Part 3. Interbank transfers
Transactions that take place between accounts at different banks are referred to as Interbank Transfers. There are rules that need to be followed when dealing with these transactions that are derived from the rules laid out in Part 2.
Before we look at an interbank transfer, let's consider in a bit more detail the same transaction carried out in Part 1 and assume the accounts are held at the same bank. Let's create a new bank called Bank, and two new customer deposit accounts, Account #1 and Account #2, held at Bank. Then consider a £100 transfer from Account #1 to Account #2. This transaction is shown in Figure 3.1.
Figure 3.1. A £100 transfer between two customer deposit accounts.
As expected, this transaction has resulted in Account #1 being overdrawn £100 and Account #2 being in credit £100. As this is a perfectly legitimate transaction that anyone can carry out, the question that arises is what does the bank do when someone performs a transaction like this?
Since this transaction happened at the same bank, all the bank has to do is record it on its set of accounts, and since all banks use computerised records, this is carried out automatically. As this is Bank's first ever transaction, and it doesn't have any prior assets or liabilities, its balance sheet will be as follows:
Figure 3.2. Bank's balance sheet after the £100 transfer between two customer deposit accounts.
As you can see from Figure 3.2, the balance sheet satisfies the accounting equation. The bank's equity is still zero (the bank hasn't created any value or equity by allowing this transaction), and liabilities are equal to assets. Notice that the overdrawn deposit account, Account # 1, now represents an asset of the bank since it is money that is owed to the bank.
So what would happen if we performed the same transaction above but between accounts at two different banks? Let's start from scratch and create two new banks, 1st Bank and 2nd Bank, and two new accounts, Account #1 and Account #2 — with Account #1 being at 1st Bank and Account #2 being at 2nd Bank — and perform the same £100 transfer. The transaction is shown in Figure 3.3.
Figure 3.3. A £100 transfer between two customer deposit accounts at different banks.
The transaction is identical to the transaction carried out at the single bank except this time it occurred between different banks. The balance sheets of both banks are shown below in Figure 3.4
Figure 3.4. Balance sheets of both banks after the transaction.
Now we have a problem; we have violated the accounting equation at both banks. Although the accounting equation is satisfied across banks, it also has to be satisified at each bank, since each bank has its own set of accounts that must adhere to the accounting equation. Effectively, we have split the double entry, performing the debit on one set of accounts and the credit on a different set of accounts, and this doesn't work.
In fact, when carrying out a transaction between two banks (or two sets of accounts) we always need two double entries (or multiples of two) to keep the accounting equations satisfied, and there are two ways of approaching this.
First approach
The first approach involves carrying out one double entry at 1st Bank and a second double entry at 2nd Bank. Since these will be single double entries carried out on separate sets of accounts, the accounting equations won't be violated. This approach is depicted in Figure 3.5.
Figure 3.5. An inter-bank transaction using double entries carried out within each set of accounts.
Second approach
The second approach involves carrying out both double entries between accounts at different banks as shown in Figure 3.6.
Figure 3.6. An inter-bank transaction using double entries carried out across sets of accounts.
In fact, both approaches effectively represent the same transaction, and both must end up being satisfied. For the transaction to be valid, all four credits and debits making up the transaction must be carried out.
The first approach should be considered the correct approach from an accounting perspective since carrying out double entries across different sets of accounts would be dubious.
However, it is more intuitive to think of funds moving between banks according to the second approach, and this approach is often used here for those purposes. It is always possible to represent the same transaction using double entries within each set of accounts, as should become apparent.
The types of accounts involved in inter-bank transfers will depend on the type of transaction that takes place. A customer deposit transfer involves transferring a liability from one bank to another, so intuitively one may conclude an asset transfer of the same value must also be transferred. This is correct; however, in modern banking, banks don't transfer physical assets between them.
Instead, banks settle by transferring assets digitally, such as reserves that are held digitally with a central bank. Settling is discussed in more detail in the next and subsequent parts, but for now we will look at how this deferred settlement is represented by a double entry on the sets of accounts — something the banks still needs to do prior to settling.
To represent the deferred settlement, we need two new accounts: a loan account for 1st Bank at 2nd Bank, and a deposit account for 2nd Bank at 1st Bank. We will call these 1st Bank's Loan Account and 2nd Bank's Deposit Account respectively. A double entry is then made between these accounts as shown in Figure 3.7.
Figure 3.7. Deferred settlement double entry of £100 between the two banks.
This transaction now represents a deposit transfer that will need settling in the future. It satisfies the accounting equations at both banks as shown in Figure 3.8.
Figure 3.8. Balance sheets of both banks after the £100 deferred settlement double entry.
1st Bank effectively owes 2nd Bank £100. You may have heard of acronyms like LIBOR and Euro LIBOR. These are rates of interest charged by banks and money markets to other banks for borrowing money. 2nd Bank may allow 1st Bank to owe this based in an inter-bank lending rate such as LIBOR, or 1st Bank may need to borrow it from elsewhere.
Prior to agreeing on any lending, outstanding balances owed are in a deferred state as represented above. In the next section we look at how deferments can be settled — at least partially — without involving borrowing or the transfer of assets between banks. And in part 12 we see how they can be settled completely through a clearing bank or a central bank using bank reserves.
back to Part 2