How banks and people ‘collude’ to make money

Customers queue in a bank. PHOTO | FILE 

In Summary

• This money will remain in circulation and, if you fail to pay back, the bank will have to look for some one else to buy your property.
• But what if the bank can’t find anyone to pay Sh5 million for the property? Suppose the best offer is Sh2 million. In that case, the bank makes a loss of Sh3 million.
• This is why I am saying it is a collusion between banks and their customers.

By Mungai Kihanya
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Everybody knows how to make money, don’t they? You do some work and get paid for it. But where does the person paying you get it from?

Money is made through collusion between a commercial bank and its customer. Suppose you have some property — maybe a car or a piece of land, or whatever that you think is worth, say, Sh10 million.

So you go to your bank and ask them to hold it as security in exchange for a Sh5 million loan. If the bank agrees, then the two of you have just colluded to create Sh5 million and injected it into the economy!

This money is now written against your name on a piece of paper (a statement). If you need some of it in cash, the bank will request for them from the Central Bank of Kenya for the currency notes.

This money will remain in circulation and, if you fail to pay back, the bank will have to look for some one else to buy your property.

But what if the bank can’t find anyone to pay Sh5 million for the property? Suppose the best offer is Sh2 million. In that case, the bank makes a loss of Sh3 million.

This is why I am saying it is a collusion between banks and their customers.

COLLUDED WITH YOUR BANK

You and your bank colluded and agreed that the property is worth Sh10 million. On that basis, you were given Sh5 million to spend on other things, but when you defaulted, there was nobody willing to pay Sh5 million for the property.

This is how the Kanu government “printed” money in the late 1980s and almost brought down the entire financial system.

Politically connected individuals were allocated public land. They then presented it to (especially government-owned) banks and got loans that were way above the market value of the land.

These borrowers then defaulted on the repayments and the banks were left holding onto land that could not fetch a tenth of the outstanding loans. Many small banks closed shop as a result. But by this time, the borrowed money was already circulating in the economy but not representing its fair market value in property.

Because of the “excess money” in circulation, the prices of many goods shot up. The phrase “excess money” means that there is more money than the fair market value of properties that it was issued against.

Since this excess money was in just a few hands, life became too expensive for the majority and the Central Bank had to find a way of removing it from circulation.

That is, stop the people holding it from buying things with it. So the Central Bank offered very attractive interest rates on savings.

Ideally, the interest rate offered must be at least as high as the inflation rate: It is the only way that the offer will make sense.

This kind of action is normally termed as “mopping up excess liquidity”. Mopping does not annihilate the money, it only reserves it and releases it gently back into the economy.