2. The Bank's Role as a True Intermediary in the Loan Contract

Let us begin by supposing a banker receives a loan of 1,000,000 monetary units (m.u.) from a customer. A true legal loan contract exists, stipulating that the customer is to give up the availability of 1,000,000 m.u. in the form of present goods (money) he could have spent, and that he is to do so for a period of time or term (the essential element of any loan contract) lasting one year. In exchange for these present goods, the banker agrees to return after one year a larger quantity than that originally received. If the agreed-upon interest rate is 10 percent, at the end of one year the banker will have to return 1,100,000 monetary units. The following book entry is made when the loan is received:

Economically speaking, this contract clearly involves a simple exchange of present goods (the availability of which is transferred from the lender to the bank) for future goods (which Bank A agrees to turn over to the lender at the end of one year). Therefore, from a monetary standpoint there is no change. A certain number of monetary units simply cease to be available to the lender and become available to the bank (for a predetermined period of time). A mere transfer of 1,000,000 m.u. takes place, without any resulting variation in the total number of preexisting monetary units.

We could view entry (1) as the journal entry made the day the contract is signed and 1,000,000 m.u. are handed over to the bank by the lender. We could also see it as Bank A's balance sheet, drawn up immediately following the transaction and registering on the left side (the asset side) 1,000,000 m.u. in the cash account and on the right side (the liability side) the debt of 1,000,000 m.u. contracted with the lender.

Let us also suppose that Bank A carries out this operation because its managers plan in turn to loan 1,000,000 m.u. to Business Z, which urgently needs the money to finance its operations and is willing to pay 15 percent interest per year for the loan of 1,000,000 m.u. from Bank A.³

When Bank A loans the money to Business Z, an entry in Bank A's journal is made to reflect the output of 1,000,000 m.u. from the cash account and Business Z's debt to the bank, replacing the original cash asset. The entry is as follows:

In this case Bank A clearly acts as a true financial intermediary. Its managers recognize and take advantage of a business opportunity.⁴ Indeed, they see a chance to make a profit, since at one place in the market there is a lender willing to loan them money at 10 percent interest, and at another Business Z is willing to take out a loan at 15 percent, leaving a profit differential of 5 percent. Therefore, the bank acts as intermediary between the original lender and Business Z, and its social function consists precisely of recognizing the existing disparity or lack of coordination (the original lender wished to loan his money but could not find a creditworthy borrower willing to take it, while Business Z urgently needed a loan of 1,000,000 m.u. and its managers did not know where to find a suitable lender). The bank, by obtaining a loan from one and granting a loan to the other, satisfies the subjective needs of both and derives a sheer entrepreneurial profit in the form of the interest differential of 5 percent.

At the end of a year, Business Z will return the 1,000,000 m.u. to Bank A, together with the agreed-upon 15 percent interest. The entries are as follows:

Soon afterward, Bank A must in turn honor the contract it entered into with the original lender, returning to him the 1,000,000 m.u. its managers had committed to pay at the end of one year, along with 10 percent interest. The entries are as follows:

In other words, the bank repays the loan, records the output from its cash account of the 1,000,000 m.u. received from Business Z and adds to that sum the 100,000 m.u. (also charged to the cash account) in agreed-upon interest it pays the original lender. On the bank's income statement, this interest is registered as a charge in the form of interest payments made during the year.

After these entries, at the end of the year, the bank's income statement would appear as follows:

This income statement reflects an entrepreneurial profit for the year of 50,000 m.u., a net income derived from the difference between the year's revenue (150,000 m.u. in interest received) and the year's expenses (100,000 m.u. in interest paid).

At the end of the year, Bank A's balance sheet would appear as follows:

If we look at the balance sheet drawn up at the very end of the year, we see that the bank's assets include 50,000 m.u. available in the cash account that correspond to the year's profit, which has been placed in the corresponding owner's equity account (capital and retained earnings) under Liabilities.

The following points recapitulate our description in accounting terms of a banking activity based on receiving and granting a loan or mutuum: one, for one year the original lender relinquished the availability of 1,000,000 m.u., present goods; two, the availability of this money was transferred to Bank A for exactly the same time period; three, Bank A discovered an opportunity to make a profit, since its managers knew of a borrower, Business Z, which was willing to pay a higher interest rate than the one the bank had agreed to pay; four, the bank granted a loan to Business Z, relinquishing in turn the availability of 1,000,000 m.u. for one year; five, Business Z obtained the availability of the 1,000,000 m.u. for one year in order to expand its activities; six, therefore, for the period of one year, the number of m.u. did not vary, as they were simply transferred from the original lender to Business Z via the intermediary—Bank A—; seven, in the course of its activities, Business Z brought in a profit enabling it to make the interest payment of 150,000 m.u. (these 150,000 m.u. do not represent any money creation, but are simply obtained by Business Z as the result of its sales and purchases); eight, at the end of one year, Business Z returned 1,000,000 m.u. to Bank A, and Bank A paid the same amount back to the original lender, along with 100,000 m.u. in interest; nine, as a result, Bank A obtained an entrepreneurial profit of 50,000 m.u. (the difference between the interest it paid the original lender and the interest it received from Business Z), a sheer entrepreneurial profit resulting from its legitimate business activity as intermediary.

As is logical, Bank A could have been mistaken in its choice of Business Z. It could have miscalculated the risk involved, or the ability of Business Z to return the loan and pay the interest. Therefore, the success of the bank's activity in this case depends not only upon its bringing the operation with Business Z to a successful conclusion, but also on its own obligation (to return to the original lender 1,000,000 m.u. plus 10-percent interest) falling due after Business Z repays the loan to the bank, along with 15-percent interest. In this way the bank can maintain its solvency and avoid any unfortunate incidents. Nevertheless, like any other business, banks are subject to possible entrepreneurial error. For example, Business Z could be unable to return on time the amount it owes the bank, or it could even suspend payments or go bankrupt, which would render Bank A insolvent as well, since it would be unable to in turn pay back the loan it received from the original lender. However, this risk is no different from that inherent in any other business activity and can be easily reduced through the use of prudence and deliberation by the bank in its business activities. Moreover, for the length of the operation (throughout the year), the bank remains fully solvent and faces no liquidity problems, since it has no obligation to make any cash payments for as long as its loan contract with the original lender remains in force.⁵