borrowers). This is known as Fractional Reserve Banking and it is the current form of banking worldwide.

The amount of money a bank can lend is affected by the cash reserve or liquidity requirement set by the local banking authority. Liquidity refers to the amount of cash a bank holds to meet its financial obligations (like customer withdrawals) as they come due.

Let’s say the cash reserve (liquidity) requirement is 10 per cent of a bank’s total deposits. This means the bank can lend $90 when it receives a $100 deposit. That $90 is used by the borrower to buy goods and the shopkeeper deposits the funds with his bank.

The second bank takes the $90, keeps 10 per cent and lends $81 to another person. That $81 goes back into the economy and eventually finds its way into the other person’s account at a third bank. The third bank, in turn, holds back $8.10 and lends out $72.90.

This goes on until there is nothing left to deposit and lend out. If you do the math, you will find that the original $100 eventually amounts to $1,000 in credit money. This is an example of the money multiplier effect resulting from banks creating money through their lending activities.

It can be seen that how money is actually created today (a) differs from the description found in some economics textbooks and (b) dispels the myth that financial institutions can only lend out pre-existing money. Banks create “cashless money” from making loans which means that money is really just an IOU.

When the average Joe learns that banks make money seemingly “out of thin air” they are either surprised or sceptical. So, for the Doubting Thomas’ out there, I‘ll leave the final comment on money creation to none other than the Bank of England. In a 2018 report the bank stated:

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” Creating money this way benefits all of the economy and us as individuals!

Morality of Money Lending

Sadly, moneylenders have often had an image problem. In biblical times, usury (money lending) was viewed as an inherently evil activity and Thomas Aquinas condemned it. Dante Alighieri relegated moneylenders to the seventh circle of Hell with blasphemers and perverts in his epic poem, Inferno. And Martin Luther and John Calvin both opposed lending money at interest.

Regrettably, there have been disreputable lending practices since antiquity. But moneylenders are not the villains behind every economic problem that humanity has ever faced. Yet, from the time of Aristotle – who believed the practice of money lending to be unnatural and unjust – credit providers have been loathed and derided by philosophers and theologians. That broad brush criticism, in my view, is totally unfair.

In the Bible, moneychangers are labelled as “thieves and marauders” and told sternly they were “wrong in what you are doing”. Even playwrights have taken aim at financiers. In The Merchant of Venice, Shakespeare focused on the relationship between a borrower and a lender in exploring the themes of money, debt and justice.

In more recent times, moneylenders have been blamed and castigated by all and sundry for causing the Global Financial Crisis (GFC). Irresponsible mortgage lending coupled with reckless financial engineering is seen as the prime culprit behind the global meltdown. In simple terms, junk mortgages were used to back triple-A rated securities.

Such poor and inexcusable lending and funding practices exposed the dark underbelly of capitalism, but to blame credit providers alone is so unfair. It’s long been my contention that the GFC was also – very much – a cultural crisis. Our modern world is very materialistic and the demand for credit to finance our contemporary lifestyles is ubiquitous.

We as a society need to take a hard look at ourselves and ask whether we have become credit junkies. We need to understand that debt is not risk free and that we need to save more and encourage habits of thrift among our children. We can’t play the victim and say “it’s not my fault” when we over commit ourselves financially.

To this end, it’s a sweeping generalisation to claim that all US subprime borrowers were innocent victims of predatory lending practices. The reality is that borrowers, bankers and brokers were united in a delusional belief that US house prices would never fall. They all acted irrationally in expecting house prices to always rise.

At the end of the day, the GFC was caused by greed which manifested itself in financially reckless behaviour by both Wall Street and Main Street (mum and dad borrowers.) However, while Main Street can be forgiven for its “irrational exuberance”, Wall Street should have known better. The destructive policies of Wall Street and the shenanigans of some of the world’s biggest banks were disgraceful.

I also acknowledge that in the aftermath of the crisis, Main Street felt abandoned while Wall Street was rescued. On the surface, this does seem unfair but rescuing troubled institutions was the lesser of two evils. Governments could not allow their banking systems to crash as this would have caused incalculable damage.

So, 15 years on; have we learnt from the excesses of the GFC? Early on yes, but the further away we humans get from any previous crisis, the less impact and influence it seems to have on our current day thinking. So, sadly, we will continue as a society to have financial downturns due to personal excesses and greed.

What is clear however, is that money-lending will remain the lifeblood of our economy. Indeed, all economies. Economies are credit-driven which means nations and households invariably have to go into debt in order to grow. That’s “good debt.” Importantly there is nothing wrong with “good debt.” Indeed, it should be encouraged whilst “bad debt” like funding a gambling habit should be discouraged.

The good news is that, unlike in Biblical times, it’s not hard nowadays to find a reputable and good prudent lender – like churches, there everywhere and we need them more than ever!

Personal Debt

In 2019-2020 there were 12,450 new bankruptcies in Australia. The overwhelming majority of these (90 per cent) originated from voluntary debtor’s petitions while only 10 per cent were forced creditor’s petitions. To put that number into perspective, new bankruptcy over the past 7 years have reduced by 54%, but like road deaths they are still too high.

The word ‘bankrupt’ comes from the Italian, banca rotta, meaning ‘broken bench’. In the sixteenth century, money lenders in Florence conducted their business on benches in outdoor markets where they exchanged money and bills. When a banker failed, his bench (aka “bank”) was broken by the people as a mark of infamy and he was called a bankrupt.

During the first half of the 19th century, debtors’ prisons were a common way to deal with unpaid debt in Europe. The father of English novelist, Charles Dickens, was imprisoned with his family in 1824 for a debt to a baker. Dickens later wrote about prison life in his masterpiece, Little Dorrit. The US also had debtors’ prisons but abolished them in the 1830s.

While the practice of publicly humiliating debtors no longer occurs, the propensity of people to get in over their heads has not changed. The mantra of some consumers today is: “I want it, I want it now and I’ll borrow rather than save for the things I want”. The end result for these individuals is often over-commitment and unsustainable household debt.

It could be argued that we have become a society of credit junkies. For many, materialistic expenditure is the drug of choice. Of course, there are those who would point the finger for rising personal indebtedness at over-eager banks and other lenders, but that is too simplistic.

Despite advice to the contrary, many people deliberately pile on debt, typically racked up on several credit cards. These individuals often see bankruptcy as an easy and attractive option. Bankruptcy no longer has the social stigma it had in the past.

Bankruptcy is now seen by many as a quick way of extinguishing debts in the mistaken belief that one’s slate will be wiped clean.

Bankruptcy, however, should be an absolute last resort as the results are long lasting and far reaching. It can destroy an individual’s credit rating and make it difficult for the person concerned to borrow again for some time. (Note: All prudent lenders would rather put in place a repayment plan rather than repossess a property or bankrupt a borrower).

In fairness, some bankruptcies are caused by illness, divorce, a death in the family or redundancy. These largely uncontrollable events – “life’s accidents” – should be viewed with compassion. In Australia, the number one trigger for bankruptcy is unemployment. Moreover almost 40 per cent of mortgage delinquencies are caused by injury and illness.

Bankruptcy laws have evolved over thousands of years and now protect debtors as well as creditors. But I believe the pendulum has swung too far. Some debtors are using bankruptcy as a modern day “get-out-of-jail-free” card. For my money, it’s far too easy for Australians to declare bankruptcy and recent amendments to bankruptcy laws make bankruptcy seem an easy option which it shouldn’t be.

It seems to me that both borrowers and lenders have a role to play in addressing the rising incidence of bankruptcy. Financial institutions need to do more to improve financial literacy skills and consumers need to become better money managers and live within their means.

If you or someone you know experiences a change in personal circumstances and are struggling to keep up the mortgage payments or other debt obligations, don’t stick your head in the sand. Contact your lender and negotiate an affordable repayment arrangement. Don’t wait until you are on a slippery slide to a “mortgagee sale” and/or bankruptcy.

Finally remember, just as there is good cholesterol and bad cholesterol there is good debt and bad debt. My tip; always bet on “good debt” !

John (JT) Thomas

This opinion piece is provided by John (JT) Thomas, a 46-year veteran of the financial services industry and since 1987 a specialist in commercial mortgage funds. Considered by many to be the father of the modern commercial mortgage fund sector, JT helped establish and then managed – for 17 years – what became the largest and most successful commercial mortgage fund in Australia – The Howard Mortgage Trust – with assets exceeding $3 billion. Under JT’s stewardship, investors never lost one cent of their investments and indeed, investors always received competitive monthly returns. JT was also Chair of the $40 billion mortgage trust industry sector working group.

JT has been proudly involved with Princeton for eight years and sits on both the Princeton Credit Committee and the Princeton Compliance Committee as well as being an advisor to the Princeton Board.

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