Wednesday, 14 October 2015

Why do banks pay interest to depositors?

The second tweet below prompts me to answer the above question.

Mike King (above) suggests that banks rent money from depositors. My answer is that, strictly speaking, they rent SAVINGS, not money. I’ll enlarge on that.

Banks do two quite separate things, 1, create money for those who want money, and 2, intermediate between borrowers and lenders. Those two activities get very mixed up in the real world, but they can in fact be separated. E.g. in a hypothetical economy where no one wanted to borrow or lend, i.e. where debt didn't exist, it would be perfectly feasible for banks to create money without creating debt. See here for more on that:

In that hypothetical scenario, banks would charge for ADMINISTRATION COSTS involved in creating money. But there'd be no point in their charging INTEREST. Any bank depositor demanding interest would told to get lost.

Quite distinct (in principle) from that money creation activity, a second bank activity is intermediating between borrowers and lenders. Lenders do not normally lend without being rewarded for doing so (though at present, what with low interest rates, the reward is near non existent).

Ergo when it comes to intermediating, banks do indeed have to pay interest. But what they’re doing there is renting savings, not money. Indeed, relevant savers would for the most part be quite happy to have their money put into relatively long term “term” accounts where their savings / money was not available without two or three months’ notice. And normal practice in most countries is not to count the stuff in those term accounts as money.

In short, banks do not pay interest in order to obtain money: they pay interest in order to obtain savings.

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