Wednesday, 5 June 2013

The Sterling Hierarchy of Money

I thought it might be useful to draw up a picture of how the monetary hierarchy works - using Sterling as an example. So here it is:
The Sterling Hierarchy of Money
This is a model of the clearing system and it uses the 'tri-party' model of transactions. Every transaction involves at least two entities and a payment institution. If you pay your garage for a service then the monetary side of the transaction goes via the bank. Even if you pay in cash the garage will bank that cash at some point.

But there are a couple of important points here. The first is that a transaction can cause a cascade of payments through the hierarchy depending upon whereabouts everybody is, and that causes the balance sheets of all the intermediary institutions to change. When you go up and down the hierarchy balance sheets tend to expand and shrink.

Let's run through a use case - the payment of benefits to an individual with an account at a Credit Union. Let's say the Partner's Credit Union which happens to have a clearing account at the Co-op bank in Liverpool.

The first thing that happens is that the Department of Work and Pensions (DWP) uses the Government Banking Service to instruct either Citibank or Royal Bank of Scotland (RBS) to make a payment to the Credit union account.  Let's say Citibank. So in the DWP accounts of Citibank are debited with the payment, and so is Citibank's reserve account at the Bank of England (BoE). That reduces the size of Citibank's balance sheet.

The payment ends up at the Co-op bank which receives a credit to its reserve account at BoE. It then credits the account of the Credit union at the local branch. This increases the size of the Co-op balance sheet.

The credit union notes the payment into its clearing account. It increases the amount in the bank in its accounts and also increases the amount in the credit union deposit account of the particular customer. Again the balance sheet of the credit union expands.

HM Treasury clears with Citibank via the 'Exchequer Pyramid' which sweeps money backwards and forwards between the operational transaction accounts at Citibank and the Consolidated Loan account held at the Bank of England. So in this case Citibank will receive a credit to its reserve account at BOE, and it then credits that to the DWP accounts - expanding Citibank balance sheet once more.

At the Bank of England side there is a debit to the Consolidated Loan account to offset the outgoing payment. The Debt Management Office of HM Treasury records the outgoing payments in its accounts and uses that data as part of its swap management operation to decide which Treasury Bills and Gilts to issue into the market. Importantly though the two flows are not directly connected. Payment and swap flows happen separately (along with the receipt flow from taxation) and the Consolidated Loan account acts as a stock buffer between those flows.

So in summary the accounting transactions are:

  • Debt Management Office: DR Government Expenditure, CR Consolidated Loan
  • Bank of England: DR Consolidated Loan, CR Citibank Reserve
  • Citibank: DR Citibank Reserve, CR DWP Account
  • Citibank: DR DWP Account, CR Citibank Reserve
  • Bank of England: DR Citibank Reserve, CR Co-op Bank Reserve
  • Co-op: DR Co-op Reserve, CR Partners Credit Union Clearing Account
  • Partners Credit Union: DR Co-op bank account, CR: Customer's deposit account

The net effect of all that is that Co-op bank and the Credit Union both get an increase in the size of their assets and liabilities. And that's because the Credit Union is a secondary financial institution.