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Banking System Explained in Detail

Misconceptions around banking

There’s a lot of confusion about how banks work and where money comes from. Very few members of the public really understand it. Economics graduates have a slightly better idea, but many university economics courses still teach a model of banking that hasn’t applied to the real world for decades. The worrying thing is that many policy makers and economist still work on this outdated model.

In this video course we’ll discover how banks really work, and how money is created. But first, to clear up any confusion, we need to see what’s wrong about the way that most people think banks work:

From the Bank of England’s 2014 Q1 Quarterly Bulletin:

“Economic commentators and academics often pay close attention to the amount of ‘broad money’ circulating in the economy. This can be thought of as the money that consumers have available for transactions, and comprises: currency (banknotes and coin) — an IOU from the central bank, mostly to consumers in the economy; and bank deposits — an IOU from commercial banks to consumers.” (McLeay, Thomas, & Radia, Money in the modern economy: an introduction, page 4)

Banks are NOT Middlemen between Savers and Borrowers:


From the Bank of England’s 2014 Q1 Quarterly Bulletin:


“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

“In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 2).

Transcript

We’ve seen the two main ideas that the general public have about the way banks work. Both of them are wrong. That’s not too surprising, after all, unlike the Positive Money team most people don’t spend their time obsessing about how banks work. And banking is complex, which means that most people give up trying to understand it. But what about economics or finance students? Most of these students and graduates have a slightly better understanding of banking. They get taught about something called the ‘money multiplier’.

Proof & Further Reading:

From the Bank of England’s 2014 Q1 Quarterly Bulletin:


“Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 2)


“In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to 

other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 2) “Part of the confusion may stem from some economists’ use of the term ‘reserves’ when referring to ‘excess reserves’ — balances held above those required by regulatory reserve requirements. In this context, ‘lending out reserves’ could be a shorthand way of describing the process of increasing lending and deposits until the bank reaches its maximum ratio. As there are no reserve requirements in the United Kingdom the process is less relevant for UK banks.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 3, footnote 2)


From a Bank of England handbook for central bankers:


“If there is a shortage of liquidity [i.e. reserves], then the central bank will (almost) always supply the need…As regards a shortage of commercial bank reserves held at the central bank, the risk is that a shortage would mean payments could not be cleared at the end of the day.” [Our addition in square brackets] (Gray, S., Handbook No. 27 – Liquidity Forecasting. Bank of England Centre for Central Banking Studies. 2008).


From Professor Charles Goodhart, advisor to the Bank of England:

“Virtually every monetary economist believes that the central bank can control the monetary base [i.e. the stock of cash and central bank reserves]… Almost all those who have worked in a central bank believe that this view is totally mistaken.” [Our addition in brackets.] Goodhart, C. (1994). What Should Central Banks Do? What Should Be Their Macroeconomic Objectives and Operations? The Economic Journal, 104 (p. 427).

Banks are NOT Middlemen between Savers and Borrowers:


From the Bank of England’s 2014 Q1 Quarterly Bulletin:


“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

“In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 2).

Transcript

In this video, you can learn how commercial banks can create money through the accounting process they use when they make loans, how banks make payments between each other using specially created central bank money, if the Bank of England really can control how much money is in the economy …and more.


How Banks Create Money:
From the Bank of England’s 2014 Q1 Quarterly Bulletin: “In the modern economy, most money takes the form of bank deposits.  Further reading.

But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” “Commercial [i.e. high-street] banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.(1)” ¬[our addition in brackets] (McLeay, Thomas, & Radia, Money creation in the modern economy, page 1 & 3)

The following paper, from Standard & Poor’s Chief Global Economist, gives a good explanation of how money is created (a bit technical):


Repeat after me: Banks Cannot and Do Not “Lend Out” Reserves

Interbank Settlement & Payment Systems


The following two publications from the Bank of England give a good explanation of settlement systems for those who want the technical details:


A Guide to the Bank of England’s Real Time Gross Settlement System

Settlement Systems Handbook (Handbook from Bank of England Centre for Central Banking Studies)

Transcript

In this video we’ll see that the type of reserve ratio that’s discussed in the textbooks has never even existed in the UK. We’ll see that the liquidity ratios that did exist have been reduced and eventually abolished, and that even when they did exist, they only limited the speed that the money supply could increase, but put no limit on the total size that it could grow to.


We’ll learn that the Capital Adequacy Ratios and Basel accords are about preventing banks from going bust when loans go bad, rather than limiting their dangerous lending or limiting how much money they create through lending. And although the capital adequacy requirements can restrain lending after a banking crisis, it doesn’t do anything to restrain lending in a boom.


We’ll also see that there is no natural limit on how quickly the banks can create money.

Transcript

You might hear some people say that “Banks don’t create money – they just create credit”.


This response often comes from civil servants and people trying to deny that banks now create the nation’s entire money supply. So let us show you why the numbers that banks create are money, and not just ‘credit’.

The Guarantee that Makes Deposits Risk-Free:

From the Bank of England’s 2014 Q1 Quarterly Bulletin:

“When a consumer makes a deposit of his or her banknotes with a bank, they are simply swapping a Bank of England IOU for a commercial bank IOU. The commercial bank gets extra banknotes but in return it credits the consumer’s account by the amount deposited. Consumers only swap their currency for bank deposits because they are confident that they could always be repaid. Banks therefore need to ensure that they can always obtain sufficient amounts of currency to meet the expected demand from depositors for repayment of their IOUs. For most household depositors, these deposits are guaranteed up to a certain value, to ensure that customers remain confident in them. [The Financial Services Compensation Scheme offers protection for retail deposits up to £85,000 per depositor per Prudential Regulation Authority authorised institution.]



This ensures that bank deposits are trusted to be easily convertible into currency and can act as a medium of exchange in its place.” (McLeay, Thomas, & Radia, Money in the modern economy: an introduction, page 7-8)


Bank notes are “risk-free” money:

“Bank of England notes are a form of ‘central bank money’,

which the public holds without incurring credit risk. This is

because the central bank is backed by the government.”

(Bank of England Quarterly Bulletin 2010 Q4, p302)

Transcript

Remember how new money is created when a bank makes a loan?


WELL, when someone repays the loan, the opposite process happens, and money is actually destroyed. It effectively disappears from the economy entirely. This video explains how.

Money is destroyed when loans are repaid:


From the Bank of England’s 2014 Q1 Quarterly Bulletin:


“Just as taking out a new loan creates money, the repayment of bank loans destroys money. For example, suppose a consumer has spent money in the supermarket throughout the month by using a credit card. Each purchase made using the credit card will have increased the outstanding loans on the consumer’s balance sheet and the deposits on the supermarket’s balance sheet. … 

If the consumer were then to pay their credit card bill in full at the end of the month, its bank would reduce the amount of deposits in the consumer’s account by the value of the credit card bill, thus destroying all of the newly created money.


“Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 3)

Transcript

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