MMP Blog #15: Clearing and the Pyramid of Liabilities

By L. Randall Wray

Last week we discussed denomination of government and private liabilities in the state money of account—the Dollar in the US, the Yen in Japan, and so on. We also introduced the concept of leverage, for example, the practice of holding a small amount of government currency in reserve against IOUs denominated in the state’s unit of account while promising to convert those IOUs to currency. This also led to a discussion of a “run” on private IOUs, demanding conversion. Since the reserves held are not nearly sufficient to meet the demand for conversion, the central bank must enter as lender of last resort to stop the run by lending its own IOUs to allow the conversions to take place. This week we examine bank clearing and the notion of a “pyramid” of liabilities with the government’s own IOUs at the top of that pyramid.

Clearing accounts extinguishes IOUs. Banks clear accounts using government IOUs, and for that reason either keep some currency on hand in their vaults, or more importantly maintain reserve deposits at the central bank. Further, they have access to more reserves should they ever need them, both through borrowing from other banks (called the interbank overnight market; this is the fed funds market in the US), or through borrowing them from the central bank.

All modern financial systems have developed procedures that ensure banks can get currency and reserves as necessary to clear accounts among themselves and with their depositors. When First National Bank receives a check drawn on Second National Bank, it asks the central bank to debit the reserves of Second National and to credit its own reserves. This is now handled electronically. Note that while Second National’s assets will be reduced (by the amount of reserves debited), its liabilities (checking deposit) will be reduced by the same amount. Similarly, when a depositor uses the ATM machine to withdraw currency, the bank’s assets (cash reserves) are reduced, and its IOUs to the depositor (the liabilities in the deposit account) are reduced by the same amount.

Other business firms use bank liabilities for clearing their own accounts. For example, the retail firm typically receives products from wholesalers on the basis of a promise to pay after a specified time period (usually 30 days). Wholesalers hold these IOUs until the end of the period, at which time the retailers pay by a check drawn on their bank account (or, increasingly, by an electronic transfer from their account to the account of the wholesaler). At this point, the retailer’s IOUs held by the wholesalers are destroyed.

Alternatively, the wholesaler might not be willing to wait until the end of the period for payment. In this case, the wholesaler can sell the retailer’s IOUs at a discount (for less than the amount that the retailer promises to pay at the end of the period). The discount is effectively interest that the wholesaler is willing to pay to get the funds earlier than promised.

Usually, it will be a financial institution that buys the IOU at a discount—called “discounting” the IOU (this is where the term “discount window” at the central bank comes from—the US Fed would buy commercial paper—IOUs of commercial firms–at a discount). In this case, the retailer will finally pay the holder of these IOUs (perhaps a financial institution) at the end of the period, who effectively earns interest (the difference between the amount paid for the IOUs and the amount paid by the retailer to extinguish the IOUs). Again, the retailer’s IOU is cancelled by delivering a bank liability (the holder of the retailer’s IOU receives a credit to her own bank account).

Pyramiding currency. Private financial liabilities are not only denominated in the government’s money of account, but they also are, ultimately, convertible into the government’s currency.

As we have discussed previously, banks explicitly promise to convert their liabilities to currency (either immediately in the case of demand deposits, or with some delay in the case of time deposits). Other private firms mostly use bank liabilities to clear their own accounts. Essentially, this means they are promising to convert their liabilities to bank liabilities, “paying by check” on a specified date (or, according to other conditions specified in the contract). For this reason, they must have deposits, or have access to deposits, with banks to make the payments.

Things can get even more complex than this, because there is a wide range of financial institutions (and, even, nonfinancial institutions that offer financial services) that can provide payment services. These can make payments for other firms, with net clearing among these “nonbank financial institutions” (also called “shadow banks”) occurring using the liabilities of banks. Banks, in turn, clear accounts using government liabilities.

There could, thus, be “six degrees of separation” (many layers of financial leveraging) between a creditor and debtor involved in clearing accounts.

We can think of a pyramid of liabilities, with different layers according to the degree of separation from the central bank. Perhaps the bottom layer consists of the IOUs of households held by other households, by firms engaged in production, by banks, and by other financial institutions. The important point is that households usually clear accounts by using liabilities issued by those higher in the debt pyramid—usually financial institutions.

The next layer up from the bottom consists of the IOUs of firms engaged in production, with their liabilities held mostly by financial institutions higher in the debt pyramid (although some are directly held by households and by other production firms), and who mostly clear accounts using liabilities issued by the financial institutions.

At the next layer we have nonbank financial institutions, which in turn clear accounts using the banks whose liabilities are higher in the pyramid. Just below the apex of the pyramid, banks use government liabilities for net clearing.

Finally, the government is highest in the pyramid—with no liabilities higher than its inconvertible IOUs.

The shape of the pyramid is instructive for two reasons. First, there is a hierarchical arrangement whereby liabilities issued by those higher in the pyramid are generally more acceptable. In some respects, this is due to higher credit worthiness (the government’s liabilities are free from credit risk; as we move down the pyramid through bank liabilities, toward nonfinancial business liabilities and finally to the IOUs of households, risk tends to rise—although this is not a firm and fast rule).

Second, the liabilities at each level typically leverage the liabilities at the higher levels. In this sense, the whole pyramid is based on leveraging of (a relatively smaller number of) government IOUs. There are typically far more liabilities lower in the pyramid than there are high in the pyramid—at least in the case of a financially developed economy.

Note however that in the case of a convertible currency, the government’s currency is not at the apex of the pyramid. Since it promises to convert its currency on demand and at a fixed exchange rate into something else (gold or foreign currency), that “something else” is at the top. The consequences have been addressed in previous blogs: government must hold or at least have access to the thing into which it will convert its currency. As we will see in coming weeks, that can constrain its ability to use policy to achieve some policy goals such as full employment and robust economic growth.

Next week we will take a bit of a diversion to look at the strange case of Euroland. This is the biggest experiment the world has ever seen that attempts to subvert what Charles Goodhart has called the “one nation, one currency” rule. The members of the European Monetary Union each gave up their own sovereign, state, currencies to adopt the euro. While there have been other such experiments, they were small, usually temporary, and often an emergency measure. In the case of Euroland, however, we had strong, developed, rich, and reasonably healthy nations that voluntarily abandoned their sovereign currencies in favour of the euro. The experiment has not gone well. To say the least.

18 responses to “MMP Blog #15: Clearing and the Pyramid of Liabilities

  1. While a bank, in theory, could turn to the Fed as a lender of last resort, doesn't this article from the the NY Fed ( demonstrate the difficulties with this arrangement? How would MMT respond to the real world constraints faced by banks during a credit crisis?

  2. Thanks for another very interesting post.I'd like to know if a distinct pyramid would always be created by any capitalist economy with a highly developed form of credit that permeates every level of economic life, or does it also need the right kind of political structure (a plutocratic-corporates-dominated pseudo democracy as in the US) to be so sharply observed? The reason I ask is that I can see that the pyramid is not just a reflection of quantity (a sort of functional but otherwise natural aggregation of liabilities created by say the many high street agents at the bottom, that aggregate in the hands of fewer and fewer agencies that hold more and more liabilities as we progress upwards towards the corporate head offices and government). For this to have happend needs the kind of political activity that has taken place in the US over the last few hundred years. The pyramid in fact is like the power structure in the US. (Truism I know :-))At the top is 'the government' but that's meant both to be a functional position relative to money, and also a politically powerful position under democratic control. In fact, the government either overlaps with business/banking plutocrats or gets bought out by their power and wealth. The government may in a formal way live at the top of the pyramid, but if it's power is in the hands of the first tier below, then they run the Fed and the Treasury etc. etc. etc. and that's very different from the benign formal role government is supposed to play relative to the US unit of account in a sovereign system.So, what would dismantle the pyramid to make it very much flatter? That wouldn't deny the need for some degree of functional hierarchy, but it wouldn't be shaped like a pyramid. Maybe more like a mixture of rolling farms, gardens, factories and workshops, with places to live, with many well placed bumps that aren't too high to climb. That sounds ecologically sustainable in a metaphorical sort of way.So the pyramid is not strictly necessary for a society (not just an economy) run properly on MMT lines with decent domocratic politics?

  3. Hi Dave,A few comments in reply.First, far and away the most common role of Fed lending on a typical day is via intraday overdrafts, which banks are required to clear by the end of the day. Prior to Lehman, this lending by the Fed was averaging about $50B every minute of the day, with peak settlement periods of about $150B per minute. So, there is a lot of lending going on by the Fed, though with so many excess reserves post Lehman, this has slowed to a trickle.Second, the Fed has always sought to create a stigma associated with its overnight or discount window lending to banks. It's stated purpose has always been to get banks to clear overdrafts among themselves by the end of the day. Several other central banks do this in their own way without stigmatizing such lending, but the Fed is unique in its approach of traditionally offering a standing facility that it discourages use of. Further complicating this is the fact that unlike most other interbank systems, the US system is highly decentralized, which means it's not unusual for the Fed's open market activities on their to not suffice for (a) offsetting all changes to the Fed's balance sheet, and (b) reserve balances in circulation to make it to every bank desiring them. Combine these two–stigma along with complications associated with the US system–and you get a greater likelihood of rising rates to dislodge banks from lending their excess reserves instead of the borrowing from the Fed.In a crisis, these characteristics make things worse, as the paper you mentioned demonstrates. Note, though, that this doesn't change the fact that the Fed is acting as a LOLR; what's happening is that the Fed's LOLR actions are occurring both in normal and crisis times but at a higher price (higher interest rate relative to the target rate) than would be desirable as a result of the Fed's own historical actions and the decentralized nature of the interabank system in the US. This is different from suggesting that Randy's arguments aren't valid–it's just that the Fed has chosen a poor, generally misguided approach given the unique US circumstances (actually, it would be misguided regardless, even in a very centralized system like Canada's, in my view) that makes the rate charged for LOLR higher than it should be.During the crisis, then, recognizing more needed to be done, the Fed then offered several more types of standing facilities to carry out a massive LOLR effort. There was little or no stigma associated with these non-conventional standing facilities, unlike the traditional discount window.I described many of these points in much greater detail (probably way too much detail for the casual reader–so you've been forewarned) here:,Scott Fullwiler

  4. Quick clarification from my comment above:"and you get a greater likelihood of rising rates to dislodge banks from lending their excess reserves instead of the borrowing from the Fed."This should be . . "and you get a greater likelihood of rising rates to dislodge banks from lending their excess reserves instead of the borrowing from the Fed–THEREFORE, BY THE TIME BANKS DO DECIDE TO GO TO THE FED INSTEAD OF BORROW IN THE OVERNIGHT MARKET, THE OVERNIGHT RATE CAN ALREADY HAVE RISEN ABOVE THE PENALTY RATE CHARGED BY THE FED." THIS IS AN ARRANGEMENT UNIQUE TO THE FED AMONG CENTRAL BANKS.

  5. I'm fascinated by this settlement business.Presumably at the top of the food chain settlement is effected by a movement in bank reserves but as you have described there are many layers underneath involving transactions that have their own settlement arrangements.So does this mean when things go wrong at the lower levels the central bank/government just stays out of it and acts on any agreement that the 2 member banks below it, involved in the relevant transaction, cobble together.Sorry I've not expressed this very well but I'm interested in where the power lies and the vulnerability of the transacting parties at the lower levels to fraud and intimidation by those parties above them in the food chain.

  6. One more question.This shadow banking world at the lower levels of 'settlement'. Is this where all the bad stuff that we've been hearing about, cdo's cds's and the trillions of on and off balance sheets deals take place?Thanks

  7. Also I would add how settlement of eurodollars fits into the shadow banking world

  8. The "Market Makers" i.e. JP Morgan, Citigroup Goldman etc at the top of the pyramid run the show. If i understand correctly the NY Fed "mandates" these primary dealers to buy and sell from the US Treasury/Fed. NPR reports more than 25% of Georgia community banks(at the bottom of the pyramid) have been closed/insolvent.

  9. So the Federal Reserve is the lender of last resort. During the recent crisis Bernanke explained that the money lent to the failing financial institutions was created electronically—essentially from nothing—by a few keystrokes. Assuming all money to be debt, from whom did the Federal Reserve borrow the money that it lent (to the as yet to be indicted crony criminal class) when it was created by these keystrokes? When money is lent to a failing private enterprise there is doubt as to whether repayment is forthcoming. When private limited liability corporations fail, their losses are socialized (borne by society) rather than recovered from the private individuals—to the extent that this is possible—who would have most directly benefited from upside of the risks they took. What limitations are there to whom the Federal Reserve can borrow from (by creating money from nothing) and then loan to? Could the Federal Reserve—acting in its politically unaccountable secrecy—chosen to fund small banks or refinance the mortgages of those who have been criminally foreclosed upon up to this time, rather than recapitalize their close associates (cronies) near the top of the pyramid?I am asking this question because spending this money borrowed into existence—or created from nothing—into circulation would seem to have a broader and more socially beneficent consequence than the mere preservation of the criminal private interests that have been temporarily stabilized by the bailouts.

    • Gary Goodman

      Glenn: Assuming all money to be debt, from whom did the Federal Reserve borrow the money that it lent (to the as yet to be indicted crony criminal class) when it was created by these keystrokes?
      Short narrow answer. Looking back at basics (which is the level of my grasp) of banking operations, Banks typically do a “swap” when they create a loan. Your wet signature loan agreement, the bank buys that asset from you with the Deposit it creates with your name on it, which is a bank statement that entitles you (or assignee) to Reserves. When a bank “gives” you a loan, what really happens is a SWAP of claims, assets and liabilities, from opposing perspectives.

      Banks PURCHASE your IOU agreement with a Deposit balance which is an IOU agreement by the bank.

      When the Fed and Treasury “create money”, Treasury gives Fed (indirectly, thanks to Congress’ archaic rules) a Treasury Bond/Bill/Note and the Fed gives Treasury a FRN (note). All of this is account balances on spreadsheets, nothing physical of course. But Treasury can issue payments out of that FRN balance, and the Fed holds the US securities … or trades them back and forth with banks to hit desired interest rate targets, by increasing or reducing reserve balances.

      So when Fed “Loaned” money to banks, it not only purchased (swapped) Treasury Securities, that were previously purchased by banks at Tsy Auctions or from other “Dealers”, it also purchased (swapped) Mortgage Securities.

      In other words, if the Bank had a $10 M mortgage security asset, they got a cash loan from the Fed by giving the Fed that asset. The Fed, like other banks, doesn’t have to “get” money to buy assets. The magic of balance sheet expansion via Swapping of Debt Obligations.

      Since FRNs are a “note” or “debt”, the Fed is actually issuing an IOU, not “money”, but the Fed’s Reserve Notes are legally non-convertible except to more FRNs. Neither Fed nor Tsy “promises” to give someone gold, silver, wool, tobacco, or anything else but an FRN credit.

      The “magic” of making the bank’s solvent included the (sneaky) process of purchasing “toxic” assets (mortgage securities after the underlying mortgages have started to go 30-60-90-120 late and into foreclosure) at “pre-toxic” prices which had assumed (wink) that the underlying mortgages were sound and the mtg sec instrument was therefore AAA-rated.

      This is similar to Cash for Clunkers. Uncle Sam bought crappy old junk cars for more than they were worth, more than dealers would give, more than junkyard would give, to be scrapped out, with the agreement that beneficiary of that payment would buy a new car.

      The Fed transferred “toxic” assets OFF the various bank’s balance sheets and onto it’s own. My understanding is the Fed created a fictional “outside” corporation like Enron’s offshore SIVs, called Maiden Lane facility (I, II, and III) and parked those “toxic” securities off it’s own official balance sheet onto the ML balance sheet. When Enron moved it’s liabilities “offshore” onto wholly-owned subsidiaries to pump up it’s books, make it’s own balance sheet look better, that was FRAUD. When the Govt took those toxic assets off the banks’ books and “hid” them in a similar manner, it was a SERVICE to the financial sector and was not FRAUD because it’s the friggin GOVT, and the Fed didn’t do it to make the Fed richer. The Fed essentially “lost” money in terms of negative-value assets to re-enrich the banking sector … notwithstanding the Fed’s alleged profits of $40B that it paid to Tsy if the negative assets are ignored.

      Since I’m a newbie, I forgot that these guys also talk about REPO agreements, which is kinda like a loan, a bit different, and that the Fed uses that mechanism too.

      So “swapping debts” “swapping assets” and “creating money” is kinda the same thing, from different conceptual perspectives, for both the Fed and for private banks.

  10. Hi,What are inside the assets of a bank ? Treasuries, Currency Reserves and what else ?You said last week : "Banks would rather hold loans as assets, because debtors pay interest on these loans. For this reason, banks leverage their currency reserves, holding a very tiny fraction of their assets in the form of reserves against their deposit liabilities."If a bank can issue its own IOUs, why does it need to give currency reserves to make a loan ?To whom does a bank exchange reserves against loans ? If they are not inside a bank, where do these reserves go ?

  11. Scott,Thank you very much for your reply. Your paper was exactly what I was looking for to understand the Fed's response to the crisis.

  12. Just trying to sharpen my understanding.It seems to me that 2 kinds of money can be distinguished quite clearly.'Govt money', represented by reserves and public debt.(am I right in classifying Govt bonds as money? QE seems to demonstrate that they are interchangeable)'Bank money', with corresponding pound for pound outstanding private debt.Both types come together through clearing hence the need for central banks to add or drain reserves when required.Within 'Bank money' which presumably is what 20, 30, whatever times as big as 'Govt money' you have the the shadow banking world in which the main players are the big banks, sovereign wealth funds, hedge funds etc with little Govt regulation.Is this is any way accurate?

  13. Hallo Prof. Wray,could You please give a more precise description of the pyramid of liabilities. What is meant by "the degree of separation from the cb".I am waiting every monday and thursday for Your blog!!Thank You very much from Germany, a MMT valley of desolation.

  14. Dear Prof. Wray,I feel I am slowly getting a picture of how the whole thing works. In your book "Understanding Modern Money" in chapter 5 Monetary Policy you are explaining the vertical and horizontal components of money supply and on page 113 you're writing about a possible short squeeze, in the case that government reduces its spending. Now I wonder, don't we have a short squeeze even if government does not increase its spending? When long and short positions zero out, don't we need extra fiat money for the interests? In order to pay interest on a morgage I presume that I need government to expand its spending to create the necessary money needed to pay the interests. Is that correct?Regards, Dietmar

  15. Dietmar: if i understand your question, that is a complex topic that puzzled "circuitistes" for a long time. that is, put it this way. Bank loans equal bank deposits, so how can you ever pay more to banks than they lend (using deposits to pay the loans) and hence how can you pay interest. very good question!!! i wrote a paper a long time ago presenting my view–they lend the interest. others assume that the deposit rate equals the loan rate so they pay interest to you and you turn it over to them (less satisfactory, i think). or you can have the whole system growing so loans and deposits are always increasing and you are servicing the "old" debt but out of bigger outstanding deposits. or finally, we can take your route: outside money (from govt) created through deficits.

  16. Pingback: The Spinning Top Economy - New Economic Perspectives