How States Can Escape the Credit Crisis: Own a Bank

Since President Obama’s stimulus plan went into effect in February, according to a report from the House Ways and Means Committee, the nation has actually lost nearly as many jobs as the plan was projected to create. Instead of adding 3.5 million new jobs, 2.7 million jobs have been lost. California, which was supposed to gain 396,000 jobs, has lost 336,400 jobs. Arizona, which was supposed to gain 70,000, has lost 77,300. Michigan, which was supposed to gain 109,000, has lost 137,300. A total of 49 states and the District of Columbia have all reported net job losses.

In this dark firmament, however, one bright star still shines. The sole state to actually gain jobs is an unlikely candidate for the distinction: North Dakota. North Dakota is also one of only two states expected to meet their budgets in 2010. (The other is Montana.) North Dakota is a sparsely populated state of less than 700,000 people, largely located in cold and isolated farming communities. Yet since 2000, the state’s GNP has grown 56%, personal income has grown 43%, and wages have grown 34%. The state not only has no funding problems, but this year it has a budget surplus of $1.3 billion, the largest it has ever had.

Why is North Dakota doing so well, when other states are suffering the ravages of a deepening credit crisis? Its secret may be that it has its own credit machine. North Dakota is the only state in the Union to own its own bank. The Bank of North Dakota (BND) was established by the state legislature in 1919 specifically to free farmers and small businessmen from the clutches of out-of-state bankers and railroad men. The bank’s stated mission is to deliver sound financial services that promote agriculture, commerce and industry in North Dakota.

The Advantages of Owning a Bank

So how does owning a bank solve the state’s funding problems? Isn’t the state still limited to the money it has? The answer is no. Chartered banks are allowed to do something nobody else can do: they can create credit on their books simply with accounting entries, using the magic of “fractional reserve” lending. As the Federal Reserve Bank of Dallas explains on its website:

Banks actually create money when they lend it. Here’s how it works: Most of a bank’s loans are made to its own customers and are deposited in their checking accounts. Because the loan becomes a new deposit, just like a paycheck does, the bank … holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times.”

How many times? President Obama puts this “multiplier effect” at 8 to 10. In a speech on April 14, he said:

“[A]lthough there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – ‘where’s our bailout?,’ they ask – the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.”

It can but it hasn’t, because private banks are limited by bank capital requirements and by their private for-profit business models. That is where a state-owned bank has an enormous advantage: states own huge amounts of capital, and they can think farther ahead that their quarterly profit statements, allowing them to take long-term risks. Their asset bases are not marred by oversized salaries and bonuses, they have no shareholders expecting a sizeable cut, and they have not marred their books with bad derivatives bets, unmarketable collateralized debt obligations, and mark to market accounting problems.

The Bank of North Dakota is set up as a dba: “the State of North Dakota doing business as the Bank of North Dakota.” Technically, that makes the capital of the state the capital of the bank. Projecting the possibilities of this arrangement to California, the State of California owns about $200 billion in real estate, has $62 billion in various investments, and has $128 billion in projected 2009 revenues. Leveraged by a factor of 8, that capital base could support nearly $4 trillion in loans.

To get a bank charter, specific investments would probably need to be earmarked by the state as startup capital; but for a typical California bank that requirement is only about $20 million. This is small potatoes for the world’s eighth largest economy, and the money would not actually be “spent.” It would just become bank equity, transmuting from one form of investment into another. In the case of the BND, the bank’s return on equity is about 25%, and it pays a hefty dividend to the state, which is expected to exceed $60 million this year. In the last decade, the BND has turned back a third of a billion dollars to the state’s general fund, offsetting taxes. California could do substantially better than that. California pays $5 billion annually just in interest on its debt. If it had its own bank, the bank could refinance this debt and return this $5 billion to the state’s own coffers; and it would make substantially more on money lent out.

Besides capital, a bank needs “reserves”, which it gets from deposits. For the BND, this too is no problem, since it has a captive deposit base. By law, the state and all its agencies must deposit their funds in the bank, which pays a competitive interest rate to the state treasurer. The bank also accepts deposits from other entities. These copious deposits can then be plowed back into the state in the form of loans.

The Central-Bank Model of Public Banking

The BND’s populist organizers originally conceived of the bank as a credit union-like institution that would free farmers from predatory lenders, but conservative interests later took control and suppressed these commercial lending functions. The BND is now chiefly a “bankers’ bank.” It acts like a central bank, with functions similar to those of a branch of the Federal Reserve. It avoids rivalry with private banks by partnering with them. Most lending is originated by a local bank. The BND then comes in to participate in the loan, share risk, and buy down the interest rate.

One of the BND’s functions is to provide a secondary market for real estate loans, which it buys from local banks. Its residential loan portfolio is now $500 billion to $600 billion. This function has helped the state to avoid the credit crisis that afflicted Wall Street when the secondary market for loans collapsed in late 2007. Before that, investors snatched up securitized loans (CDOs) from the banks, making room on the banks’ books for more loans. But these “shadow lenders” disappeared when they realized that the credit default swaps supposedly protecting their CDOs were a highly unreliable form of insurance. In North Dakota, this secondary real estate market has been provided by the BND, keeping the credit market stable.

Other services the BND provides include guarantees for entrepreneurial startups and student loans, the purchase of municipal bonds from public institutions, and a well-funded disaster loan program. When Fargo was struck by a massive flood recently, the disaster fund helped the city to avoid the devastation suffered by New Orleans in similar circumstances; and when North Dakota failed to meet its state budget a few years ago, the BND met the shortfall. The BND has an account with the Federal Reserve Bank, but its deposits are not insured by the FDIC. Rather, they are guaranteed by the State of North Dakota itself – a prudent move today, when the FDIC is verging on bankruptcy.

The Commercial Banking Model: The Commonwealth Bank of Australia

The BND studiously avoids competition with private banks, but a publicly-owned bank could profitably engage in commercial lending. One very successful precedent for this approach was the Commonwealth Bank of Australia, which served both central bank and commercial bank functions. For nearly a century, the publicly-owned Commonwealth Bank provided financing for housing, small business and other enterprise, affording effective competition that kept interest rates low and the private banks honest. Commonwealth Bank put the needs of borrowers ahead of profits, ensuring that sound investment flows were maintained to farming and other essential areas; yet the Bank was always profitable, from 1911 until nearly the end of the century.

Indeed, it was apparently too profitable, making it a takeover target. It was simply “too good not to be privatized.” The Bank was sold in the 1990s for a good deal of money, but according to proponents, its loss as a social and economic institution was incalculable.

A State Bank of Florida?

Could the sort of commercial model tested by Commonwealth Bank work today in the United States? Economist Farid Khavari thinks so. A Democratic candidate for governor of Florida, he proposes a Bank of the State of Florida (BSF) that would make loans to Floridians at much lower interest rates than they are getting now, using the magic of fractional reserve lending. He explains:

“For $100 in deposits, a bank can create $900 in new money by making loans. So, the BSF can pay 6% for CDs, and make mortgage loans at 2%. For $6 per year in interest paid out, the BSF can earn $18 by lending $900 at 2% for mortgages.”

The state would earn $15,000 per $100,000 of mortgage, at a cost of about $1,700; while the homeowner would save $88,000 in interest and pay for the home 15 years sooner. “Our bank will save people about seven years of their pay over the course of 30 years, just on interest costs,” says Dr. Khavari. He also proposes 6% credit cards and 6% Certificates of Deposit.

Besides earning billions of dollars per year for the state on these loans while saving hefty sums for consumers, the state could refinance its own debts at very low interest rates, along with those of its agencies and municipal governments. According to a German study, interest composes 30% to 50% of everything we buy. Slashing interest costs can make projects such as low-cost housing, alternative energy development, and infrastructure construction not only sustainable but profitable for the state, while at the same time creating much-needed jobs.

Ellen Brown is an attorney, founder of the Public Banking Institute, and author of twelve books, including the best-selling Web of Debt, The Public Bank Solution, and Banking on the People: Democratizing Money in the Digital Age. She also co-hosts a radio program on PRN.FM called “It’s Our Money.” Her 400+ blog articles are posted at This article was first published in Scheer Post. Read other articles by Ellen.

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  1. ajohnstone said on December 5th, 2009 at 6:00am #

    “Federal Reserve Bank of Dallas explains on its website: “Banks actually create money when they lend it.” the author informs us

    Oh , this website creates a lot of misunderstanding .
    The New York Federal Reserve gives a rather more sophisticated explanation.

    But it is all made very clear on Page 57 of Fed Today

    The theory that banks can create “money out of nothing” comes in two forms.
    In the crude version, it is argued that if the banks have to keep 10 percent of their assets as cash (as used to be the rule; it’s now as low as 1 percent) this means that if someone deposits $1000 in a bank that bank can then lend out $9000. Actually, what it means is that it can lend out $900.

    The more sophisticated version takes over from here and assumes that the $900 is then spent and that the people who receive it then deposit it in one or other bank. These banks can then lend out 90 percent of what has been deposited with them, or between them a further $810. So that means that the original $$1000 has already become $1710. In other words, the banking system this has “created” an extra $710 “out of nothing”. But the process doesn’t stop here. The $810 also ends up with the banks, who then lend out a further $729. The process continues until, in the end, the banking system has lend out a total of $9000.

    Banks can’t and don’t “create credit”. They can only lend out what has been lent to them, ie other people’s purchasing power. So, bank credit only re-arranges, not increases purchasing power.Banks are financial intermediaries that borrow money from some people and then lend it others. Banks fund loans to customers by a mixture of two methods, one of these is using money deposited with it from customers , the other is through the wholesale banking market, i.e. effectively money deposited with it from other institutions .Generally, small banks are deposit-rich and large banks are deposit-poor. Large banks loan out more money than has been deposited with them by borrowing from small banks. Small banks themselves borrow from depositors and other banks as well. An entire national economy can loan out more money than has been deposited in its banks by borrowing from foreign banks. The origin of their profits is the difference between the rate of interest they charge those they lend to compared to that they have to pay those the borrow from. An alternative to saying banks ‘create’ money is just to say that they help circulate it. The only body which can create additional purchasing power is the government via its Central Bank. It can in effect print more money.

    Banks are not the only actors involved in the process – a bank makes a loan but that is not immediately redeposited, it gets spent on consumer goods or turned into productive capital so all these things have to happen first before it ‘comes back’ into the banking system, so the bank is not necessarily the active subject in all of this, so it’s not just like the banks sitting in isolation of everything deciding to create money out of nothing, if all the other activity didn’t happen then the banks wouldn’t be able to do what they do. It’s ‘created’ as a result of activities going on outside and outwith of the banks themselves, it’s not about them ‘creating’ credit and at some point it then having to react with the real economy, it’s about the activities of the real economy dictating it’s need and the banks responding to it.The fact that the bank doesn’t create money becomes obvious during a commercial crisis, during which too many depositors try to redeem their IOUs (their deposits) than can be redeemed- a run on the bank .

    The present banking crisis is not all that complicated . When borrowing became less available and more expensive banks came unstuck. They found that, when their loans came up for renewal they had to pay more interest on them than they were getting from those they were lending money too. Since banks make a profit by paying depositors and creditors a lower rate of interest than they charge those they lent money to, this meant they were making a loss. That’s what can go wrong when banks can’t get hold of other people’s money on the right terms.
    What can also go wrong is that they make unsound loans- the sub-prime situation . If they buy a house and the lend someone the money to buy it, if that person defaults they are left with the house. In normal times they can resell it but because there has been overproduction in the housing market they are finding that they can’t get the same price for it as they paid for it. In other words, they lost money.
    In fact this effective overproduction in the housing sector could be said to be what has provoked the present financial crisis.

    Another explanation of how banks cannot create credit can be read here

    “Credit creationists…. are the ‘mystical school of banking theorists'”

  2. Ellen Brown said on December 5th, 2009 at 10:15am #

    That is how the reserve requirement used to work, but it is not how it works today. See

    Here’s how it would work today: let’s say California were to earmark $10 billion of its $62 billion socked away in investments as the capital for starting its new state-owned bank. It also takes in $10 billion of deposits (initially by transferring its own revenues out of the Wall Street banks where they are now). It can now, technically, make $18 billion in loans, keeping $2 billion in “reserve.” The $18 billion are added to both sides of the balance sheet, as assets and liabilities. It can now lend 90% of that, etc. That’s how it’s done technically, but in fact nobody checks to see if the reserves are there before making loans. The banks make loans to any creditworthy borrower who walks in the door. They only check the reserves and capital when the regulator comes around every three months, and if they don’t have them they either borrow from the money market or the Fed, or they sell off some loans temporarily until the heat is off. Meanwhile, interest keeps accumulating and adds to the capital base. So when the Bank for International Settlements comes knocking and wants to check the 8% capital requirement, they’ve got that covered too. They can extent their initial $10 billion to AT LEAST $100 billion in loans. And their initial $10 billion in investment is never at risk, unless they go bankrupt. That money is never “lent” and neither are the deposits of their customers. The worst that can happen is that some loans default and the bank no longer has as much in the way of “assets” (mainly meaning performing loans) as “liabilities” (checkbook money issued). The bank is then called a “zombie bank” — it can’t lend any more till it rebuilds its asset base — or it is declared insolvent and is put through bankruptcy. But a state bank would not go bankrupt, particularly if it were set up as a dba of the state (as the Bank of North Dakota is), unless the state itself went bankrupt; and a state has the power to tax, so that is highly unlikely, particularly if it can refinance all its old loans at very low interest rates.