The rules of money

An important job of modern retail banking is to provide a convenient and efficient means for people and businesses to transact with each other. How banks achieve this in practice is a technological matter, but there are mathematical and accounting principles that describe this interaction.

The key principles are encapsulated by:

These principles are used throughout this blog, so it is important to have a clear understanding of them. Those that are already proficient can skip this and go to part 3.

The accounting equation

The accounting equation is a statement of what is owned or held and what is owed, and applies to individual businesses, people and the whole world economy as well as individual banks. The equation cannot be violated and is written as:

Assets = Liabilities + Equity

Assets

An asset is anything of value that can be exchanged or sold for money, as well as money itself. Examples are buildings, stocks and shares, bonds, a bank's loan book, gold reserves and cash reserves. Assets that are cash, whether digital or physical, or that can be easily converted to cash are termed liquid assets, whilst those that are hard to sell, illiquid. Gold and shares are easily converted to cash, whilst a mortgage loan on the books of a bank is paid back over decades and is, hence, an illiquid asset.

Liabilities

Liabilities are what a bank, business or person owes to others. If you have a mortgage with a bank, then that is your liability. For a bank, liabilities would include customer savings, customer deposits, and money borrowed by the bank. It is important to distinguish between money borrowed by a bank and money lent by a bank. Money borrowed by a bank is that bank's liability, whilst money lent by a bank is that bank's asset. The same applies to people and businesses.

Equity

Finally, equity is the difference between assets and liabilities. It represents what a bank or other business is worth to its stakeholders, or what the nett worth of a person is. It is what would be left if a bank, business or person settled all of their liabilities. Types of equity at a bank or business include capital paid in from the owners or shareholders and earnings retained from profits made. If liabilities exceed assets, then that bank, business or person would have negative equity and be technically bankrupt. Therefore, another way of writing the accounting equation is:

Equity = Assets - Liabilities

The account

An account is a record of the changes in a specific asset, liability or equity, ordered chronologically. Today, this would most likely be a digital record stored on a computer system. Examples of accounts include: mortgage loan accounts, deposit accounts, an account for government bonds, an account for a bank's earnings, and for a bank's cash reserves. An example of an individual deposit account as presented to a customer by their bank in the UK is shown in Figure 2.1.

Figure 2.1. An example of an individual customer deposit account.

Ignoring the starting balance, there are four entries recorded on the account: a payment of £100 is entered into the account leaving it in credit; £50 is withdrawn leaving it still in credit; £100 is withdrawn leaving it overdrawn by £50; and finally £50 is paid in leaving the account with a balance of £0 again.

The double entry

However; the above example only tells one side of the transaction story. This is because it is not possible to debit or credit a single account without violating the accounting equation. A credit entry in one account must have a corresponding debit entry in either the same account or in a different account and vice versa, and the sum of all credits must always equal the sum of all debits. This is the double entry principle, and is fundamental to accounting and bookkeeping as well as money and banking.

CR and DR

In the last example, the balance column is shown with the abbreviations CR and DR, which are short for credit and debit. (CR) means the balance is a credit balance, whilst (DR) means the balance is a debit balance. It is important not to take credit to mean positive and debit to mean negative since this actually depends on the type of account. For a liability or equity account, a credit increases the liability or equity and a debit decreases it. For an asset account a debit increases the asset whilst a credit decreases the asset. This is a natural consequence of assets being on the other side of the accounting equation to liabilities and equity, and it means a double entry can be made between any two accounts without violating the accounting equation.

Sometimes the same account can be either a liability or an asset account depending on whether it has a (DR) balance or a (CR) balance. A customer deposit account may be overdrawn, in which case it will have a (DR) balance and be considered an asset account to the bank. Later it could be in credit, in which case it will have a (CR) balance and be a liability account. An equity account with a (DR) balance always indicates negative equity, since equity is always the difference between assets and liabilities.

back to Part 1

Continue to Part 3:
Interbank transfers