We all know banks charge interest on the loans we take out with them.
Some banks also pay interest on deposits, so these banks earn money on
the difference between interest charged on loans and interest paid on deposits.
Banks also earn money by charging fees, providing other services to customers and businesses, and from other investments,
but we will focus on the money banks earn from charging interest on the money banks create.
To illustrate how banks earn money, consider a mortgage loan taken out from a bank to purchase a house.
For simplicity, consider a 100% loan-to-value mortgage on a £100,000 house purchased with no arrangement fees,
and consider all transactions are carried out at the same bank.
We will also ignore solicitors, contracts and bank managers,
since their involvement doen't change the underlying transactions we are interested in.
First we need to create the loan, for which we will need a mortgage loan account we will call House Buyer's Mortgage Account,
and a deposit account we will call House Buyer's Deposit Account, both belonging to the customer buying the house.
The mortgage loan is created with the double entry shown in Figure 7.1.
Figure 7.1. The mortgage loan creation for a house purchase.
Next the house buyer's deposit is transferred to the house seller
(this may be done automatically by the bank and may involve intermediate accounts with solicitors, but the end result is the same).
For this we need a new deposit account, which we will call
House Seller's Deposit Account. The double entry for this is shown in Figure 7.2.
Figure 7.2. The house purchase transaction.
Now, assume that the loan is paid back over 20 years at 5% interest.
The monthly payments on this loan are £660. The first month's payment will comprise a £417 interest payment
and a £243 principle payment. These figures have been rounded for demonstration purposes.
To be able to pay this, our house buyer needs an income.
To keep things really simple, let's assume the house seller employs the house buyer on a £1000 a month salary
(the house seller could be a house builder, for example.)
Let's also assume no interest is paid by the bank on deposits, and no tax is paid by either the employer or employee.
At the end of the 1st month, the house seller pays the house buyer's salary as shown in Figure 7.3.
Figure 7.3. The 1st month's salary transaction.
Next, the house buyer pays the 1st month's mortgage repayment as shown in Figure 7.4.
Figure 7.4. The 1st month's mortgage repayment transaction.
And finally for month 1, the bank charges the house buyer interest on the amount of the loan outstanding.
For this, we will need a new account we will call Bank's Earnings, belonging to the bank.
The 1st month's interest payment is shown in Figure 7.5.
Figure 7.5. The 1st month's loan interest charge.
All these transactions are perfectly valid, and as they occurred at the same bank, there is nothing else the bank
needs to do except record the double entries on its set of accounts.
After month 1, the bank's balance sheet looks as shown in Figure 7.6.
Figure 7.6. Bank's balance sheet after the first mortgage repayment.
We can see that the bank has earned £417 of interest.
The bank's liabilties have been reduced by the amount of the mortgage repayment, but
the assets only by the amount of the mortgage repayment less the interest charged.
Therefore, the bank's assets now exceed its liabilities and the bank now has equity.
We can also see that the amount of money in deposit accounts
has been reduced from £100,000 to £99,340, and the amount of debt outstanding
now exceeds the amount of deposits.
As more of the debt is paid back, the money in deposit accounts is reduced further as can be seen
if we repeat the above transactions to month 10 as shown in Figure 7.7.
Figure 7.7. Accounts after the 10th mortgage repayment.
Note that the interest charge reduces from £417 to £416
in month 2 and continues to reduce
as the debt is paid off. This is because interest is charged on the amount of debt outstanding,
and this is accounted for when the monthly payments are calculated so that
the monthly payments do not change (unless the interest rate changes).
Therefore more principle is paid off each month than the month before but less interest.
The bank's balance sheet after month 10 is shown in Figure 7.8.
Figure 7.8. Bank's balance sheet after the 10th mortgage repayment.
If we continue repeating these transactions, deposit accounts will eventually run dry.
If we fast forward to month 100, the house seller's account has run out of funds and the house
buyer's salary can no longer be paid. The house buyer still has money
to carry on paying the mortgage until month 151 at which point their account is reduced to £340.
At this point there are insufficient funds to pay the £660 mortgage repayment on month 152.
The bank's balance sheet at month 151 is shown in Figure 7.9. (We have dropped the house seller's deposit account since it is empty)
Figure 7.9. Bank's balance sheet after the 151st mortgage repayment.
By looking at these simple transactions,
it helps us see the mechanism by which banks earn money.
It also shows why banks have to create new loans to keep the money supply reflated.
Banks have an interest in keeping the money supply from running dry since
people, businesses and other banks would otherwise default on their loans,
and defaults are bad for banks as explained in the next part.