Creation
Payment
At first, the banking business model was to collect a spread between the interest banks paid on deposited stones and the interest banks collected on lent stones. However, over time, the banks became trusted intermediaries for day-to-day payments. For example, imagine that the carpenter wants to buy goods from various merchants. He does not want to cart his stones around all day. This is heavy and dangerous. So instead, he goes to the bank, hands over some stones, and the bank gives him a paper note indicating that the bank is good for those stones. The bankers called these banknotes. Various shops in town were originally skeptical of this scheme; they thought that banknotes were not money but only the promise of money. But over time, they liked the system too, because they did not have to keep as many stones in the back rooms of shops. Everyone could transact with banknotes, and simply exchange them for stones when needed.
Settlement
This new payment system worked extremely well, because now villagers can buy things when they need them, rather than when they have stones, and they can buy at nearly every shop in the village using debt or banknotes, because the debtor is a trusted third-party, a bank. However, the banks realized something odd: they often become each other’s creditors without trying. For example, imagine that the architect banks at the raccoon’s bank and the zoologist banks at the badger’s bank. When the architect buys from the zoologist, she gives the zoologist a banknote from the raccoon. The zoologist then goes to exchange this banknote for stones at the raccoon’s bank. But this is a hassle. Now the zoologist has to walk his stones from the raccoon’s bank to the badger’s. The zoologist would rather have the raccoon just deposit the stones directly at the badger’s bank, but the raccoon cannot do this, as it would require manipulating the badger’s balance sheet. So instead, the banks decide that the zoologist can deposit the architect’s banknote directly at the zoologist’s own bank, and then the badger will collect the debt from the raccoon. The banks call this scheme gross settlement. However, for a brief moment, the badger is inadvertently a creditor to the raccoon, because it creates a deposit for the zoologist before it has the architect’s stones from the raccoon. the badger is loaning the raccoon stones, as an artifact of who pays who in the village. So the banks hire the fastest kids in town to run stones between banks. They settle these incidental, transient debts as fast as possible.
Residual
Gross settlement is appealing because it is simple. The raccoon’s bank knows the architect, and the badger’s bank knows the zoologist. Every banknote is settled immediately after the transaction, by stone runners. Neither bank is touching the other bank’s balance sheet, and the zoologist himself does nothing. His stones stay within the banking system. But the banks have problems with this system. First, it is costly, time-consuming, and dangerous to transport stones constantly. And second, it is terribly inefficient. In one day, the raccoon might transfer ten thousand stones to the badger, while the badger transfers eight thousand stones to the raccoon. It would be better if they netted, if the raccoon simply transferred two thousand stones. So the banks agree: at the end of each day, the bankers will convene and settle all debts by netting their transactions. They call this nightly meeting scheme net debt settlement and the net payment the residual. At the end of the day, the raccoon might transfer only five stones to the badger, but this residual payment says nothing about the day’s transactions. It could mask hundreds of transactions between its customers.
Deferral
One night, the bank leaders convene to settle their debts, and Poseidon Bank asks a question: rather than settle with the raccoon’s bank tonight, could it possibly settle with the raccoon tomorrow night and pay one night of interest? The bankers thought about this and decided that it was not only acceptable, it was desirable. The ability to pay one’s debts, which the bankers called solvency, is different from liquidity. When the small bank was forced to sell its balance sheet at a discount, it was solvent but not liquid, and the inflexibility of the system caused real value to be destroyed. Or take the fishmonger, who pays his suppliers with banknotes in the morning before going out to fish but isn’t able to sell his fish to the restaurants until evening. Under immediate gross settlement, his bank account was often dangerously low, but it was always full again by nightfall. Thus, the bankers reason, it would be better if the system had some flexibility. Since Poseidon is good for the money and only owes the raccoon for incidental reasons due to who paid who today, why not defer settlement another day? So the banks agreed that while eventually settling was critical to the system, banks could borrow from each other for one night at a special interest rate, which they called the overnight rate. Just as villagers could go into debt to each other in order to resolve a timing-mismatch, so banks could go into debt to each other for exactly the same reason.
Acceptance
The villagers begin to wonder: what is money? Stones are obviously money, but so are banknotes and even bank deposits. For example, every time the bookseller sells a book, he is either paid in stones directly or he is paid with a banknote. After a while, the bookseller realizes something: he hasn’t seen a stone in a while. Everyone buys from him using banknotes, and he doesn’t even convert that banknote to stones. He simply deposits the banknote at his bank, and then banks settle the debt later, sometimes days later. The bookseller realizes that once he’s handed a banknote, he considers himself paid. Of course, if he only viewed stones as money, he would not be paid until he converted this banknote into stones. But he goes to bed each night with only a number on a balance sheet to tell him he has money. The villagers begin to wonder if maybe all the things they thought mattered about special gray stones—durability, portability, scarcity—were not the real reason people were willing to accept them as money. Maybe money was just anything that another person would accept as settlement for a debt. If this were true, then a banknotes were also money.
Creation
An extremely profitable businessman came to the badger’s bank for a loan, but the badger has a problem. His storehouse of stones is nearly empty, and he cannot issue more debt without another villager handing over more stones as deposits. But then he thinks about the bookseller. The bookseller accepts banknotes as payment and buys goods for his family using banknotes as well. He has not asked for his stones in the storehouse in years, and the badger does not even think of himself as storing his particular stones anywhere. He only has a pile of stones in the storehouse, and he can’t remember the last time he worried about running out of them. What he does worry about is the residual payment owed at nightly settlement. Sometimes he is paid a little, sometimes he pays a little, depending on payments across the village. And if he owes more than he expects, he can borrow at the overnight rate. In his mind, the real risk is not a villager asking for their stones. It’s his overnight interest payment growing if he keeps rolling his debts forward. This is the risk that he must and can manage. So he takes out his balance sheet, and simply writes down a new line: a liability in the form of new deposits for the businessman and an asset in the form of this man’s debt to the bank. His sheet balances. This isn’t an accounting trick in his mind, and he doesn’t even think about it as creating money, because he isn’t creating stones. The liability or deposit is simply a claim for stones against his bank. The profitable businessman can now, if he wants, ask for real, physical, special gray stones, and the badger could give them to him. But he won’t! He will only ask for banknotes and repay his debt in banknotes. Thus, with a stroke of the pen, the businessman has banknotes to expand his business, and the badger’s residual payments shift, imperceptibly, day over day, as slightly more money in the village is a claim against the stones in his storehouse.