The Banking System

Why Should I Care?

The financial industry holds the key to any important changes we need to make to the economy. Bankers are in the middle of the power structure of the economic system. They are a big part of the control component of the system. If we want change, we need money to fuel investments. That money comes from banks. Also, if the banking system prints too much money, most of us will be impoverished, so that matters. Having community-centred banks can make a big difference in alleviating social inequalities and fighting climate change.

This Lecture Has 5 Parts

• Banks & Credit Unions
• History of Banking
• Bank of Canada
• History of Central Banks
• Tools of Central Banking

What is the Banking System?

The Banking System is a network of commercial lenders and government institutions that supply loans to the Canadian public. The Bank of Canada is the government’s bank, and the lender of last resort of the banking industry in Canada. It also produces coins and paper notes, and manages the supply of money in the economy.

• Banks and Credit Unions

In Canada, there are many kinds of financial institutions. 

• Deposit-taking Bank
• Deposit-taking Non-Bank
• Non-Deposit-taking Lending Institution
• Central Bank

A Deposit-taking Bank is a for-profit company that offers two services. First, it offers a safe-house for savings, and often provides an incentive to attract deposits. Second, it lends out money with interest. Most people do not want to use their money, so banks loan out most of the deposits, and keep a fractional reserve on hand for clients who want their deposits back. Because of the risky nature of loaning someone else’s money, banks are strictly regulated. In Canada, the larger banks follow rules, a “charter” set by the government. This helps reduce the risk of bank runs and bankruptcies. For many reasons, the banking industry is more stable, but not as competitive in Canada as it may be elsewhere.

The largest banks in Canada are the Chartered Banks, which are federally regulated and owned by Canadian shareholders. These are the Royal Bank of Canada, Toronto-Dominion Bank, CIBC, ScotiaBank and Bank of Montreal (BMO). There are also regional banks such as the Montreal headquartered National Bank and the Laurentian Bank, ATB (Alberta), as well as the First Nations Investment Bank (Saskatchewan). A more recent development is the chartering of corporate brands, such as the Canadian Tire Bank, and President's Choice Financial (owned by Loblaw's).

Foreign banks are allowed to operate in Canada, but they cannot acquire a Canadian Chartered Bank.

A Deposit-taking Non-Bank is a financial institution that offers the same services as Chartered Banks but are regulated provincially. In Quebec they are called Caisse populaires. In the rest of Canada they are called Credit Unions. There are many such institutions across Canada, the larger of which are the Teachers Credit Union in Ontario, the Vancity credit union in British-Columbia, and UNI or Caisse populaire acadienne ltée. in New-Brunswick.  In Quebec, about 5 million people deposit their money in a caisse populaire or caisse d’économie which are members of the non-profit Mouvement Desjardins.

Interview with Julien Brault - on Banks and Credit Unions

Differences between Banks and Credit Unions

Type of Financial Institution	Bank	Credit Union
Authority	Federal Charter	Provincial Charter
Legal Form	Corporation	Cooperative
Services Offered	Savings and Loans	Savings and Loans
Local Retail	Branch owned by Head Office	Locally owned Credit Union
Local Control	No	Yes
Customers	Clients	Members
Board Voting Rights	Shareholders	Members
Profit-seeking	Yes	No
Earnings Distributed	Shareholders receive Dividends + Sponsorships	Members receive Ristournes / Rebates + Community Donations
Listed on TSX	Yes	No

Another type of financial institution is the Non-Deposit-Taking Lender. There are many examples of this, such as Honda Canada Finances Inc.,  or General Motors Financial Company, Inc. These are the lending corporations, which don't manage savings accounts. You cannot get a debit/Interac card from these institutions. Often they are lending arms of car manufacturers. They will offer car loans, and benefit from the dealerships to provide the service.

Finally, Central Banks are state-owned and operated financial institutions which usually do not offer their services to regular citizens. Accounts in these banks are reserved to government, and large financial institutions. In some countries, the central bank is also the financial regulator, but in Canada that role is separate and run by provincial authority.

• History of Banking

A not-so-long time ago, people would stop by their bank to get some cash before they go shopping. A long long time ago, people would stop by their safe-house to get some gold coins before going to the market. According to historians, modern banking was probably created in London, England around 1640 when goldsmiths (safe-houses of gold coins and bars) started to issue IOU notes. There are also accounts of paper money being printed in China at the same time.

This financial paper proved that the holder was the rightful owner of a certain quantity of gold. These notes were more practical to transport than gold, so people started to use them as money. Modern banking began when these notes were issued as loans. The loans were intended to people how did not have gold. The lender was taking quite a risk because he is lending someone else’s gold.

• Bank of Canada

The Bank of Canada is the country's central bank. It was created in 1934, at the crux of the Great Depression. It helped to stabilize the country’s banking industry at a time when 9,000 US banks failed, and dozens of Canadian banks were on the brink of bankruptcy.

Thanks to the central bank, there wasn't a single bank run in Canada during this time, however, it should be noted that the sector was engaged in consolidation, where many banks merged, such as the Bank of Ottawa with the Bank of Nova Scotia, the Bank of Toronto with the Dominion Bank, the Imperial Bank with the Bank of Commerce, or the Banque du Peuple with the Banque Nationale. All these mergers helped to stabilize the sector. They had, however, accrued quite a bit of debt to buy each other out, so the creation of a central bank helped keep the new giants afloat.

The Bank of Canada is a federally owned and run agency. However, it is independent of Parliament. Economists do not approve of politicians managing money supply themselves because the latter tend to print too much money, which creates inflation and reduces purchasing power.

The Bank of Canada oversees and manages a sister organization called Payments Canada, the transactional clearinghouse association. This institution guarantees that very large transactions are cleared (they get the OK to pass from one bank to another), and settled (the money is taken out from one account, and added in the right account). Many of these transactions are between the Big 5 Banks, but the association’s membership includes regional banks, Desjardins, large credit unions, and other financial institutions such as Trusts.

Some of the transactions are overnight loans, with or without the central bank; the said loans are subject to the Bank of Canada’s overnight rate (policy interest rate).

The banks main roles are

1. Manage Monetary Policy:
   Canada's monetary policy is implemented by the inflation-control target and a flexible exchange rate with other currencies.
2. Oversee the Financial System:
   Canada's financial system consists of financial institutions, markets, such as the Toronto Stock Exchange, and payments systems. The Bank of Canada oversees their proper daily functioning.
3. Issue Currency:
   The Bank of Canada is the country’s sole authority for issuing bank notes and is responsible for the design, production and distribution of Canada’s bank notes.
4. Federal Government Banker:
   The Bank of Canada provides funds-management services to the Government of Canada, itself and other clients. The Bank of Canada will buy, hold, and sell federal bonds, such as Treasury Bills, allowing the federal government to borrow money from the central bank.
   
5. Supervise Retail Payments:
   The Bank of Canada makes sure that the payments system works well, so that retail transactions can occur smoothly across the country.

Source: Bank of Canada. https://www.bankofcanada.ca/core-functions/

• History of Central Banks

Europeans invented the modern central bank. Take a look a the list below. The first central bank was invented by the Dutch, whose international trading posts (think of New Amsterdam/New York City) generated much financial activity in Holland.

Bank of Amsterdam (1609)
Bank of Sweden (1664)
Bank of England (1694)
Bank of France (1800)
Reichsbank-Germany (1876)
Bank of Japan (1882)
US Federal Reserve (1914)
Bank of Canada (1934)
People's Bank of China (1948)

The Bank of England was created to fund a war. It became a true central bank in 1844, being the sole printer of bank notes in the UK.

Napoleon created the Banque de France as one of many government reforms. He also rewrote the laws of the land, known as the Code Napoleon, which is the basis of Quebec’s Civil Code.

The Bank of Canada was created in 1934 amid the Great Depression. Prior to this date, private banks such as the Merchant’s Bank of Halifax (now called Royal Bank of Canada), the Banque d’Hochelaga, the Quebec Bank, the Banque du Peuple, the Banque Canadienne Nationale, and the Bank of Ottawa, among many others, issued their own bank notes. This paper money was regulated by the British colonial office and later federal charters. The money was supported by gold stored in each of the bank vaults. This is known as a Free Banking system under a gold standard.

Canada’s first bank, the Bank of Montreal (1817), was considered the government’s main lender until Ottawa created its central bank in 1934.

The US Federal Reserve Bank was created in 1914 after the terrible Banking Crisis of 1907. The Fed was severely criticized by Milton Friedman (1963) for not keeping monetary supply steady during the Great Depression. Friedman argued that restrictive monetary policy was a contributing factor to the Great Depression, which had been triggered by the stock market crash of October 1929. Prior to the 1930’s a central bank could not print money without increasing its stock of gold. This was called the Gold Standard.

The Great Depression forced Europe to abandon this system as governments felt this was too constraining. The US followed in 1933, and Canada in 1934. Central banks adopted the Fiat Currency system, where bank notes are not exchangeable for gold, or any other supporting asset, at a guaranteed rate.

Hyperinflation in the Weimar Republic

Weimar is a mid-size city in central Germany where the first democratic constitution was signed giving its name to the Weimar Republic period in German politics (1918–33).

Weimar coat of arms

Unable to pay its World War I debts to France and the UK, Germany was quick to drop the Gold Standard in 1918. Its economy was in recession, so until 1922 it proceeded to print large quantities of its currency. This created the first European episode of hyperinflation in history, and great social strife. Many historians argue that German hyperinflation partially led to Hitler’s political ascension. After the end of World War II, the Americans and British were quick to negotiate a Gold Standard monetary regime that would avoid hyperinflation in the future. The negotiations took place in Bretton Woods, a ski resort located in the US State of New Hampshire.

It was decided there that the US dollar would be pegged to weights of gold. The US dollar then replaced gold as the reserve asset of European central banks. It also supplanted the British pound as the currency used to buy oil on world markets. This US-led Gold Standard was in place from 1945 to 1970.

• Tools of Central Banking

A central bank has three tools at its disposal to manage money supply. First, the central bank will set the lowest interest rate in the land, the overnight rate. This is the signalling tool.

Once the signal is set, the central bank can use operational tools to execute the policy.

The second tool allows the central bank to deposit  or withdraw money in the accounts of the commercial banks, who are its clients.

Third, central bank can buy or sell on the bond market to directly inject or withdraw money from circulation.

1. Overnight Rate

The Bank of Canada sets an interest rate on loans it calls the Policy Interest Rate. In 2018, it was 1.75 percent, a very low interest rate offered only to large-scale million-dollar loans on the overnight inter-bank market. In 2022, it started the year at 0.25 percent, the lowest it had ever been.

Chartered Banks, other Commercial Banks, and large Credit Unions, often need overnight loans to uphold debit requirements at ATM’s and bank tellers. They also may need money to cover a client’s cheque, a transfer on a financial market, or a bad client who is not paying their monthly loan payment.

These loans are usually contracted with competing banks on the overnight market, which is overseen by the Bank of Canada. The overnight interest rate can be set on the free-market. In Canada, it is mostly set by the central bank which also offers last-resort loans to commercial banks. This offering acts as a ceiling for the market interest rate. The banks are thus “forced” to match the rate offered by the Bank of Canada. This “overnight” inter-bank interest rate is therefore set by the central bank’s policy.

2. Commercial Bank Deposits

The Bank of Canada can deposit new money (or withdraw money) into the accounts of the major banks. By increasing its deposits, it puts money in the hands of the banks. They usually keep a small reserve of that deposit, and lend the rest. These new funds are an injection in the money supply. Paper money is printed, and part of this operation, but most of the new money is online scripture.

The opposite is also true. If the Bank of Canada withdraws money from the banks, they have to reduce their lending and this decreases the money supply.

This tool is used in conjunction with the overnight rate. For example, the Bank of Canada will reduce its overnight rate to encourage banks to reduce their lending rates. At lower interest rates, Canadians will demand more loans. When this occurs, the central bank increases its deposits at the chartered banks to enable them to allow the new loans. This grows the money supply.

When the overnight rate is increased, every bank in the country must increase their interest rates because if they did not, they would stand to lose profits. Creditors react by demanding fewer loans, and money supply is reduced.

3. Transactions on Bond Markets

The central bank can modify money supply by using open-market transactions on the bond market. The central bank holds both currency and bonds on its balance sheet.

If the central bank wants to increase money supply, it buys bonds (sells money) from the open-market. Its currency is now added to general circulation.

If the central bank wants to decrease money supply, it sells bonds (buys money) to the open-market. This currency is now sitting at the central bank and taken out of circulation.

A money monopoly

Since the Bank of Canada has a monopoly on printing money in Canada, it controls the production of new bills, coins, and some of the scriptural currency. Whether by Deposits or Bond Transactions, the Bank of Canada can add/remove money from circulation to pursue its goals. Since money is now controlled by a government agency, money has become a policy. Thus, money supply can become a normative question.

Also, the power to create money is a dangerous thing, potentially. Too much money will reduce the value of money. Consequently, prices will grow. Out of control policy will result in galloping and hyper-inflation.

Money creation

The Bank of Canada controls the first steps in the creation of money in the country. However, it does not actually print or create most of the money in circulation. This is done through the commercial banks. Every day, banks create money in the form of loans, basically out of thin air. The money sits as a liability on the bank's accounting statements. When the loans are repaid, the liability is erased and the money disappears de facto. In order to keep people confident in the resilience of the banking system, many countries ask banks to keep a fraction of their liabilities in paper cash. This is called fractional reserves.

Fractional reserve banking allows for large quantities of money to be created with rather small injections from the central bank. For example, if the reserve requirement is 2 percent of deposits, then banks can issue 98 percent of deposits back into circulation as loans. Most people don't ask for their money in cash, so deposits usually sit in the bank. The loans eventually circle back to the bank as deposits since however got the loan will spend it, and so it comes back to the banks.

The money will cycle through the economy many times. This is called the Money Multiplier. Each time it cycles, it allows for income to be generated, which is good for aggregate output and employment. The number of cycles can be calculated using the following equation.

Money Supply = Money Injection / Reserve Share

A 2 percent reserve will allow for the money to cycle 50 times in the economy.

This means that a 100 million dollar injection of funds by the Bank of Canada can result in a 5 billion dollar increase in money supply.

The lower the reserve ratio, the higher the money multiplier. The higher the reserve ratio, the lower the money multiplier.

Reserve Ratio	Money Multiplier	Injection of Funds	Money Creation
2 percent	50	100 M$	5,000 M$
5 percent	20	100 M$	2,000 M$
10 percent	10	100 M$	1,000 M$

Keep in mind that a withdrawal of funds by the central bank can have a wild effect on money supply, depending on the reserve ratio. If the central bank withdraws funds from the commercial banks, the banks have to stop emitting new titles of debt and may even ask it's clients to pay off their debt faster than anticipated.

Green Policy

The financial industry is a key player in the economy. It acts as a pivot for almost all of the economy since every transaction comes through banks and the accounts they hold for their clients. In terms of pollution, banks themselves are rather ‘clean’ businesses, since they operate in office towers and commercial spaces. They don’t use many natural resources, and do not emit toxins.

However, the banks lend billions of dollars every day to large corporations, and to individuals, who make decisions that may adversely affect the environment. If banks rubber-stamp a loan for a new coal mine, or a new automobile plant, they are part of the problem. If banks provide home loans that grow more suburban sprawl, and generate more dependency on the automobile, they are part of the problem.

Green Banking is becoming an important concept in financial districts such as Bay Street, in Toronto, Wall Street in New York City, or in the City District in London, UK. The idea is to propose financial products to clients who wish to reduce their ecological footprint. Banks in Canada offer loan incentives for electric cars, and investment portfolios divested from polluting industries for registered retirement savings plans.

Critics of Green Banking argue that commercial banks are not going far enough, since they mostly fund wind and solar energy, and shy away from the low-profit sectors of sustainable transportation and energy efficiency.  But mostly, the big banks have not stopped lending to polluters. In Canada, all of the banks are servicing the oil sands, nuclear, and military sectors of the economy.

Most economists would agree that government will have to step in to borrow money on bond markets to finance the green transition. Of course, if a project fails, the taxpayers will be responsible for paying the loans.

Climate Change Solution

To tackle this issue, society will need to fund thousands and thousands of projects. Many cities still rely on coal and oil to generate electricity. If you reduce the consumption of fossil fuels, it would be best to offer an alternative supply of energy. The Question is: Who will fund this?

Governments are studying their options as we speak. Already, the World Bank and the Green Climate Fund are lending billions of dollars all over the world to support projects who help communities find alternatives to their energy needs. However, this is not enough, and we need more money. Environmentalists are calling upon Public Financial Institutions, such as Pension Plan Managers, Credit Unions, and Labour-Sponsored Investment Funds, to promote Climate projects, encourage carbon capture, and divest from GHG emitting projects. In the US, the Democratic Party is proposing a Green New Deal, a reference to the massive investment program the US funded in the 1930’s to help the country grow out of the Great Depression. This time, the program would help the US reduce its consumption of oil and coal, update its electrical grid and invest massively in renewable energies.

Another way to fund all these projects is through the Carbon Tax policy. If a tax is applied on all products made from carbon-related inputs, such as oil, coal, plastics, natural gas and propane, then markets will adapt and demand will be much higher for products for which you don’t need to pay the tax.

Would you pay extra for soap that comes in a plastic bottle? If not, your dollars will be spent on alternative products.

Where do the banks come in this scenario? Most economists would agree that bankers don’t really care about saving the environment. They care about growing their profits, by providing loans to people who can pay them back, with interest. As they should. We certainly don’t need banks filing for bankruptcy.

Producers of carbon-free products will need loans. Producers of carbon-taxed products will have to cut down their production and probably won’t be eligible for bank loans anymore. The Carbon Tax system would work without adding regulations on the banking sector, that part of the equation could be left-alone, so to speak.

In Canada, the Carbon Tax is a very contentious topic, especially in oil-rich provinces such as Alberta and Saskatchewan. Nonetheless, the federal government of Justin Trudeau (Liberal Party), has implemented a modest 20 $ per tonne charge on carbon products as of 2019. The tax is planned to increase each year by ten dollars, until it reaches 50$ in 2022. Already the tax is said to have increased gas prices by 4 cents per litre in the first year.

Democracy Booster

Private banks are notoriously opaque institutions. They are, however, public, in the sense that they are openly-owned and listed corporations on the Toronto Stock Market. This means they have to hold an annual assembly for stockholders to vote on issues of management and governance. There is therefore some room here for regular stockholders, but also for large pension funds, to voice concerns. It is up to Canadians to participate in these assemblies to make their voice heard.

Credit Unions are not ‘public’, but they are much more democratic, having many elections and voting mechanisms that allow members to decide on issues of management and governance. However, in Canada, they can’t afford to refuse business from polluting sectors of industry. Even Desjardins has been knee-deep in tar sands.

As for the central bank, it’s a different issue. It cannot be a political body, so democratic representation is out of the question. The risk is too great that politicians use the printing press to further their interests. Therefore, the independence of the central bank towards politicians is of great importance. This being said, great economic changes will need to be funded and capitalized. The central bank does have a role to play in such a major economic shift so as to make funds available, while controlling inflation.

Wrap-Up

Banks are for-profit companies that spin deposits into loans. In Quebec, most people deal with a Caisse populaire Desjardins, which are locally controlled non-profit organizations.

Central Banks were created to print and manage money supply. They have also helped save failing banks and provide extra money to war-mongering governments. The Bank of Canada is relatively young, being created in 1934, during the Great Depression.

Most central banks are independent of elected politicians, as the temptation to print money is too big, and painfully inflationary.

Monetary Policy is conducted through direct transactions of money in the bond market, or by changing the overnight rate for bank loans.

Cheat Sheet

Chartered Bank:
A for-profit private corporation under federal permit to lend money bearing interest and accept deposits.

Credit Union:
A non-profit organization under provincial permit to lend money bearing interest and accept deposits to and from its members.

Gold Standard:
A financial system where each unit of money is backed by gold. Money is usually issued by a central bank, but money supply is fixed.

Free Banking:
A financial system where banks issue their own money, called bank notes. Bank notes are exchangeable for gold, or another asset. No central bank.

Central Bank:
A government institution that prints money and conducts monetary policy.

Overnight Rate:
The lowest interest rate in the land, offered by the Bank of Canada to commercial banks, overnight to cover unpredictable debits.

References and Further Reading

Binhammer, H. H., & Sephton, P. S. (2001). Money, Banking, and the Canadian Financial System, 8th edition. Toronto: Nelson Thomson Learning.

Friedman, L. (Feb. 21, 2019). What Is the Green New Deal? A Climate Proposal, Explained. The New York Times.  https://www.nytimes.com/2019/02/21/climate/green-new-deal-questions-answers.html

Friedman, M. & Schwartz, A. J. (1963) A Monetary History of the United States, 1867-1960. Princeton University Press. https://press.princeton.edu/books/paperback/9780691003542/a-monetary-history-of-the-united-states-1867-1960

Rudin, R. (1988). Banking en français: les banques canadiennes-françaises de 1835 à 1925. Montreal: Boréal.

Yeo, S. (2019). NEWS FEATURE – Where climate cash is flowing and why it’s not enough. Nature.com. Retrieved from Web. https://www.nature.com/articles/d41586-019-02712-3