A waterfall starts with a single drop

Have you ever dreamt about becoming a MPC (Monetary Policy Committee) member and influencing monetary supply? You can do so without leaving the house, but think twice about chasing yields.

Economies across the world have a love-hate relationship with debt, seeing the word as an ugly adage but continuing to spend and borrow at the expense of their debt burden. The United States of America’s outstanding debt alone now exceeds $31trillion, costing the country $400bn annually in interest. That’s an unfathomably big number and to many people it’s just that – a number. But have you ever wondered where it comes from? In this short blog, we’ll explore how money is created and why it’s relevant for your TreasurySpring Fixed-Term Fund subscriptions.

Among TreasurySpring’s 450+ products, banks represent a large percentage of available obligors. This reflects the unique role they play in modern economies. Anyone with a bank account knows that banks hold and lend deposits. But depositors may be unaware that by placing money with banks, they are directly contributing to the money creation process. Yes, you read that right: you don’t need to be a central banker to create money.

Due to the mechanics of double entry accounting, whenever a depositor places money with a bank, the bank simultaneously writes a liability (an IOU to the depositor) and an asset (the cash they receive from the depositor). But banks haven’t become the giants they are by just holding deposits. Instead, on an aggregate level, banks lend a portion of their deposits to generate returns.

When banks loan depositors’ funds, their liability remains unchanged – they still owe depositors their money back. But instead of the asset being in the form of the cash received, it’s now the loan written, and where does the cash go?… To the bank account of the person or company with whom the borrower is transacting. Once the money is transferred to another bank, the receiving bank writes another double entry account in the form of an IOU to the depositor and the cash received from the lending bank. The recipient bank thus repeats the cycle. Herein lies the financial magic of money creation: taking deposits and writing loans creates new money and repaying loans destroys money created.

So, if banks can create money, why don’t they just continue indefinitely? The answer, in part, lies in the most vehemently discussed subjects in financial markets over the last year… inflation, interest rates and banks’ risk. The creation of money accelerates spending and fuels demand-driven inflation. Central banks use interest rates as a mechanism to control money creation. By increasing rates, banks’ borrowing costs increase as depositors expect a higher yield. Higher funding costs are then passed onto bank loans, which in turn dampens demand for borrowing and curtails spending.

This is all very interesting, but why does it matter to me as a TreasurySpring client, I hear you ask.

By using TreasurySpring’s products, clients can deploy and generate revenue from their excess capital. This was an unloved space when rates were at record lows but hikes now mean treasurers are missing out on additional returns. Return from a one-year, £1mm investment with TreasurySpring could now pay for a full-time employee – a tempting prospect for even the most conservative finance director.

But the same, conservative finance director should also note that absolute returns are only half the story. Returns are, at least in theory, directly proportionate to the investor’s risks, with government debt commonly being held as the risk-free benchmark. This pattern is seen in our products’ curve with term and credit premiums contributing to higher yields. While absolute return is about achieving the highest yield, the risk-adjusted return considers the increase in absolute return for each additional unit of risk assumed.

This all matters to the investment choices available. Putting our MPC member hat back on, the choice to raise rates helps reduce inflation, but at the expense of increasing debt servicing cost and declining credit quality. Highly leveraged borrowers and the banks that provide leverage may continue to offer higher absolute returns, but with growing risk that they may fail to meet their obligations. The question for investors then becomes how much more absolute return above the risk-free rate is required to justify the additional risk?

TreasurySpring isn’t in the business of predicting the future (if we were, we would have all booked holidays to avoid the weather), but effective cash management gives consideration for all possible scenarios. Our range of products, covering government, Supranational, Sovereign and Agency (SSA), repo and unsecured lending gives clients the ability to build a risk profile of their choice.