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Part 3. Interbank transfers

Transactions that take place between accounts at different banks are referred to as Interbank Transfers. There are rules that need to be followed when dealing with these transactions that are derived from the rules laid out in Part 2.

Before we look at an interbank transfer, let's consider in a bit more detail a simple transaction between accounts held at the same bank. Let's create a new bank called Bank, and two new customer deposit accounts, Account #1 and Account #2, held at Bank. Then consider a £100 transfer from Account #1 to Account #2. This transaction is shown in Figure 3.1.

Account #1 Description Debits Credits Balance Starting balance £0 Transferred to Account #2 £100 £100 (DR) Account #2 Description Debits Credits Balance Starting balance £0 Received from Account #1 £100 £100 (CR)

Figure 3.1. A £100 transfer between two customer deposit accounts.

As expected, this transaction has resulted in Account #1 being overdrawn £100 and Account #2 being in credit £100. As this is a perfectly legitimate transaction that anyone can carry out, the question that arises is what does the bank do when someone performs a transaction like this?

Since this transaction happened at the same bank, all the bank has to do is record the transaction on its set of accounts, and since all banks use computerised records, this is carried out automatically. As this is Bank's first ever transaction, and it doesn't have any prior assets or liabilities, its balance sheet will be as follows:

Bank's Assets Account #1 £100 Total assets £100 Bank's Liabilities Account #2 £100 Total liabilities £100

Figure 3.2. Bank's balance sheet after the £100 transfer between two customer deposit accounts.

As you can see from Figure 3.2, the balance sheet satisfies the accounting equation. The bank's equity is still zero (the bank hasn't created any value or equity by allowing this transaction), and liabilities are equal to assets. Notice that the overdrawn deposit account, Account # 1, now represents an asset of the bank since it is money that is owed to the bank.

So what would happen if we performed the same transaction above but between accounts at two different banks? Let's start from scratch and create two new banks, 1st Bank and 2nd Bank, and two new accounts, Account #1 and Account #2 — with Account #1 being at 1st Bank and Account #2 being at 2nd Bank — and perform the same £100 transfer. The transaction is shown in Figure 3.3.

Account #1 1st Bank Description Debits Credits Balance Starting balance £0 Transferred to Account #2 £100 £100 (DR) Account #2 2nd Bank Description Debits Credits Balance Starting balance £0 Received from Account #1 £100 £100 (CR)

Figure 3.3. A £100 transfer between two customer deposit accounts at different banks.

The transaction is identical to the transaction carried out at the single bank except this time it occurred between different banks. The balance sheets of both banks are shown below in Figure 3.4

1st Bank's Assets Account #1 £100 Total assets £100 1st Bank's Liabilities Total liabilities £0 2nd Bank's Assets Total assets £0 2nd Bank's Liabilities Account #2 £100 Total liabilities £100

Figure 3.4. Balance sheets of both banks after the transaction.

Now we have a problem; we have violated the accounting equation at both banks. Although the accounting equation is satisfied across banks, it also has to be satisified at each bank, since each bank has its own set of accounts that must adhere to the accounting equation. Effectively, we have split the double entry, performing the debit on one set of accounts and the credit on a different set of accounts, and this doesn't work.

In fact, when carrying out a transaction between two banks (or two sets of accounts) we always need two double entries (or multiples of two) to keep the accounting equations satisfied, and there are two ways of approaching this.

First approach

The first approach involves carrying out one double entry at 1st Bank and a second double entry at 2nd Bank. Since these will be single double entries carried out on separate sets of accounts, the accounting equations won't be violated. This approach is depicted in Figure 3.5.

1st Bank (DR) (CR) (CR) (DR) 2nd Bank

Figure 3.5. An inter-bank transaction using double entries carried out within each set of accounts.

Second approach

The second approach involves carrying out both double entries between accounts at different banks as shown in Figure 3.6.

1st Bank (DR) (CR) (CR) (DR) 2nd Bank

Figure 3.6. An inter-bank transaction using double entries carried out across sets of accounts.

In fact, both approaches must be satisfied, and effectively represent the same transaction. For the transaction to be valid, all four credits and debits making up the transaction must be carried out. We will also see later that when carrying out a transaction involving 3 banks, we need three double entries to represent the transaction.

The types of accounts involved in inter-bank transfers will depend on the type of transaction that takes place. A customer deposit transfer involves transfering a liability from one bank to another. Intuitively it makes sense that a corresponding asset transfer of the same value also takes place. However, in modern day to day banking, banks don't transfer physical assets between them when customers make payments using their deposit accounts or move deposits around.

Instead, banks defer settling in the same way businesses defer payments, and settle later on, except usually on shorter timescales. This process is discussed in more detail in the next and subsequent parts, but for now we will look at how this deferment is represented by a double entry on the sets of accounts, since banks still need to record deferments to ensure the accounting equation is satisfied and to provide a record of all deposit transfers that will need settling.

For our example, we need two new accounts: a loan account for 1st Bank at 2nd Bank, and a deposit account for 2nd Bank at 1st Bank. We will call these 1st Bank's Loan Account and 2nd Bank's Deposit Account respectively. A double entry is then made between these accounts as shown in Figure 3.7.

1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Starting balance £0 Borrowed by deferring settlement £100 £100 (DR) 2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Starting balance £0 Owed by deferring settlement £100 £100 (CR)

Figure 3.7. Deferred settlement double entry of £100 between the two banks.

This transaction now represents a deposit transfer that will need settling in the future. It satisfies the accounting equations at both banks as shown in Figure 3.8.

1st Bank's Assets Account #1 £100 Total assets £100 1st Bank's Liabilities 2nd Bank's Deposit Account £100 Total liabilities £100 2nd Bank's Assets 1st Bank's Loan Account £100 Total assets £100 2nd Bank's Liabilities Account #2 £100 Total liabilities £100

Figure 3.8. Balance sheets of both banks after the £100 deferred settlement double entry.

In the next section we look at how deferments are settled — at least partially — without involving the transfer of assets between banks. And in Part 12 we see how they can be settled completely when central banks are involved.

back to Part 2