Monetary System and Its Operational Phenomenon

 

Money is a medium of transactions. This is the fundamental function of money, among others. In the primitive ages, transactions between people would be taken place by barter system. It was a process to end a transaction by goods and goods. One would exchange his goods with others by other goods. This can be simply referred to as transaction through one item with another one. But there is a lack of double coincidences among the needs of different people. There needs a match between demand and supply. In real life situation, demand cannot match with supply creating a gap in them. The situation leads people to produce all what they need. This is subsistent living. It is merely possible to produce all required items for living. Subsistent living cannot improve the standard of living. Upgradation needs work segmentation which is echoed by Adam Smith as division of labor.

Who invented money? It is a question having no specific answer. In true sense, money is a social invention as a solution of needs. There are different components used as money since its inception. They were corn, salt, different metals from cowrie, copper, silver to gold. Before starting fiat money, gold standard was in widely use. In mid of twentieth century, gold standard was phased out. Dollar-gold standard became prevalent. This did not continue due to exorbitant privilege of a single currency which was issued in excess of gold stock. The money maintained by different countries in dollar could not be settled in gold. Dollar issuing country declared closure of gold window. Afterwards, monetary system becomes a standard of fiat money based on fractional reserve mechanism. Monetary authorities or central banks manage the standard. The system is operated by licensed banks.

Under barter system, a part of output was retained as savings. Physical items are rarely possible to last long. With the invention of money, output produced becomes a token in monetary term. It does not only work as medium of transactions, it also acts as a store of savings. As a result, money becomes a savings tool. Savings is a source of fund, investors cannot utilize. Someone is needed, who will utilize the savings. There need intermediaries which will collect fund from savers and extend the same as loans to users of the same. This is a simple equation but it is not so simple as it seems. Example can be cited here. An intermediary collects deposits of 100 units of money. It extends the same to an investor as loans. Deposits are short in tenure but loan is long. This mismatch cannot run the show. Prudent framework is required for safeguarding deposits. Monetary authorities work behind the system in which intermediaries operate.

Fractional reserve system is in place globally for banking or intermediary operations. Under the framework, banks cannot extend all money as loans; rather they need to keep a part thereof as reserve. If it is mandatory to maintain reserve at 10 percent, banks can lend 90 units of money. In fractional money system, money becomes recycled. The loans become deposits again. These deposits are again used for lending, after retention of adequate reserves. As a rule of thumb, a deposit can generate loan money proportionately in terms of reserve requirement. Fractional reserve system empowers banks to create money. Really is it possible? It is a question. Fiat money is a magical instrument. There is a bookkeeping rule under which it operates.

 Monetary authorities or payment systems platforms facilitate to run the framework. How it works is a question. Payment settlements systems support all intermediaries licensed by monetary authorities. All banks work as a unit. They use payment instruments like cheques, drafts, electronic instructions, etc. Depositors can transfer payments from their deposits to others. The transfers are executed through clearing systems arranged by central payment settlements platforms. This is also a transmission channel through which money is injected in the economies.

What is the technique followed by the systems? This is nothing but a bookkeeping method. Normally banks maintain reserves with the platforms which arrange to make payment settlements among banks. In this case, the platforms follow same procedures as banks do while maintaining depositors’ accounts. Payments from one bank to another bank are executed respectively by debit from paying bank’s account and by credit to receiving bank’s account. Is there any challenge in executing transactions among banks? No work is problem free. Same is applicable in this case also. Banks are maintaining reserve accounts with settlements platforms. Their customers can make payments instructions through cheques which are sent to clearing systems by beneficiaries’ banks. What will happen in case of insufficient fund available in reserve accounts? Will the platforms return the requests? Or will the platforms honor the requests? These are inevitable issues in executing settlements of transactions.

Bank-run is a common word used in banking industry. It is a run by depositors towards banks for withdrawal of money. This situation leads a bank to face liquidation which creates contagion effects among operators and the economy as a whole. The effect is unmanageable in real sense. Considering the point in view, banking system is well regulated and under continuous monitoring net. Being regulators, they never want banks to face run. But loans may be in problems which result in default in repayments. Money created by fractional reserve system requires death through arrival at banks by repayments. Non-death of money can make banks to be illiquid. The situation may be unmanageable. In this situation, banks should go for run. Ideally it should be. But it is not let to be run. As a lender of last resort, regulators support banks to overcome the situation through injection of liquidity. 

Payment settlements platforms support problems ridden banks through liquidity injection as said earlier. This is not so tough procedures. Rather bookkeeping makes money to be a magical tool. Say A-Bank faces problems. It is debited with the payment instruction received. At the same time, beneficiary - say B-Bank - is credited by the same amount. The net position is zero though A-Bank is given overdraft facilities meaning that the bank is in position of debit balance which is receivable by payment settlements platforms. On the other hand, beneficiary bank is in credit balance which will be used for settlements against their payables.

Now B-Bank’s advice is received by the platforms for settlement of payment to C-Bank. Same procedure is followed. B-Bank reserve is reduced with increase in reserve of C-Bank. The function of debit and credit is executed between banks without involvement of regulators’ accounts. Does it have impact on the economy? It has no impact since the transactions are just changes in respective accounts without creating money. Does it continue? This warrants review which can show impacts, if any.

In the above proposition, settlements through bookkeeping can keep problem ridden banks hidden. For temporary situation, this is a way-out to overcome. But the solution may require injection of money in case of cash demand by banks having credit balance in their reserve accounts. Delivery of cash notes reduces the balance of relevant banks by creating assets in the books of regulators. In economies of digital money, such requirements are not expected to be visible. Therefore, regulators can support problem ridden banks without touching their books. If it happens, banks are expected to exercise moral hazard, encouraging irregularities in banking operations. It means that deposits are used for inappropriate lending. Such a way of operations results in misappropriation in societies with capital flight, price level hike, unrest and many more.

Prudential regulations of banking system torch the road to go. Despite, created money remains alive. It benefits all but cannot do equally. As such, bookkeeping settlement should be avoided by liquidity support against collaterals. With regards to Bangladesh, banking system is running under regulatory framework. Very recently, regulations on prompt corrective action (PCA) are formulated. Banks need to follow the rules in the context of capital adequacy, liquidity, profitability, and different other parameters. Banks will face stringent actions for non-compliance of PCA. It is expected that new framework will keep the industry alert to be resilient in sound operations.


Mehdi Rahman works in the development sector.