Banking faces seismic changes

Jul 1, 2021·Alasdair Macleod
The role of commercial banks in the global economy is changing, with lending to governments and their agencies now more important than lending to goods and services industries. It is a trend which is due to continue.

The new Basel 3 regulations seem set to encourage this trend, despite retail depositors being accorded a stable funding status. Central bank digital currencies are anticipated to augment and perhaps replace non-financial business credit over the next five to ten years.

But the increasing financialisation of commercial banking brings the risk of tying its future firmly to a financial bubble. And with price inflation on the increase, it is only a matter of very little time before that bubble bursts.

This article looks at some of the implications for commercial banking of Basel 3, CBDCs and the changing economic role of commercial banks.


The introduction of both Basel 3 banking regulations and central bank plans for digital currencies will affect commercial banks’ priorities and their role in the overall financial system. Basel 3, particularly with regard to the application of the net stable funding ratio (NSFR), will change banking priorities by imposing standardised risk factors across the industry, and central bank digital currencies (CBDCs) threaten to cut the banks out of their intermediary role between central banks and non-financial users of money and credit.

Few members of the public think positively about the banks and their cartel, so popular opinion is unlikely to shed many tears if CBDCs displace them. Ever since the goldsmiths in London began in the seventeenth century to take in deposits upon which they paid six percent, with the agreement that they were not trustees of the money but proprietors of it, banking has contravened the spirit of Roman law by taking in deposits and using them as they please, without depositors fully realising the arrangement. This breach of “natural” law was originally a ruling by the Roman juror, Ulpian (170—228 AD), later codified by the Emperor Justinian (527—565 AD).

Ulpian had a point. If a depositor is unaware that his property is to be possessed by another without a banking licence, even today it would be ruled in the courts as fraudulent behaviour. But in 1848 English Judge Lord Cottenham in Foley v. Hill and others ruled otherwise in the case of banking relationships, that a deposit becomes the property of the bank, despite the majority of depositors unaware they no longer possess it. Ever since, the practice of a bank taking into its possession someone else’s property and disposing of it as it sees fit has been indisputably accepted in banking law.

For classical economists, banks are responsible for a credit cycle, first accelerating progress unsustainably and then halting it as the negative consequences of credit expansion manifest themselves. Keynesians, who fail to associate periodic banking crises with an earlier credit expansion, believe that money and credit should be guided by the state, blaming free market shortcomings for economic failures. Then there is the public perception of bankers being too ready to deny honest folk credit while paying themselves massive bonuses —a malevolent combination which particularly fuelled the political narrative following the Lehman failure. From every angle, banks appear to be always under attack.

From a banker’s perspective, the political narrative in particular has to be controlled, which is why banks are such large contributors to campaign funds in America. Their political influence in other jurisdictions is on similar lines as those of other businesses, mainly through lobbying, which might be less obvious to the public but is just as effective. Politicians, central banks and regulators all consult the banks before introducing regulatory changes and it is the lawyers employed by large banks who often end up setting the regulatory agenda.

The introduction of Basel 3 NSFR regulations has followed a different course from national regulatory evolution, broadly independent from these influences. Framing supranational regulations at the behest of the G20, the Basel Committee is broadly unaffected by bank lobbying and the lobbying of national politicians and their regulatory bodies. In the wake of the Lehman failure, both the brief and the objective were simple: to ensure that the risk of one bank failure leading to others was to be prevented. After much delay (the final NSFR regulations were published in October 2014) this aspect of Basel 3 is now being implemented.

Whether they succeed in their objective remains to be seen. It has always been possible for national regulators to soften some aspects of Basel regulations in minor ways. But it appears to be a reasonable attempt at ensuring that the financing of illiquid, or risky assets is not overly dependent on liquid deposits.

Contrasting with the imposition of a global regulatory standard under Basel 3, central bank digital currencies (CBDCs) are still at the concept stage. The possibility of central banks issuing a new form of fiat currency directly to the general public, or sections of it, is being discussed by central banks in the context of directing the application of extra currency to stimulate those parts the expansion of commercial bank credit do not appear to reach. Alternatively, the issuance of a CBDC might be available to promote specific economic and political objectives, such as for the benefit of businesses and activities associated with climate change. It is certainly less controversial than paying for costly political projects with additional taxes.

The production and dissemination of CBDCs are massive projects, requiring all businesses and consumers to have accounts with an agency under the direct control of the central bank. The coordination of tax, welfare and other state records will be required to ensure all accounts created for CBDCs are genuine and eligible for whatever the central bank dictates from time to time. It will require consumers and businesses alike to cede control over their activities to the state, raising deep issues of personal freedom. It would almost certainly require central banks to be more accountable to politicians, undermining the concept of their independence from political influences.

It would appear that CBDCs are a long-term project still in its early stages, pregnant with issues not easily addressed and requiring extensive, controversial legislation.

The current role of the banks

There are significant misunderstandings to be corrected about the role of banks in the economy. Both their users and their regulators seem either unaware of a commercial banker’s true motivation, or only view one aspect of banking while ignoring others.

It is usual for depositors to believe they have deposited money with their bank, when in fact they have transferred a credit to the bank’s possession. Even if they have paid physical cash into their bank, they have not contributed to a deposit. Instead, they have increased the bank’s liability to them, and the bank will use these balances as its sees fit. The ultimate test is what happens if the bank is declared insolvent. The depositor will then find he or she is simply a creditor.

Of course, there are depositor protection schemes in some jurisdictions, but it can be argued that they are to protect the banks from old-fashioned runs rather than protecting depositors. Importantly, a depositor protection scheme insulates banks from its depositors’ anticipation of impending failure. Combined with the exclusivity of being granted a banking licence, a bank’s sense of responsibility to service the needs and wishes of its deposit customers is substantially reduced by deposit protection schemes. The amelioration of a bank’s responsibility to its current and future depositors encourages a cavalier approach to its own reputation.

In effect, regulators have sought to make banking risk depositor-proof as a matter of policy. Both regulators and central banks view commercial banks as intermediaries between depositors and borrowers, and all their licensing, regulation and monetary policy is with this belief in mind. But as can be seen from Foley v. Hill and others the legal facts are otherwise, with depositors having no rights over their former property.

Despite the facts, the conventional understanding is that banking is the negotiation for interest between depositors and borrowers. Only those who lend the money of others are bankers. And so long as its borrowers repay the bank before money is due to be returned to the depositors, the bank will remain solvent. With depositors generally able to withdraw deposits at little or no notice, and with loans being less liquid in their repayment solvency, maintaining solvency until Basel 3 has been seen to be mostly a matter of experience and calculation by bankers.

Only a small portion of the original source of these deposits is money itself. Most of it originates as credit, from payments, salaries, the sales of goods and services, and the like, whose origin from other bank accounts. When tracing it back even further, we must note that money is the one good that is not consumed, and that a current payment is the result of a series of payments which in all cases originated from bank credit where the payment is not made in cash. And even cash is in fact credit when it is not specie, in this case drawn from a central bank and a liability to it.

We can approximately estimate credit originally drawn on a central bank distinguished from credit originating from a commercial bank. Total payments in the non-financial sector relate to an economy’s gross output. Gross output is the sum of all transactions which cover the intermediary steps of the production of goods and services up to and including final sales to consumers. In the case of the USA, this was approximately $39.5 trillion in the year ending Q1, 2021[i]. The Fed’s monetary base at that time was $5.8 trillion, which tells us that by nearly seven times the origin of payments could be deemed to originate from bank credit compared with credit originating from the Fed.[ii] In the past the ratio was in fact far higher. Before the Fed increased its balance sheet as a response to the financial crisis of 2008—09, payments originating from bank credit were over 30 times the Fed’s monetary base.

The change in this ratio is an important consideration for the future relationship between central and commercial banks and is discussed later in this article.

That an average of the origin of only one seventh of a depositor’s dollars is central bank originated as opposed to originating from commercial bank credit does not occur to the depositor. Nor can anyone distinguish between the two, both sources of credit being fully fungible. But it does show how dependent modern economies have become on bank credit expansion as opposed to central bank credit. And today, we are referring to credit based on money being issued out of thin air, the logical development of the moneylender’s fraudulent treatment of other peoples’ property identified as such by the Roman juror Ulpian 19 centuries ago.

The diminishing importance of bank credit for industry

It is commonly assumed that bank credit is created by money being loaned into existence and the banking system as a whole recycling loan expansion into deposits as the loans are drawn down. Any imbalances between individual banks are subsequently reconciled through wholesale money markets. Most commentators explain the creation and expansion of bank credit this way. But this is not how it actually works.

In fact, banks expand credit by a process of double-entry book-keeping. Once a loan agreement is signed, the bank will credit its balance sheet with the value of the loan as an asset. At the same time, it credits the counterparty’s current account with the proceeds of the loan, which for the bank is a matching liability to the loan recorded as an asset. As the loan facility is drawn down or repaid, both sides of the bank’s balance sheet adjust in lockstep. The customer’s account with the bank does not necessarily reflect the bank’s own double entry book-keeping, typically showing only the customer’s net balance.

A bank’s internal accounting procedures were effectively confirmed by the Foley v. Hill and others case referred to above and was common practice before. The important point to note is that banks create credit out of loan agreements without any other parties being involved. The role of wholesale markets is entirely different from involvement with credit creation, being restricted to fulfilling other requirements for interbank relationships.

Since the erosion and eventual ending of the Glass-Steagall Act, which was introduced in 1933 to separate commercial from certain investment banking activities, the creation of bank credit for the purpose of conventional lending has been outpaced by other banking activities. Even before the 1980s financial deregulation in London, large American banks such as Citibank saw fee income as an increasingly important source of revenue compared with net interest income derived from bank lending.

The degree to which American banking has changed is reflected in the Fed’s H.8 release for the largest 25 domestically chartered banks (Table 6). Out of a total $9.128 trillion of bank credit between them, only $1.269 trillion is loaned to commercial and industrial businesses compared with $5.653 trillion to the government and its agencies, mostly in the form of securities. The idea that bank credit primarily supports commerce is denied by these figures.

We must inquire, therefore, as to the current and future purpose of commercial banks, and whether their interests are in line with those of society as a whole.

Commercial banks and their relationship with economic activity

From the evidence of their balance sheets, we can see that the major US banks overwhelmingly expand credit for the benefit of governments and government interests. The position for smaller American banks is more in favour of business lending but is still 60% less than their total lending to the Federal Government and its agencies. Undoubtedly, the relative reduction in non-financial business lending is attributed to the increase in funding required by governments generally in a post-Lehman crisis world, the increased perception of relative lending risk, and the general trend towards purely financial activities and securitisation.

The granting of licences by governments to banks to undertake activities which otherwise would not be permitted also appears to have encouraged a trend to use banking licences to a wider extent. Particularly for the major banks, traditional lending activities have become a lower priority.

The ability to create any form of money or credit out of nothing seems certain to tempt banks to drift from their original commercial purpose, not that such a purpose actually existed other than in the public’s collective mind in the first place. There is little doubt that their customers see banks as intermediaries between depositors and borrowers and are in the main unaware of their ability to create credit, let alone how they do so. They naturally assume that banking is simply a process of lending savings which already exist. This assumption is consistent with the regulatory approach as well, which addresses systemic risks in the interests of depositors by limiting the relationship between a bank’s own capital and the size of its balance sheet. It used to be described as fractional reserve banking from regulations historically aimed at controlling this ratio.

The fact that a bank can create its own deposits separates it from a commercial obligation to provide a secure repository for credit owed to the general public. Consequently, the assumption that a bank’s commercial interests somehow coincide with those of their customers, the common basis behind the success of free markets when everyone acts in their own interests, is unlikely to apply. If it did, then we would see banks operating with greater customer focus. We would see banks working actively to assist customers, instead of hiding behind regulations and blaming customers for permitting fraudulent access to their accounts, which happens increasingly often.[iii]

Despite the overwhelming quantities of money that originated as bank credit, by neglecting their relationships with the general public national commercial banking systems have opened the possibility of radical reform. Furthermore, the new Basel 3 regulations seem set to discourage lending to corporate borrowers.

The NSFR calculation anticipates corporate deposits in favour of non-financial entities with a maturity of less than one year as being less stable as a source of available funding than retail deposits, assigning to them a 50% haircut for funding balance sheet assets. Deposits recorded from this source are therefore inefficient funding for assets compared with retail deposits, and deposits from small businesses, which only suffer a 5% or 10% haircut for the purpose of funding the asset side of a bank’s balance sheet. The theory is that with old-fashioned bank runs by retail depositors now hopefully confined to the past, retail deposits can be regarded as almost as stable a source of balance sheet funding as a bank’s equity capital. But larger corporates can destabilise a bank’s balance sheet very easily if they are permitted to withdraw funds with little notice.

The logic appears flawless, until it is considered in the context of a bank’s double-entry book-keeping. Let us say that a corporate customer requests a bridging loan, or alternatively a working capital facility. If either are to be granted, the bank marks it down as an asset, and at the same time records the position as a matching corporate deposit. We can be assured that where an asset and a deposit are related in this way, they escape the two elements of Basel 3 that matter: the liquid coverage ratio (LCR —which favours high quality assets) and the NSFR discussed above. But we have yet to see how the change will affect lending practices. In this context we should note that the 50% haircut on corporate deposits not matched by an originating loan recorded as a bank asset is unattractive as a means of a bank’s balance sheet funding.

If a bank prioritises other liabilities to fund its balance sheet, then its overall corporate business is bound to suffer. And if deposit business from corporate clients is discouraged by not offering corporate deposit facilities, less emphasis is bound to be placed on corporate business generally, reducing the whole banking sector’s involvement in providing credit for manufacturing and service sector businesses. It seems likely therefore, that Basel 3 will end up reinforcing the trend towards the financialisation of banking, the acquisition of government and government-sponsored debt, the accumulation of central bank reserves, and loans to financial institutions. Lending to the non-financial corporate sector would appear to be orphaned by these developments.

Central banks anticipate a vacuum to fill

The logic behind the future deployment of CBDCs must include an acknowledgement that bank lending is moving away from non-financial activities. We have already noted that a consequence of the expansion of central bank balance sheets has been to reduce the relationship between gross output in the US and the Fed’s balance sheet from 30 to 1 to 7 to 1 in the last thirteen years. Projecting this trend into the future suggests that this ratio will fall further, and that the Fed will need to consider its economic role in this light.

To state bureaucrats a CBDC is an attractive solution, ripe to be implemented on a five-to-ten-year timescale. It allows a government agency to engage in state-sponsored banking, replacing commercial bank credit with a digital currency applied to stimulate economic activities deemed to be in the public interest. The gathering and deployment of business and personal data, so far kept in separate silos, becomes fully justified. A CBDC represents the acme of monetary and economic socialisation.

But there is a bigger picture…

Behind the convenience of a CBDC solution important monetary and economic considerations are being assumed or ignored. While central and commercial bank credit is expected to be continually expanded to finance government spending and asset inflation, the increasingly obvious consequences for prices are certain to lead to higher interest rates —and soon. Central banks will find they have to escalate their attempts to support asset prices in financial markets, by yet further monetary expansion, or risk seeing the asset bubble implode. By embarking on a policy of engendering economic confidence by a perpetual bull market, central banks have tied the fate of their currencies to stock and bond markets.

The strategy of large commercial banks being increasingly committed to purely financial activities and turning their backs on non-financial credit expansion has led to them swapping one risk for another. Furthermore, in financial activities banks are increasingly bound to each other’s fate, exchanging counterparty risk from industrial debtors for those with other banks. And nowhere does this matter more than in cross-border banking relationships, where undercapitalised banks in, say, the EU, pose a global systemic risk which is not addressed by Basel 3’s NSFR.

As to CBDCs, the time taken to introduce them, including all the enabling legislation, makes them unlikely to matter. The financial bubble will be pricked long before then.


[i] See

[ii] It is a common error to equate payments with so-called velocity of circulation. Consumers earn their salaries and profits over the course of a year which they then spend and save. They provide the state with its taxes, which the state spends once. Furthermore, production is only sold once. Second-hand transactions are excluded from national statistics.

[iii] It is nonsense, as banks often claim, that money drained from customer accounts by fraudulent activity cannot be traced. With the single exception of physical cash, the destination of funds is always known. Unusual activity is easily identified, the receiving bank alerted, and the return of funds requested. The fact that the whole banking system has refused to implement the necessary procedures we can take as an indication of the level of importance accorded to depositor protection.

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