Banking and money creation (part 1)
Do banks lend savers’ money out? Do they really create money? What are the constraints on how much money banks lend out? Did you see some animation that claimed to blow the lid on how banks really work? Are you more interested in reality than youtube videos? I am.
In this two-part series, I’ll explain a bit about banks, and I’ll kill off the myths, half-truths, confusions and misunderstandings circulated (wittingly or unwittingly) by “monetary-reform” evangelists.
Do banks lend savers’ money out?
Sort of. There is a sense in which money is lent from depositor to borrower, but that’s an over-simplification that can be partly incorrect. Similarly, when a bank issues a loan, it does create broad money; but explanations that focus on that, and in particular the fruitloopery around the various expositions of “Fractional Reserve Banking”, are usually wrong, and misleading. Let’s look at that in some detail.
So, firstly: there is a sense in which a bank lends money from saver to borrower. But in some senses it does not. Let me explain two senses in which it does not: saver and borrower have no related transaction, and money for loans comes from savers AND from the wholesale market.
I’ll take each of those two in turn.
In Part Two, I’ll look at one of the many restrictions on the amounts that banks can loan: a bank is not just restricted by the amount of deposits it has and the amount it can borrow wholesale. Finally, I’ll comment on the “Fractional Reserve Banking” that gets circulated in YouTube videos and other silliness.
But before that – in what sense does a bank lend savers’ money out?
The money that banks lend out, is in a sense the money that the bank has borrowed from savers and investors. When a bank lends out £100, it has to have received that £100 from savers and investors in the first place. And at the moment the loan is issued, the bank’s ability to instantly repay its savers and investors has just diminished by £100; £100 from savers and investors is now locked in on the bank’s balance sheet, while that loan is outstanding. So, in one sense, the amount of money floating around the economy to go into transactions hasn’t changed: as soon as the loan is made, there are £100 of liabilities (loans to the bank from savers and investors) that are locked onto the balance sheet to balance their £100 asset, the £100 loan, that is about to get spent. However, in another sense, the amount of money that’s out there, has changed, and that’s reflected in the measure of broad money, M4. M4 measures how much money is out there, and is a very broad measure of it: it includes all the money in all current accounts. And it doesn’t count as negative money the amount in loan accounts. So, at the moment you receive your £100 loan, the bank puts £100 in your current account, and a matching debt of £100 in your loan account. M4 adds up all the money in current accounts (plus cash, plus some other things), but it doesn’t include the amount in loan accounts as negatives, so the amount of money in circulation as measured by M4 has increased. In practice, the amount of money that can move around in transactions has not changed, because that £100 is locked on the balance sheet.
So, that’s the sense in which the bank lends savers’ money to borrowers. Now I’ll look at two of the senses in which the bank does not lend money from saver to borrower.
Saver and borrower have no related transaction
If Saver saves £1440 in BigBank and then BigBank lends £1440 to Borrower, then Borrower don’t owe Saver any money. Borrower owes BigBank £1440, and BigBank owes Saver £1440. Saver’s money is at the bank, the bank’s money is with Borrower. Saver can take their money out any time, regardless of Borrower taking the £1440 loan out of the bank and spending half of it on leopardskin accessories and booze, and squandering the rest.
And Saver may well want their money before Borrower has repaid the loan. One of the main roles banks have, is acting as a buffer between those who want to lend money short-term, and those who want to borrow money long-term. So banks buffer between two groups. The first group is those who want to save (i.e. lend money in return for interest – when you put savings into the bank, you are giving the bank a loan), and these savers often want access to their savings at a minute’s notice. The second group is those who want to borrow money, but who don’t want to risk the money being recalled at a moment’s notice. Imagine if you took out a mortgage, bought a house, then the next day, your mortgager asked for all their money back. Banks borrow from the first group, and lend to the second group. The second group couldn’t borrow directly off the first group, because their needs, on having access to the money at short notice, clash.
So in that sense, Saver’s money hasn’t been lent to Borrower – the bank mediates transactions between a pool of (typically short-term) savers, and a pool of (typically long-term) borrowers.
Furthermore, savers aren’t a bank’s only source of money to lend:
Money for loans comes from savers AND from the wholesale market
In the case of RBS, on average, a loan of £1440 is funded by £1000 from savers, and £440 from the wholesale market: that’s what RBS’s 144% ratio of loans to deposits means.
So, Borrower’s £1440 loan would appear on the RBS balance sheet as a £1440 asset. So, that means there’s £1440 of liabilities on RBS’s balance sheet matching it. Now, there aren’t specific assets balancing it, but for illustration, let’s take averages across the balance sheet, and just look at the two big liabilities in RBS’s books: savers’ deposits, and RBS’s borrowings from the banking wholesale market; we’ll take it as if Borrower’s loan is representative of RBS’s entire loan book.
According Stephen Hester of RBS, his bank’s loans to other people are equivalent to 144% of people’s savings with RBS. Hence, balancing RBSs books, on average, we see that the £1440 of loan (the bank’s asset) is balanced by £1000 of its liabilities to savers; the rest of the money, £440, appears on RBS’s balance sheet as liabilities to investors from the banking wholesale market: that is to say, investors have put £440 into RBS through the wholesale market, and RBS’s liability of £440 to them, is on the balance sheet balancing out the remaining £440 of the RBS asset that is Borrower’s loan from RBS.
Stephen Hester announced that he wanted to bring that ratio to 100%: i.e. RBS want to remove their net dependency on the wholesale market, so that on their balance sheet, deposits are balanced by loans. To take the opposite extreme, just before Northern Rock imploded, its loans were 3.5 times the size of its deposits – almost all of the backing had come from the wholesale market.
So, in summary, not all loans come from deposits – some of them come from the wholesale market.
So do banks really create money? How do bank loans differ from me lending money to someone directly?
Well, there are commonalities: I can’t lend money that I don’t have, and neither can banks; banks can’t lend out more than they’ve had from savers and investors. But there are some differences too.
Firstly, they get treated different, statistically: when I lend money to someone, that doesn’t count as increasing the statistical measure of “broad money”. When a bank lends money to someone, it does increase that statistical measure. And to a degree, that’s reflecting differences that the different loans have on the amount of money circulating: given a pool of savers, then it’s a safe bet that, for much of the time, their savings would lie idle. But it wouldn’t always be predictable as to which savings would be idle. By pooling (often short-term) savings in a bank, and lending from that pool (often long-term), idle money finds a use, and those who do need access to their savings can get it, without loans having to be called in. So, in that regard, the banking system that pools savers’ money, and lends out from it, does increase the amount of liquidity in the economy. And that’s what the statistical measure of broad money is there to measure, which is why it increases when banks lend out money, but doesn’t increase when you or I lend out money.
More in the next post
That’s all for this post. In the next post I’ll look at some of the other restrictions on how much money banks can lend out: they’re not just restricted by the amount of money deposited by savers and the money they can raise on the wholesale market: there are additional restrictions too.