At the macro level cooperative systems can have a big impact on the financial system. For example, with a little cooperation, adept use of technology and some interest-free loans banks could play an active role in helping to control the money supply to prevent inflation.

The existing banking system is meant to control inflation by limiting the creation of debt. Unfortunately the system fails to achieve this because it provides a profit incentive for each bank to issue as many loans – and therefore create as much debt – as possible even though all banks understand that too much debt puts them all at the risk of systemic failure.
One of the basic functions of banks is to supply credit and there is a limited amount of credit that a community can support. The current banking system is a Tragedy of the Commons where community credit is the commons.

The tragedy occurs because of the way extra money tokens are introduced into the monetary system.

When a bank creates a loan it puts money into a cash deposit account and balances it with a loan secured against an asset. The quantity of money that banks can lend is constrained by the need to set aside a percentage of this amount, placing it in reserve so that it is never loaned out. The exact amount of the reserve depends on the policies of the controller of the currency, which is normally a Central Bank.

Other rules that banks must observe include the need to accept transfers of money from other banks and the need to keep their books balanced, which means they must have loans backed by assets to match their cash deposits.

When an individual transfers money from a bank, the bank has to ensure that its total deposits continue to match its loans. One way to achieve this balance is to borrow money from another bank that has more deposits than loans. The new loan is secured against the loans of the borrowing bank. When this happens we have a loan secured by another loan which in turn is secured by a real asset.  The original asset has been used a second time to create money. This means the system can generate many more loans than there are existing real assets.

The result is a continuous system where loans and deposits are created, loans are repaid, money is transferred between banks and loans are made between banks. The system automatically keeps the number of money tokens in balance with loans made and it should be self regulating.

However, all banks make profits by issuing loans. As they continue to make loans they find that they in turn have to go out to other banks to borrow money to keep their balances in line with their assets. In a growing economy and in one where loans are being rapidly repaid many banks have to increase their supply of cash by borrowing money at interest from other banks. However, there is always a strong push for assets to be over valued and too many loans created, giving rise to the temptation for for financial institutions to invent derivatives and insurances under the guise of reducing risk.

We can break this cycle of positive feedback if we can find another way for banks to obtain deposits without having to pay interest on those deposits. If such a system could be put in place it would result in greater profits for the banks because they no longer have to borrow money and pay interest on the increase in the money supply. It would also reduce the incentive for banks to encourage asset inflation or to develop unnecessary and risky financial products.

It can be done by banks issuing a limited number of interest free loans where the money in the deposit account does not collect interest.   The issues with such a system are deciding where the loan money will be invested, ensuring the loans will be repaid and securing the loans in case they are not repaid.  These objectives can be achieved in the following way.

There are many institutions that have large cash deposits which collect interest which in turn are used to pay benefits to their members.  Such institutions are pension funds, superannuation funds, and governments with defined benefits committments.

Such an institution can ask the bank for an interest free loan secured against its existing deposit. The institution promises not to collect interest on the money from the interest free loan while-ever it is in its account and it promises not to remove its cash deposit while-ever the interest free loan is outstanding.  The institution still expects to receive interest on its deposit.

The Institution takes the interest free loan and it in turn creates smaller loans using the loan money and giving it to its members according to some criteria.  This money is also interest free and it must be invested to build a new productive asset.  The loan must be repaid from the income from the productive asset.

Overall system control is achieved by finding Institutions willing to commit their money long term to fixed deposits and by finding enough projects that will be able to repay the loans from the new productive assets.   Banks are limited on the amount of interest free loans they can create by finding institutions willing to risk their existing deposits.  Institutions will limit the deposits they allow to be used as security because if too many interest free loans are created so the interest on interest bearing loans will drop.

Institutions can use this process to control asset inflation within their communities.  For example, if there is housing/land price bubble then interest free loans can be issued to members to build new dwellings.  Even the threat of such an action will help prevent house/land speculation.

The system described above is a strategy to solve the tragedy of the credit commons.  In this case the community commons is credit.  The strategy is to give credit to members of a community but under the condition that they repay the credit from the earnings from new investments.  It is important that the interest free credit be used to create new assets not buy old assets. Using interest free credit to buy existing assets will simply cause an asset bubble and increase the problem.

Compliance is controlled by requiring the members of the Institution who receives the loans to use them for investment purposes.  If they cheat the system then they will never receive another interest free loan from any other organisation.

Banks win from the system because they increase the money supply without having to borrow money from other banks.  Banks can still borrow money from other banks but such loans will be with existing money not newly created money.  After a short time it is expected that banks will operate at a 100% fractional reserve.  That means they will only lend money they have on deposit.

In summary we have built a collaborative system where the credit commons is limited by the ability to create new productive assets.

This contrasts with the current system where the credit commons is unlimited and each bank is limited in its credit creation only by its willingness to create loans.  As we have seen the current system forces banks to exploit the credit commons because if they don’t then others will. The interest free loans approach means that banks are not tempted to create loans that encourage bubbles in asset prices.

8 thoughts on “Making a profit on interest free loans

  1. Hi Kevin

    I found your post as I was wondering why a philanthropist doesn’t set up a community bank offering interest free loans. There are clear ways this bank would still profit…so I was wondering if it had been done. Hence I found your very well reasoned post. Let’s hope the banks take note! LeahG

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  2. Leah,

    To my knowledge it hasn’t been set up the way suggested because it needs “the internet” to make it technically possible on massive scale. It requires reliable electronic identification systems, more calculations and very good communications.

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  3. You know there is a company, who is not a bank, that has created a new lending system that is interest and fee free. They do this through consumer loyalty. I wish I had an analogous; however, they are truly the only ones I found that do this sort of lending. Maybe it can be compared to old time shop owners allowing consumers to purchase items on “credit” if they forgot their wallets or didn’t have the money that month. They are called floatmoney.com. What I do personally is shop through them and that builds up my line of credit to borrow against. That line is reported to build up my credit score. So maybe the banking system is not the answer; I think the answer is this new consumer credit model like the institutional system you are referring to. Is this the type of system you were referring to Mr. Cox?

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    1. Matthew the reason we have interest on money tokens is to cover the cost of defaults and inflation. It is important to distinguish between money tokens (which are a promise) and savings (which is unspent earnings). Money tokens have no value in and of themselves and hence should not earn interest. However, savings have value and if we give them to someone else to use we should expect to pay interest.

      The problem with the financial system is that the legitimate charges of interest to cover broken promises and inflation have been found to be easily exploited and so we are awash with money tokens which is partly used to transfer value from the poor to the rich.

      One way to slow down the exploitation of the creation of money tokens, that has always been present, is to find ways to get rid of interest on interest. My post on the Time Value of Money points out one way that we can do it by simply changing the rules on how we repay loans. We repay the capital first and then repay interest and we do not charge interest on interest.

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      1. That would be great way to mitigate the financial burden for most to know they are paying off their capital first and not being subject to paying interest on interest. This should be implemented swiftly; however, this type of model would meet the most adverse resistance by banks and credit card companies alike who have grown increasingly powerful at controlling the current market. Paying interest on interest always seemed to me like an under-handed way to keep consumers in debt. I think this has destabilized the economy to a catastrophic degree. So what do you think of the business model that Float Money is using? Make merchants pay the interest for the consumers loan through continued shopping loyalty and the consumer only pays the principal payments. Do you believe that this type of outside the box thinking can lead to a paradigm shift like what you purpose?

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      2. Matthew thank you for pointing me to floatmoney. I will get in touch with them. It is exactly the sort of system that I am talking about. They would make their money from transaction fees with the merchants. The reason they can make money is that bankers can now – in the USA – pay very little for new money. However, the main reason is that they have captured the credit card market of the people who pay off their credit cards every month and they do not pay interest on credit and rarely, if ever, default.

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      3. Mr. Cox, your ideas I hope can enlighten a lot of people. I have been in situations that require the use of interest bearing lines of credit and have been burned by a system that perpetuates the use of such products. I would venture to say only 1 to 5 percent of Americans can and will pay every interest bearing line of credit off before it brings about a fee or addition of interest charge. At one point, before I had to turn to a bank to do a debt consolidation loan, I had determined that it would take me 21 years to pay off my credit card situation; if I only paid the minimum due and had no other charges. I paid it off in four by getting a loan that had interest, changing life habits, and paying extra on the principle. If only forward thinkers like yourself and the company I spoke of had been around at that point then I would have been able to pay it off quicker. I don’t know what else can be done to make other people believe there are other options out there and these options are not there to burn them by hidden charges, fees, or interest. So, I ask you keep evangelizing your view points Mr. Cox. So maybe eventually all these voices in the wilderness will get heard and actualized. I feel that change is coming and it is people like you who will bring this world out of economic desolation.

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