A Brief Note on Loan Payments, Accounting and Bank IOUs

Whenever I discuss banking operations, I usually receive at least one question asking me about how a loan is paid off and where the payments go, in addition to further clarification of bank IOUs. So, I’m going to answer them all at once. First, though, I want to point out that when you ask about how a bank processes your loan payments or terminates a loan, that is not exactly a macroeconomics question. It is an accounting question.

Now, before we begin, do try to temper your politics concerning banks, profits and taxing banks. Set them aside, because I am telling you right now, if you do not, you simply will not understand anything I’m about to say, which is nothing more than simple, basic accounting reality. We are going to discuss the fact that banks are subject to taxation, so if you allow the politically marinated part of your brain to begin spouting off such nonsense as, “Bank’s don’t pay tax. They weasel out of it by paying politicians. Then when they go broke, they get a bail out and… Wall Street and… and… and…”, then I’m going to ask that you write 1,000 times on the chalkboard, “I will not consider the Democratic Party and the media to be an educational and informational resource.” I won’t respond to nonsensical political diatribes, ok?

Fine. Let’s begin.

So, let’s assume that you’ve obtained a $20,000 car loan five years ago from a bank that you do not bank with. The bank lent its IOU to you, which it denominated in government’s unit of account so the IOUs would act as “money” and purchase your car. For that privilege, the bank charged you interest. In techospeak, the bank took an asset position and leveraged the government’s HPM to earn a profit. It earned that profit through interest. Profit means income and so, when the bank receives your payment which includes interest, the bank will incur a tax liability on the interest. The bank must settle all tax liabilities owed to the government, so it takes a certain amount from that interest payment and applies it to an account specifically for that purpose. It also has an earnings account called a capital account, into which it places some of the interest payment.

In the beginning when you purchased the car, the bank IOUs were spent and shifted $20,000 of the lending bank’s reserves to another bank to purchase the car. Over the life of the loan, you gradually shifted back reserves to the lending bank by making payments. So, the $20,000 in reserves was eventually returned to the lending bank. Importantly here, as they were returned, the bank accounted for that principle and deleted some numbers from your loan. So, 20,000 in principle IOUs – 100 principle IOUs = 19,900 bank IOUs remaining. Each time you make a payment, the IOUs evaporate until we arrive at 20,000 bank IOUs – 20,000 bank IOUs = 0 bank IOUs. If the interest, then, over the life of the loan was, let us say $4,000, then the total reserve shift to the lending bank was $20,000 + $4,000 = $24,000. With the final payment, the lending bank then finally extinguished all of the 20,000 IOUs and the $4,000 that it earned from the entire process was divided up between its tax liability account and its capital account.

So what then is bank lending? Simple: when you do not have enough dollars earned from income or saved up to buy something that you would really like to buy, a bank is willing create some of its very own “money” just for you out of thin air if you qualify, and then lend it to you so you can buy something that you would really like. And just as a car mechanic charges you for parts and labor plus tax, the bank charges you principle and a fee plus tax for creating the “money” for you. The tax is simply wrapped up into the interest payment (fee).

Bank money creation, then, is a service that a bank is willing to perform for you if you qualify for that service, and in return for that service, the bank expects to be paid. Essentially, in this context, it is no different than any other business. When it is paid, it is earning an income and so, that income is subject to taxation. A bank simply thinks ahead about taxes like any business does and splits some of its paycheck between its tax liability account and its earnings (capital account).

What we are talking about here is that a bank simply cannot lend out its reserves for you to buy things. So, it creates a coupon that is not a US Dollar, but the coupon can and will move reserves between reserve accounts so that payments for those goods purchased with the coupon will clear. The reserves always remain with the central bank and the bank coupons (IOUs) behave like US Dollars behave in the private sector. 20,000 bank IOUs are similar to a farmer’s market coupon that is good for $20,000 worth of something. When you hand over the coupon, the car dealership will hand over the keys to the car, because when the dealership deposits the coupon, $20,000 will shift over to the dealership’s bank’s reserve account and the dealership’s bank account will rise by 20,000. Another way to view it is this way: When consumers are short US Dollars, banks are willing to provide a substitute so that consumers can keep spending. Also, it is important for you to understand that bank credit money is not counterfeiting. We can safely leave such a nonsensical claim to delusional mainstream economystics like Krugman who think the Earth is banana-shaped.

A bank IOU is merely a promise. The bank promises that it will shift some of its reserves to another reserve account in exchange for its IOU if you hand over to the bank your IOU – your promise to the bank, which is exactly what happens when you spend the IOUs – you are demanding HPM. Spend the IOUs and the reserves shift clearing the payment for the thing you purchased. The key thing here is the word “spend”. The bank will not shift its reserves unless you actually spend the IOUs. Once you spend the bank IOUs, the bank has held up its end of the bargain, agreeing to do what it said it would do. The bank then holds onto your IOU until you fulfill your end of the bargain. The bank does NOT promise to actually create US Dollars for you. That would be counterfeiting and the federal government would be paying regular visits to the bank, and the purpose of those visits wouldn’t be because numerous federal agents were interested in opening checking accounts.

Hopefully, you now understand the basics of how a bank processes your loan payments and a little more about bank credit.