eBusiness Weekly
Solomon Severa
Have you ever wondered the logic behind how a bank treats your deposits as a credit balance?
Each time you withdraw money, it debits your account which effectively reduces your credit balance.
If you ask an accountant, lecturer, or even a bank professional why. Some will tell you, it’s because banks treat your deposit money as credit you have extended to them. When they extended a loan to you, they treat you as their debtor because you owe them.
At your first attempt to do a bank reconciliation and you become worried at how different your bank statement is, from your conventional accounting books. You are told to just remember a credit on the bank statement is a debit in your books and vice versa. More than often, with no further explanation. After any of these responses, you are left still wondering why is it so.
The reason for all those absurd answers stems from the misconception of trying to deduce logic from an accounting perspective. The logic is derived from banking as defined by early laws or the core function of banking. A bank, according to those laws, is mainly in the business of selling and buying securities.
When you deposit your money in the bank, the bank is not borrowing your money, instead, you are buying its security (promissory note) or exchanging your money for their security. As with all securities, you are compensated for the opportunity cost of not spending your money today by way of interest. When the bank gives out a loan, it’s not lending out money per se, the bank is purchasing a security from you or exchanging their money for your security.
These laws gave bankers a legal right to create an asset (promissory note/security) out of thin air, sell it to the public (in exchange for your money/ deposits). Also, to create on behalf of the public a promissory note and buy it instantly ( in case of granting a loan).
A bank records these transactions from the perspective of purchasing an instrument (issuing out a loan as generally known) and selling a promissory note (generally known as taking a deposit).
When you repay a loan, you are honouring your promissory note (which was created on your behalf by the bank). By making a withdrawal from your account you are liquidating your security (promissory note you previously purchased from the bank). To clarify my argument, I will illustrate two scenarios.
Here are two simplified scenarios to illustrate my argument, firstly, when you walk into a bank wanting to make a deposit. The bank creates a promissory note and sells it to you. The bank records the transaction by crediting (decreasing) its asset account by the value of the promissory note which was an asset to them.
It debits your bank account reflecting your asset account has increased in form of an instrument not because you have money in your bank account. We can say you have a claim or a legal right as per the agreement to reverse the transaction by liquidating your security if you want your money back.
A second scenario is when you walk into a bank and request a loan. A bank creates a security on your behalf with terms stipulated in a loan agreement and then buys the security from you.
It records the transaction by debiting (increasing) its asset account and gives you cash. In cases where the loan amount has to be deposited in your account, then a second security/instrument has to be made again for a fictitious cash loan. Making it look like you were given a cash loan and immediately deposited it.
Until recently, accountants used to differentiate between a cash account and a bank account but nowadays they have coined the term cash and cash equivalent. The right notion in this is to remember that your bank account is part of the cash equivalents (short-term liquid security which you can liquidate as stipulated by the agreement between you and the bank), not the cash.
Another prevalent misconception is thinking of banks as institutions that act as a safe custodian of your ‘deposit money’ and pay you interest because they are going to make a profit when they loan it to someone in need.
That does not make sense when you consider how the bank records loans and deposits on their balance sheet (statement of financial position) or how they record transactions in your bank account. If a bank was holding your account on your behalf, then your account should reflect a debit balance the instant you deposit.
Solomon Severa is an Independent Macro Analyst. He writes in his personal capacity.
