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How does money transfer between banks and different countries work?

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Answer by Faisal Khan:

How do banks transfer money?

A question asked of me often is How do banks transfer money? How is money transferred from one country to another? I mean how does it work? How does my account get debited of $100 and somewhere around the world someone’s account get credited for $100.

Another parallel question is, How does $100 Million transfer? I mean, say if America is giving someone loan, how do the two countries transfer $100 Million? Or even $10 Billion? How does this work? How can the wealth of one country decrease by $10 Billion and another one’s increase by $10 Billion?

Is money physically moved? Do they transfer cash in vaults?

How does this all work?

The most common answer cited by many is SWIFT or Wire Transfer but it still doesn’t answer the question. You still walk away feeling equally baffled by the whole thing.

So, how does money really get transferred between banks?

Tl;dr:

It’s all about trust and ledger adjustments. Essentially, IOUs being exchanged.

The Solution

There are a million ways to explain the solution. Some use complex ledger examples, others, will use a mix of ledger and trust lines, etc. I decided to use an exceedingly simple example that explains the general concept well.
Granted, a lot many things are left out, or not quite accurate, but then again, the whole goal here is to make sure you grasp the concept of how banking transfer work.

The Lemonade Bunch

For any bank to function, there must be deposits and customers. So for our example, lets assume this lemonade stand business, aptly called The Lemonade Bunch.

These three hard working folks, generate a lot of income. They sell lemonade like crazy and make lots of money.

At the end of the day, they tally their sales and its US$100,000. Now they are holding on to that cash. They need to deposit this money in some bank. Wells-Fargo seems to be their bank of choice, so they walk in to a Wells-Fargo branch and deposit their money (assume for a minute, they are the only clients for Wells-Fargo)

So they go, deposit the money and then get a receipt for their deposit, which would look something like this:

The bank now has one customer, and the bank’s balance would look something like this:

The Banking System

To truly understand how the whole banking eco-system works, imagine a school. A school's hallway has access to all the classes. Each class having students and a teacher.

In our example, imagine each class being a country.

With each class representing a country, then within each class are students and a teacher. The students would be the banks, and the teacher the central bank.

This is how USA (for example) would look like:

As you can see, that young lady over there, representing Wells-Fargo. She is holding on to US$ 100,000 in deposits of The Lemonade Bunch.

So, like in regular school, at the start of each class, there is a roll call, remember that? except this roll-call is slightly different. To start out with, every student (i.e. bank) has brought with them, their ledger book. The ledger book contains all the deposit slips they have issued, and in their back-pack, let us assume, they have brought the money (currency notes & coins) that was deposited.

In case of Wells-Fargo, she would have brought in US$ 100,000 and a copy of the receipt she gave out to The Lemonade Bunch.  Likewise, the teacher would ask this of everyone:

  • Teacher (pointing to a certain bank): How much money do you have? (and prove it)
  • Student (being the bank), would they say out loud, how much money they have and show their cash/coins as well.

Everyone makes notes. So if Bank of America says it has so much money, the teacher notes it down and other banks can too note it down.

This what for example how the balance sheets would look like for the US Classroom. I've deliberately not shown the Debit / Credit, etc. for non-accounting people would have a hard time grasping the concept. In plain English, it shows:

  • A Bank (and how much client money they are holding)
  • The Teacher (and how much bank money he/she is holding)

Typical example of how the ledger would look like for customers, banks and central bank.

To make sense of this screenshot, ignore the Teacher (French) and Teacher (China), we will come to them later on. The spreadsheet ledger view shows three banks and their clients:

  • Bank of America
    • Steve Construction (Client)
    • Arthur Photography (Client)
  • JP Morgan Chase
    • Jane's Bakery (Client)
    • Megan Old Books (Client)
  • Wells-Fargo
    • The Lemonade Bunch (Client)
    • Josh Music (Client)

The deposits of each client are marked, and it shows how each client's balances are in check with the bank.

The balance money from customers (money taken from customers) matches the books of the customers (balance in bank).

…and as you would expect, all the balances of the bank, are reflected in the ledger of the Teacher (the Central Bank):

Consolidated view of Balance information as filed with the Central Bank, in this case the Federal Reserve.

So the total balance in the classroom for USA is US$ 1,100,000 (One Million One Hundred Thousand Only). There are a couple of walk-way points from this exercise:

  • The total amount of money in circulation is known. (US$ 1,100,000)
  • The distribution of this money as deposited in various banks is known.
  • There is a general consensus (based on the ledger being maintained by the Central Bank) as to how much money each bank holds.
  • If a bank tries to create money (for example: JP Morgan Chase makes up a fake client and says it has received US$ 1 Million from that client), it would have to demonstrate to the teacher (central bank) that it has the money (classical case of Show me the money!). If JP Morgan Chase is able to show the currency notes, etc. its balances would be adjusted accordingly. However, if they cannot show the money, then the central bank will not accept their new found wealth and general consensus amongst the banks will be, not to accept JP Morgan Chase's claim that it has additional US$ 1 Million.
  • The consensus and double-entry system ensures to a larger extent (for our example) that unfounded creation of wealth cannot be done.

The Central Banks

So, at the end of the school (banking) day, all the teachers (central banks) then get together in a common room.

Central Bankers in a room comparing notes (wealth statements)

As you might have guessed, the Teacher, too compare notes. Here the information regarding the wealth ledgers of countries is going to be shared amongst the group.

Assume, that the de facto currency being traded in the world is the US Dollar (to make things simple), this is how the ledger positions for all the central banks would look like:

Ledger Statement of All the Central Banks after their first Meetup!

Is this wealth?

Yup! This is it. What were you expecting?

This is how the wealth of nations is recorded. In ledgers, which are consensus based amongst the banks, central bank and the central banks of the world.

To keep the example simple, as cited earlier, if anyone tries to add value into their economy, the others would have to agree to it. Because the system is based on double-ledger entries, one cannot unilaterally try to take advantage of the system.

Because each country has its own currency (just to spice up matters a bit), and If anyone tries to make money out of thin air, then can, but they can only do so in their own denominated currency. Others will agree that a particular country's money supply has increased and will adjust accordingly, based on the exchange rate against the US Dollar (which in our example is the global currency being used by all the banks).

So How Does Money Transfer Work?

So, let us assume our company The Lemonade Bunch needs to do a wire transfer of US$ 50,000 to China and $10,000 to France. How does this value really get transported? The answer again, is simple a consensus based value transfer.

In our example, you will see The Lemonade Bunch, sets aside two IOUs for US$ 50,000 and US$ 10,000 aside. The ledger statement would look something like this:

Notice how the total wealth of The Lemonade Bunch is reduced down to US$ 40,000 in their ledger. Likewise the wealth of Wells-Fargo has also been reduced down to US$ 115,000 (as IOUs are created).

These two IOUs are then moved to Wells-Fargo's IOUs, and the money is deducted from The Lemonade Bunch's account. Now the ledger position would look something like this:

Continuing with the same pattern, the next logical step is to deduct the IOUs total from Wells-Fargo's total wealth in the ledger and pass these IOUs to American Central Bank (Teacher). The ledger statement would now look like this (the two IOUs have been lumped together):

You can already see the total wealth as recorded by the US Central Bank has also been reduced from US$ 1,100,000 down to US$ 1,040,000.

Giving Money To The Counter-party

As per the previous experience, all the Teachers (Central Banks) gather in a room and exchange wealth statements. The same would happen this time around, except the ledger is slightly different (as can be seen below):

The reverse process would now start. US Central Bank would have the following conversation at the end of the initial wealth exchange:

US Central Bank: "Hey China!"
China Central Bank: "Yo! What up?"
US Central Bank: "Hey, I got a US$ 50,000 IOU for you, for "Bank of China" that needs to be credited to "Xing Framers" account with them."
China Central Bank: "Cool. Give it to me and I will hand it over to them with the instruction to credit further."

the same conversation would happen with the French Central Bank

US Central Bank: "Hey France!"
French Central Bank: "Oui?"
US Central Bank: (Grrrrr) [smiling] "Hey, I got a US$ 10,000 IOU for you, for "BNP Paribas" that needs to be credited to John-Pierre Imports account with them."
French Central Bank: "Cool. Give it to me and I will hand it over to them with the instruction to credit further."

US Central Bank does just that, and the ledger statement would look something like this:

Once both the Central Bank of France and Central Bank of China accept the IOUs, there collective wealth would increase (as well as the wealth of the bank where further credit is due). The ledger would look something like this:

Just two more steps left, before the entire money (value) transfer is completed.

Both the Central Bank of China and Central Bank of France, credit the IOUs to the Bank. The Banks (namely Bank of China and BNP Paribas) now have an IOU Credit liability for further credit into the account of the beneficiary which would be Xing Framers and John Pierre Imports respectively.

The last step is to credit the bank account balances of each company, which would essentially bring this money (value) transfer cycle to come to an end.

Once this credit to bank ledger is done, the final ledgers would look like this:

Conclusion

I hope with the above example, you will get a very good (if not heuristic) sense of how money is transferred. Though the above example has been simplified almost to an elementary level, this is pretty much all that happens when money (wealth) value transfer happens from one bank to another, be it within the country, or across borders.

The above model can be expanded to include how correspondent banking would work and how balances are maintained with each other, etc. however, that might be a blog article for some other day.

If you look closely, this somewhat mimics what a blockchain looks like? Its not public or decentralized, but it is consensus based and has a double-entry system to ensure there is no double spend or creation of wealth that others may (or may not agree to). 

I initially wrote this answer as a blog post: How Do Banks Transfer Money?

How does money transfer between banks and different countries work?

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