How does the money supply behave when bank loans are repaid?

Question

In a fractional reserve system when banks lend out money, that money is created out of thin air by a accounting journal entry, and the money supply goes up by the amount of the loan & when the loan gets paid off, that money disappears back into thin air and the money supply goes back down which is often also described as "destroying the money"

As under normally amortized loan, out of monthly payments, some part goes towards interest & some towards principal repayment, so the question is does the money equivalent of principal repayment disappears into thin air every time the payment is made towards principal of the loan, or does it only disappears at end of the loan term all at once when the loan has been repaid in full?

If the money gets destroyed or rather disappears from the money cycle every time the principal is repaid from the monthly payments, then does it means that the banks are only left with the interest parts & nothing out of the principal portion on their books?

Also how does the money gets depleted from the money cycle and disappears into thin air in the case of "interest only loans", where during the term of the loan only interest payments are being paid by the borrower & the principal is repaid all at once at the end of the term of loan in form of a single one time payment.

So is it that in such interest only loans because the principal gets repaid all at once at the end of the loan term so at that time immediately it gets depleted from the money cycle all at once & disappears into the thin air?

And most importantly: if all of the money equivalent of the principal amount of loans disappears then how does the banks end up recovering the actual amount loaned by them to the others & not just the interest on that loan?

Answer 1

The money is removed when the loan principal is repaid. The actual point in the loan this occurs depends on the loan terms. For a typical compound interest rate loan, this means a small portion of the principal is repaid every month, and a matching liability deposit (money in the customers account) is removed.

For an interest only loan, this occurs at the end of the loan - assuming all the principal is repaid then.

Interest payments essentially circulate through the monetary system. They're deducted from the customer's account, recognised as income by the bank, and then paid out as some form of expense, e.g. salaries, rent, taxes, etc. They may also be moved into an internal account to provide required loss provisions on loans.

Loan defaults are also an expense, and this is the achilles heel of the banking system. If defaults on loans exceed the bank's loss provisions and profits from interest, then the bank will have to write off against its capital - and this interferes with the regulatory controls on lending, causing the money supply to shrink. In practice, central bank or government intervention is inevitable if this occurs.

As far as the relationship of principal to the money supply. Essentially the banking system relies on new lending always being sufficient to replace the money being removed. In most banking systems, new lending is typically in excess of loan repayment, and so we see the money supply more or less continuously expanding.

Answer 2

I think your source of confusion is that adding or removing money to account is only one of the steps.

When you borrow two things happen:

1. An amount is added to your account.
2. You actually use the money - this causes central bank reserves to actually start to move: either given to you as cash when you withdraw or transferred to another bank when you transfer. Therefore the central bank reserves that were locked away begin to circulate either as cash in people's hands or between banks during clearing. So the money in circulation increases.

Similar thing happens when the bank pays money for other reasons: such as paying interest on deposits, paying salaries to clerks and other expenses.

Therefore money not just appear out of thin air it comes from the 'vaults' of the banks.

However as long as the money sits on the account unused there is no need to actually keep the corresponding money in the vault. That's the basis of the fractional reserve banking.

When you pay back the loan principal two things happen:

1. First you need to deposit cash or transfer money to your account: this moves reserves into your bank.
2. The bank removes money from your account. So it cannot be withdrawn or transferred anymore, so the reserves are locked out of circulation, therefore the amount of money in circulation reduces.

Similar thing happens when money is paid to bank for other reasons: such as bank service charges, loan interest payments, etc.

Therefore money not just disappear, it goes into the 'vaults' of the banks.

Answer 3

When an unpaid loan is written off against the bookkeeping profits sitting on a bank's P&L account, the endogenous money supply (total spendable money swilling around the economy) remains unchanged - please correct me if you think I am wrong.

I'll explain this by way of an example: If I take out a loan to buy a car, every time I make a repayment my current account (spendable money) is reduced, as is the outstanding balance on my loan account with the bank - so what was spendable money sitting in my current account effectively disappears into thin air. However, when a bank writes off an unpaid loan it has made to one its customers, it doesn't reduce its own cash reserves, but instead reduces the bookkeeping profit sitting in its Profit and Loss Account - no 'spendable' bank account balances anywhere are reduced by doing this!

The net profit of a bank only becomes 'spendable' money when bookkeeping entries are made to transfer and credit it to customers' (and its own?) bank accounts.

Answer 4

I appreciate the order of write-off is loss reserve, profits and then capital - but reducing these balances when writing off loans does NOT 'destroy' spendable money in accounting terms. I'll explain why: in double-entry bookkeeping, moving 'money' to a loss reserve keeps it on the debit side of the ledger - the same side that the outstanding balance on a loan account sits (loans are assets to the bank). Therefore, one cannot cancel the other out. Instead, what happens is that a provision for bad debts account is created, and some of the profit sitting in the P&L is moved and credited to it. When the a loan is written-off, the accounting entries are: Debit Bad Debts Account & Credit Loan Account. Doing this does NOT diminish the quantity of 'money' in existence in the bank's accounts.

From the bank's perspective, and in accounting terms, only its customers can 'destroy' money by paying-off their loans and reducing the balances on their bank accounts. It is impossible for the bank to 'destroy' money it has created itself through the act of lending.

However, I do concede that when the bank destroys money by charging its customers interest and moving it to the P&L, that can be used later to write off bad loans - but the money is effectively destroyed when it is taken from customers' accounts.

Answer 5

The creation of money occurs when the bank loans out any amount not backed by its reserves to a borrower. The borrower's debt is the excess money. As the borrower pays back the money to the bank, the supply of money in the system contracts. This is of course until the bank lends further against its reserves to another borrower.

Interest payments are akin to money received for a product, that is the loan, and management of the risk held by the bank in lending money. Interest only loans pay for the service of holding the money you and the bank created by borrowing from the bank. Then like all loans, once the payment is made, the supply of money you the borrower created is shrunk. The bank however has made money on the interest.

Over time supply and demand for loans and lending expand and contract the money supply. This coupled with the reserve rate requirements dictated by central banks dictates the supply of money in the system.

Answer 6

I don't believe Mike Hall is correct when he states principal repayments plus loan equals a net increase in the money supply. Principal repaid to a bank is no longer held in a deposit account and is not a liability of the bank. It cancels the equivalent amount of the loan contract asset and is not available to the bank or anyone to spend. It is removed from the money supply permanently.

However, the reserve account balances transferred to the lending bank when principal is repaid, does add to the bank's balance sheet as an asset. But this only replaces the lost reserves transferred from the bank when the original loan was made.

Answer 7

I don't believe that Mike Hall's claim that the money supply increases when principal is repaid is correct. Principal payments are offset by the equivalent reduction in the bank's loan asset. The principal received is not recorded as a liability of the bank in any deposit account and is not available for spending by anyone, including the bank. It is permanently removed from the money supply.

However, the reserve account balances that are transferred to the lending bank when principal is repaid does end up on the asset side of a banks balance sheet but it merely replaces the reserve balances lost when the loan was originally paid out. So the loan process leaves the money supply unchanged.

What does change the money supply is the rate of new loans minus the rate of repayment. If new loans tend to be less than the repayment of existing loans, a shrinking economy, the money supply could theoretically shrink.

Answer 8

Think in terms of paper money:

the borrower pays off a loan of £5 to a lender by giving the lender a £5 note out of her wage packet: the money in the borrower’s wage packet has been reduced by £5, but the money in the lender’s pocket has been increased by the same £5: net increase in the supply of money = £0.

If the original lender is an ordinary person, the act of lending reduces the money in her pocket by £5 at the same time as it increases the money in the borrower’s pocket by £5.

So here, no money has been created by borrowing, lending, and repaying: all that has happened is a transfer of existing money from lender to borrower and back again.

However, if the loan is made by a bank, then the bank creates the £5 that is loaned and, other things being constant, this counts as an increase in the overall supply of money.

The loan is repaid by the borrower transferring £5 of her money back to the lender bank.

This does reduce the money available to the borrower by £5, but, at the same time, it increases the money available to the lender (the bank) by that same £5: the net increase of the money supply through this repayment is zero, but, overall the bank has increased the supply of money by the £5 it created to make the original loan.