“The idea is to provide centralized clearing infrastructure…”
What are clearing houses and why do they create even more elasticity for the monetary system?
Let’s review the concept of elasticity. I can not stretch a 5$ note to make it a 10$ note. Currency is not elastic, but the bank can expand its balance sheet by creating a loan and a deposit. So even though I only have 5$, I can make a 10$ payment by taking credit. During an economic boom, everybody is happy and spends money. Credits are given away and the money market is expanding. During a recession, a time when the economy is doing badly, less money is being spent and less credit is being given away, so the system contracts again.
Clearinghouses are helping banks to net out their payments. We have millions of transactions every day between all the banks. Imagine I am paying for the drinks for the party that I am organizing. I am ordering online. Therefore my bank is paying the bank of the supermarket 500 $. Imagine now, they would have to send someone with a 500$ note from one bank to the other bank. That would destroy the elasticity and take a lot of work.
Even doing each transaction using the computer would take a lot of time. On the one hand the bank of the supermarket probably receives 1000 orders a day with different amounts, on the other hand, they have to pay other banks, for example, the wholesaler of the supermarket. So wouldn’t it be easier if there is an institution in between, where all the banks have a bank account with some money and this institution keeps track of all the payments and at the end of the day this institution just nets out all the payments. So the banks either receive or pay one amount at the end of the day, instead of paying and receiving 1000 of payments every day. This institution is called a clearing house.
The clearing house makes sure that at the end of the day the banks that spend more money than they receive are paying their bills and vice verse. That is why banks can have overdrafts during the day, which creates elasticity. They only have to make sure that they can make their payments at the end of the day. If they do not have enough money, they could either borrow money from the clearinghouse or the other member banks. If you want to know more about that topic you can read the article written by Charles F. Dunbar and this topic leads us to our next blog entry: Fed Funds.
Financial Times Quote: The Ft writes about the importance of having a good and centralized clearinghouse system to support the interbank money market.
The first article: The hierarchy of money
The second article: Why do we need banks?
The third article: Why we need a central bank?
The fourth article: How can banks create money out of thin air?
The fifth article: Why do we need central banks especially in a crisis?
The seventh article: What are Fed Funds?
The eighth article: What are dealers, brokers and repos?
The ninth article: Quantitative easing and open market operation
The tenth article: Eurodollars
The eleventh article: Discounts, Discounts, Discounts
The twelfth article: Why dealers provide liquidity
Written by: Philine Paschen