Part 4. Interbank settlements
As already mentioned, in day to day banking, banks don't transfer physical assets for every bank transaction people and businesses make. Instead, they keep track of bank transfers and tally up at the end of a period — such as a day — and settle any outstanding balances. We will look at how this process works next.
Let's continue from Part 3 and carry out a second customer deposit transfer, but this time with 1st Bank as the recipient bank. We will create two new customer deposit accounts, Account #3 and Account #4, with Account #3 being at 2nd Bank and Account #4 being at 1st Bank, and carry out a £95 transfer from Account #3 to Account #4. This transfer is shown in Figure 4.1.
As explained in Part 3, every interbank transfer requires two double entries, and we will carry out a deferred settlement double entry as before. To do this, we will set up two similar accounts: a loan account for 2nd Bank at 1st Bank and a deposit account for 1st Bank at 2nd Bank. We will call these 2nd Bank's Loan Account and 1st Bank's Deposit Account respectively. The deferred settlement double entry is shown in Figure 4.2.
The balance sheets of both banks are shown below in Figure 4.3. As you can see by the blue arrows, 2nd Bank now has both a loan and a deposit balance with 1st Bank. Similarly, 1st Bank now has both a loan and a deposit balance with 2nd Bank.
At the end of the period, each bank assesses the other bank's loan and deposit accounts and carries out a double entry to reduce one or both to a zero balance. Whatever balance is left is the balance that needs settling.
Let's start with 1st Bank. We can see that a transfer of £95 from 2nd Bank's deposit account to 2nd Bank's loan account will reduce the loan account balance to zero. This is shown in Figure 4.4.
We can carry out just this single double entry because it is between accounts at the same bank. Also, because both accounts belong to the same customer — in this case a bank — we aren't altering the customer's overall balance with the bank. The balance sheets now look as shown in Figure 4.5.
Now let's do the same at 2nd Bank. This time we can transfer £95 from 1st Bank's deposit account to 1st Bank's loan account to reduce the deposit account balance to zero. This is shown in Figure 4.6.
And the balance sheets are shown in Figure 4.7.
After tallying up, we are left with 1st Bank owing 2nd Bank £5 as indicated by the blue double-headed arrow. This is the amount that acually needs to be transferred to 2nd Bank from 1st Bank's assets to settle the outstanding £5 debt. As we will see in Part 12, this would normally be transferred from the bank's digital reserves, but as we don't have any reserves, this is as far as we can take our example for now.
The two important things to note are that, firstly, many interbank transfers cancel each other out so that the amount to settle at the end of a period will be significantly less than if each transfer were settled one at a time; and, secondly, both banks agree on the amount from their separate set of accounts.back to Part 3