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How Payments are Made

Transferring Money from one Account to Another

The following is an account of how payments are made on an individual basis. The key to the profitability of the banking business model however is the larger picture of aggregated payments. In the individual examples below, the bank must have in reserves the full amount necessary to settle the individual payment or provide the depositor with the cash necessary for him to make the payment himself. 

However, in the aggregate, inflows and outflows of payments between banks mostly cancel out. This means the bank ends up only needing to transfer reserves to other banks to make up the shortfall between inflows and outflows during the accounting period, if there is one. Similarly, banks only expect depositors to request to withdraw a small portion of the money in their deposit accounts at a given time. As a result, as long as there isn’t a bank run, banks can get away with only keeping a small fraction of the deposits they owe in reserves. This is where the term ‘Fractional Reserve Banking’ comes from.

What Occurs Within a Bank

In How Commercial Banks Create Money, we showed how banks create the numbers that appear in our bank accounts. These numbers are referred to as ‘bank deposits.’ At the moment, the newly-created money is simply sitting in Robert’s account, but naturally Robert will want to spend the money. What happens when he does?

A a reminder, Robert borrowed $10,000 in order to buy a car. Once the loan was granted, Robert’s bank’s balance sheet appeared as follows:

Wanting to support American manufacturing, Robert picks out a car which is on sale at a Ford dealership. In order to purchase the car, Robert must transfer the money from his account at BOA to the Ford dealership’s bank account. If the dealership also banks at BOA it is a very simple process for Robert to transfer the money to them.
Robert simply instructs his bank to make a payment of $10,000 from his bank account to the dealership’s account. BOA then deducts $10,000 from Robert’s account, and adds it to the dealership’s account, as shown here.

However, what if Robert and Ford bank with different banks? Payments can then be made using cash or central bank reserves.

Cash Payments

If Robert and the dealership bank with different banks Robert could withdraw $10,000 in cash and pay at the dealership in person.

In the example balance sheets above, we’ve left out everything that isn’t relevant to the transaction in question. But of course, BOA doesn’t only have one loan, or one customer – there will be many other assets and liabilities recorded on their balance sheet. We’re going to leave most of these items out for now, to keep things simple, but for the next transaction, we’re going to show the cash that BOA got from the Federal Reserve in the earlier example. We’ll also show the shareholder equity that was there from the beginning, just so the balance sheets balance.

Any cash that a bank holds in its vault legally belongs to the bank and, therefore, it appears on the asset side of their balance sheet.

BOA’s balance sheet, just after it has granted the $10,000 loan to Robert, appears as shown here.

Robert then withdraws the $10,000 from his bank account. At this point, the bank could be said to be ‘extinguishing’ its liability to Robert by repaying him in cash. Robert’s account balance of $0 shows that the bank no longer has a liability to him.

He uses the $10,000 cash to pay the Ford dealership, who banks with Wells Fargo. Prior to Ford placing the $10,000 in their bank account at Wells Fargo, Wells Fargo’s balance sheet show $0 asset and $0 liability.

When Ford deposits the money in their bank account, Wells Fargo adds $10,000 to their cash reserves (as they now own this cash), and increases their liabilities to Ford by $10,000.

Central Bank Reserve Payments

Of course, making payments in cash is highly inconvenient, not to mention potentially dangerous. As such, payments for large amounts of money tend to be made electronically, using central bank reserves.

In the same way that you may have a bank account with a commercial bank, commercial banks have bank accounts at the central bank, known as reserve accounts. Reserve accounts hold a special type of money known as central bank reserves, which can be thought of as being an electronic form of cash, created by the central bank. Central bank reserves are used to make electronic payments between banks. So, if Robert and the Ford dealership bank with different banks, the payment could be made by electronic transfer using these reserves.

To show how banks make payments using reserves, we must first include central bank reserves on BOA’s balance sheet. We’ll also show shareholder equity so that the balance sheet balances. (Again, this is a simplified example).

BOA’s balance sheet just after it has granted the $10,000 loan to Robert appears as shown here.

Meanwhile, Wells Fargo’s balance sheet shows $0 assets and $0 liabilities.

Robert then instructs BOA to make a payment of $10,000 to Ford’s bank account. Upon receiving this instruction, BOA reduces the balance of Robert’s account and transfers the reserves to Wells Fargo’s reserve account.

Upon receiving the transfer of central bank reserves, Wells Fargo credits Ford’s account with $10,000, finishing the transaction.

The Payment from the Perspective of the Federal Reserve

Let’s look at the same transfer of reserves from the perspective of the Fed’s balance sheet. With both banks banking at the Fed, transferring reserves between reserve accounts is the same as when two individuals at the same bank make a payment to each other; a liability to one customer becomes a liability to another customer. However, while reserves appear as an asset on the balance sheet of commercial banks, they are a liability of the central bank (just as your bank balance is actually a liability of a commercial bank). Before the payment is made from BOA to Wells Fargo, the reserve accounts appear as shown here.

Robert then instructs BOA to transfer $10,000 from his bank account to the Ford dealer’s account at Wells Fargo. To do so, BOA will contact the Fed (electronically), asking them to transfer $10,000 from its reserve account to Wells Fargo’s reserve account.

Once Wells Fargo receives confirmation that the reserves have been transferred, they will credit the Ford dealer’s account, as before.