A Framework for a Basic Bank

In analysis, it’s helpful to simplify and focus on the core elements of a system. Today, we will identify the essential processes and structures required to create a functional bank, accompanied by diagrams to illustrate these key processes.

1. Loan Creation

Banks operate on the fundamental principle that loans create deposits. When a bank advances a loan to Person A, it simultaneously:

Credits an advance into Person A’s bank account (a liability for the bank)
Debits a loan note of the same value (an asset for the bank)

flowchart TD
    %% Nodes
    subgraph "🏦 Bank"
        BankSystem("Bank Processing"):::bank
        LoanNote("📜 Loan Note (Asset)"):::asset
        A("💰 Person A's Account (Liability)"):::liability
    end
    
    %% Edges
    BankSystem -->|Creates Loan| LoanNote
    BankSystem -->|Creates Advance| A
    A -->|Deposit Liability| BankSystem
    LoanNote -->|Loan Asset| BankSystem
    
    %% Styling
    classDef bank fill:#B2DFDB,stroke:#00897B,stroke-width:2px;
    classDef asset fill:#BBDEFB,stroke:#1976D2,stroke-width:2px;
    classDef liability fill:#FFE0B2,stroke:#FB8C00,stroke-width:2px;

At this stage, Person A has a deposit in their bank account that can be used to make payments. When a loan or advance is issued, the bank’s balance sheet expands as its assets and liabilities increase.

2. Deposit Transfers

If Person A decides to pay Person B, the bank processes the transaction:

Debit Person A’s account
Credit Person B’s account

flowchart LR
    %% Nodes
    subgraph "🏦 Bank"
        BankSystem("Bank Processing"):::bank
        A("💰 Person A's Account"):::liability
        B("💰 Person B's Account"):::liability
    end
    
    %% Edges
    A -- Debit --> BankSystem
    BankSystem -- Credit --> B
    
    %% Styling
    classDef bank fill:#B2DFDB,stroke:#00897B,stroke-width:2px;
    classDef liability fill:#FFE0B2,stroke:#FB8C00,stroke-width:2px;

The deposit remains within the bank, but its ownership changes. Importantly that is all a bank liability can ever do - change ownership.

3. Interest Payments

When it comes time to pay interest or fees, the bank transfers money from Person A to Person O (the owner/operator of the bank):

Debit Person A’s account
Credit Person O’s account

flowchart LR
    %% Nodes
    subgraph "🏦 Bank"
        BankSystem("Bank Processing"):::bank
        A("💰 Person A's Account"):::liability
        O("💰 Person O's Account"):::profit
    end
    
    %% Edges
    A -- Debit --> BankSystem
    BankSystem -- Credit --> O
    
    %% Styling
    classDef bank fill:#B2DFDB,stroke:#00897B,stroke-width:2px;
    classDef liability fill:#FFE0B2,stroke:#FB8C00,stroke-width:2px;
    classDef profit fill:#F8BBD0,stroke:#C2185B,stroke-width:2px;

This is the bank’s profit mechanism - the reward the owner gets for assessing and granting loans at risk.

4. Loan Repayment

When Person A repays the principal of the loan:

Debit Person A’s account
Credit the loan note (reducing its size)

flowchart TD
    %% Nodes
    subgraph "🏦 Bank"
        BankSystem("Bank Processing"):::bank
        A("💰 Person A's Account"):::liability
        LoanNote("📜 Person A's Loan Note"):::asset
    end
    
    %% Edges
    A -- Debit --> BankSystem
    BankSystem -- Credit --> LoanNote
    
    %% Styling
    classDef bank fill:#B2DFDB,stroke:#00897B,stroke-width:2px;
    classDef asset fill:#BBDEFB,stroke:#1976D2,stroke-width:2px;
    classDef liability fill:#FFE0B2,stroke:#FB8C00,stroke-width:2px;

The bank’s balance sheet shrinks as its assets (loan notes) and liabilities (deposits) both decrease.

5. Loan Default

If Person A cannot repay the loan, the loss is distributed across all deposit accounts (except for Person O’s):

The amount written off is credited against Person A’s loan note
The same amount is debited pro-rata across all deposit accounts (Person B, Person C, Person D, Person E)

flowchart TD
    %% Nodes
    subgraph "🏦 Bank"
        BankSystem("Bank Processing"):::bank
        LoanNote("📜 Person A's Loan Note"):::asset
        B("💰 Person B's Account"):::liability
        C("💰 Person C's Account"):::liability
        D("💰 Person D's Account"):::liability
        E("💰 Person E's Account"):::liability
    end
    
    %% Edges
    LoanNote -- Write-off Processed by Bank --> BankSystem
    BankSystem -- Distributes Loss --> B
    BankSystem -- Distributes Loss --> C
    BankSystem -- Distributes Loss --> D
    BankSystem -- Distributes Loss --> E
    
    %% Styling
    classDef bank fill:#B2DFDB,stroke:#00897B,stroke-width:2px;
    classDef asset fill:#BBDEFB,stroke:#1976D2,stroke-width:2px;
    classDef liability fill:#FFE0B2,stroke:#FB8C00,stroke-width:2px;

The bank’s depositors indirectly bear the cost of defaults.

6. Owner Consumption

The bank owner (Person O) needs to eat as well. They pay for goods and services by transfer from their account in the usual way:

Debit Person O’s account
Credit Person C’s account

flowchart LR
    %% Nodes
    subgraph "🏦 Bank"
        BankSystem("Bank Processing"):::bank
        C("💰 Person C's Account"):::liability
        O("💰 Person O's Account"):::profit
    end
    
    %% Edges
    O -- Debit --> BankSystem
    BankSystem -- Credit --> C
    
    %% Styling
    classDef bank fill:#B2DFDB,stroke:#00897B,stroke-width:2px;
    classDef liability fill:#FFE0B2,stroke:#FB8C00,stroke-width:2px;
    classDef profit fill:#F8BBD0,stroke:#C2185B,stroke-width:2px;

Like other profits, owners use interest received to transfer goods and services to themselves. When they pay for goods and services, that money goes back into the system, allowing borrowers to use the money to pay interest again in the future.

The Bank’s Profit Strategy

And that’s all that is required to create an operational bank. Looking at these processes, we can quickly see what the bank’s strategy will be:

Demand as much physical collateral as possible to cover the loan.
Charge as much interest as possible on loans
Pay as little as possible on deposits (ideally nothing if there is no competition)

The bank’s approach benefits the owner at the expense of depositors. It favours stable assets, like land and gold, as collateral.

Conclusion

A basic bank generates profits by issuing loans and charging fees and interest. When borrowers fail to repay these loans, depositors face losses. Banks maximise their earnings, when there is no competition or the ability to convert bank money into other assets, while providing minimal returns to depositors.

Despite this, the process holds significant value, allowing individuals and businesses to utilise substantial assets to develop new production methods without first selling them.

The regulatory trick is to enhance this basic framework, retaining the benefits while minimising the downsides.

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1. Loan Creation#

2. Deposit Transfers#

3. Interest Payments#

4. Loan Repayment#

5. Loan Default#

6. Owner Consumption#

The Bank’s Profit Strategy#

Conclusion#