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.
Wow. Stumbled across this article as a link from the Green Party website and it frightening how much misunderstanding existed. I just want to make it very clear to anyone who does come across this that the argument has been now settled with demonstrable clarity by the Bank of England and Andrew Smith, author of this article, is very much on the losing side of that argument.
Please see
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf
for the Bank of England explanation
and
http://www.positivemoney.org
for more information on this issue which is of enormous importance to a sustainable future for our planet.
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I explain above how the M4 measure of liquidity increases. That’s what banks are there for, after all, as I describe in these two blog posts – they create liquidity by borrowing short-term and loaning that money out long-term (and the rising yield curve enables them to make money on the difference). If they could lend out money at a profit without having to borrow it in loans that cost them money, then that’s exactly what they would do, because that would enable them to make more profit.
Find me a legally-operating bank that has lent out more than it has received in deposits or borrowed from the wholesale market. Why do you think banks borrow from the wholesale market? After all, that costs them money. Why were Icesave offering 10% on deposits?
By the way, M4L isn’t growing at the moment – total sterling lending of monetary financial institutions to the private sector shrank for several months in 2010, and it shrank over the year as a whole. (data series LPMAVBS http://bit.ly/fsBYMo – links to the BoE)
Let’s talk about balancing the books. Where do you think customer savings, wholesale lending, and customer loans appear on these books (in terms of assets and liabilities)? What do you think happens to the balance sheet when the bank gives me a new mortgage? What do you think balances my mortgage?
Tou are mistaken about the wholesale market. Banks borrow short term to balance their books, but lend out long term, and that’s where they make their profits.
AS: “Where does the money come from that the bank lends out? It comes from savers and/or from the wholesale market”.
RL: Not so. If it did, the amt of money in the system wd be constant. But it is not. It is growing.
The banks lend out a multiple of what they hold.
No, I don’t agree – and I think this really pinpoints the bit about banking that you misunderstand, Richard.
Where does the money come from that the bank lends out? It comes from savers and/or from the wholesale market.
Do banks get that money for free? No, they don’t. They pay interest on loans from the wholesale market. And they pay savers interest; and they also pay savers with a non-cash benefit too: free banking – the bank pays for a service which is then provided free at the point of use. All those cash machines we use, the bank branches, and so on.
So, a lot of the interest from borrowers passes through the bank, and out again to its lenders, and out in the form of services.
Most people accept that in general, goods and services get provided at a price. Things that cost money to provide, generally get charged for, one way or another. Providing a cash advance is no different: it costs the bank money to provide this service, and so they charge a price for it – that price, is the interest.
Try this thought experiment. Imagine an economy where banking was fully computerised, with tiny marginal costs.
Here loans could be provided at zero interest. A man who needs money could borrow the £100 in the same way, with +100 going into his account and -100 going in to the bank’s ledger.
He works, he pays the money back, the loan is annihilated, and the money in the total system remains as it ever was.
In fact, the supply would dwindle, because unpaid loans would destroy money.
Andrew,
you say “There is a sense in which money is lent from depositor to borrower, but that’s an over-simplification that can be partly incorrect”.
Let us try to clarify, because “sense” belongs to counselling, not to a subject that claims to be a science.
1 At the point a loan of £100 is made, two numbers are created, £100 in the borrowers account, and an equal and opposite -£100 in the bank’s ledgers.
Agreed?
2 the borrower then engages in activity in the real economy to pay back first the interest, then the capital. Say the interest amounts to £25. So to clear his debt, the borrower must pay back £125. When he finishes paying back the capital sum of £100, the initial loan is annihilated (£100-100=0), but the bank is £25 better off than it was initially (less inflation of course), and can therefore make yet more loans.
Agreed?
3 That £25 has been sucked out of the real economy and passed to the banking sector. Yet the money supply in the real economy is normally increasing (unless, rarely, there is deflation).
So where is the new money coming from? It is coming from other loans made by banks.
Agreed?
4 Therefore the debt/interest banking system is a species of Ponzi scheme. It only maintains itself if it grows.
This makes the debt interest mode of creating money a driver of economic growth.
Agreed?
No, I thought not 🙁
If you’d like to be very specific about the precise point on which you think he and I disagree, with a quote of substance and a linked source, then that would be useful.
Hmmm…
It is interesting to compare what you say here with what Mervyn King recently said… He doesn’t seem to agree with you…