How is money really made by banks? – Banking 101 (Part 3 of 6)


Before we start looking at how money is really
created, we need to have a quick look at what types of money we actually use in the economy.
There’s actually three types of money that we use in the economy. As a member of the
public, you will only have ever used two of them. The simplest form is cash — the £5, £10,
£20 and £50 bank notes and the metal coins that most of us will have in our wallets at
any point in time. As you probably know, only the government, via the Royal Mint and the
Bank of England, is allowed to create these. If you try to make your own at home, pretty
soon you’ll get the police kicking down your door at 2 in the morning. Now imagine that you need to pay your rent,
and your landlord has an account with a different bank to you. When you log into your internet
banking and make the payment to your landlord, your bank has to send some money to your landlord’s
bank to ‘settle’ and complete the transaction. Of course, the banks don’t want to make
these payments to each other in physical cash because carrying all this money around is
dangerous, even if they use protected security vans and guards with bullet vests and helmets. So instead, they use a type of electronic
money, which is called ‘central bank reserves’. Remember that name because we’ll be using
it a lot in this video. Central bank reserves are effectively an electronic
version of cash, and banks use these electronic central bank reserves to make payments to
each other. The central bank reserves are created by the Bank of England — we’ll
cover how later on — and they can only be ‘stored’ in accounts that the big banks
have with the Bank of England. To get one of these bank accounts at the Bank
of England, you have to be a bank. So as members of the public, we can’t get our hands on
any central bank reserves. We just have to use the physical cash. So the first two types of money are 1) Cash
and 2) Central Bank Reserves. Remember that central bank reserves are like an electronic
version of cash that only the banks can use to make payments between themselves. The third type of money is a type of money
that isn’t created by the Bank of England, the Royal Mint or any other part of government.
This third type of money is the type of money that’s in your bank account right now. This money is just numbers in a computer system. Bankers and economists refer to this type
of money with jargon such as ‘bank deposits’ ‘demand deposits’, ‘sight deposits’
or ‘bank credit’. These terms all mean pretty much the same thing and are used interchangeably.
They might also be referred to as bank liabilities — this is the accounting term, because this
money is a liability of the bank to you i.e. it’s what the bank needs to repay you at
some point in the future. Now in a legal sense, the numbers in your
account aren’t really money at all. But despite that, they serve exactly the same
purpose as the £10 and £20 notes that you might hold in your wallet. It’s this type of electronic, bank-deposit
money that now makes up over 97% of all the money used in the UK economy. Less than 3%
of the money supply is cash created by the government. And all this electronic bank-money is created
by the banks, as we’ll explain now. The Balloon Model Let’s revisit the multiplier model that
we saw in the last video. Remember that it describes the money system as having a base
of ‘base money’. In the simplified version, the ‘base’ is made up of cash. In reality,
it’s not just cash in this base — it’s also the electronic central bank reserves
that banks keep in their accounts at the Bank of England. But it’s true that this base
is made up of money — either cash or electronic — that was created by either the Bank of
England or the Royal Mint. Now let’s look at the top of the pyramid.
The rest of the pyramid is made up of the third type of money — the electronic bank-created
money. So the pyramid is split up into a base of government-created money, and a tower of
bank-created money at the top. Remember that we said this pyramid, in theory,
is limited by the reserve ratio? Well, there is no reserve ratio, and there hasn’t been
for years. This means that the total amount of money
in the economy isn’t really limited. It can keep expanding without coming to a point
at the top. So the pyramid is actually the wrong shape
to describe the money system. In reality its closer to a balloon of bank-created
money, wrapped around a smaller balloon of base money. In this case, the base money is
the electronic central bank reserves and cash. As we’ll see in this video, the Bank of
England has relatively little control over the total size of the balloon of bank-created
money. They can’t really control how much money
is in the economy, even if they claim to be able to. The outer balloon of bank created money could
expand out of control and the Bank of England wouldn’t be able to stop it — at least
not within the current monetary system. We saw this happen before the crisis. In 2006,
the outer balloon of bank-created money was 80 times bigger than the inner balloon of
base money. The multiplier wasn’t 10 times, like the textbook models suggest: it was actually
80 times! And then when banks panicked during the crisis
and refused to lend, the Bank of England pumped a load of extra base money into the inner
balloon, through the scheme known as Quantitative Easing. But this didn’t lead to a massive
increase in the size of the outer balloon. Right now the outer balloon — the amount
of bank-created money — is only 14 times bigger than the inner balloon. This shows
that there is no real connection between the amount of central bank reserves — or base
money — and how much money that the banks are able to create. WHAT DETERMINES THE AMOUNT OF MONEY IN THE
ECONOMY? So what actually affects the ratio between
bank-created money in the outer balloon and government-created cash and central bank reserves
in the inner balloon? What determines how much money is created for the economy? The research that we have done suggests that
the amount of money that banks can create is not determined by reserve ratios, or by
regulation, or by the control of the Bank of England. The reality is that the total amount of money
depends on the confidence of banks. If they’re feeling confident, banks will create new money
by lending more. And when they’re scared, they limit their lending, which limits the
creation of money. So the size of the outer balloon really depends
on the confidence and incentives of the banks. Or to put it another way, the amount of money
in the economy depends on the mood swings of bankers. Given that the amount of money in the economy
can determine the health of the economy, does it sound like a good idea to have such an
important thing decided by the mood swings of bankers? Probably not! EXACTLY HOW BANKS CREATE MONEY OUT OF NOTHING OK, back to the numbers in your bank account.
These numbers are all created by banks. The vast majority of these numbers were created
when somebody took out a loan from a bank. Let’s see how this happens. A customer, who we’ll call Robert, walks
into a Barclays Bank and asks to borrow £10,000 for home improvements. Barclays runs a quick
automated credit check and decides that the customer can be relied on to keep up repayments
on the loan. The customer signs a loan contract promising
to repay the £10,000, plus the interest, over the next 4 years, according to an agreed
monthly schedule. This loan contract is a legal contract that
binds the customer to make repayments to the bank. This means that it is a legal contract
that is considered to be worth £10,000 (plus the interest). Because it’s an asset, Barclays can record
the loan on its balance sheet. Now if you haven’t come across a balance
sheet before, don’t worry — it’s pretty simple. There’s two parts to a balance sheet. One
half records all the things that the bank owns — this could be money, other financial
products like bonds and derivatives, bank buildings, computers, and most importantly,
the loans it has made. How can you own a loan? Well, if someone signs
a contract promising to pay you money, then that contract is worth something. It’s considered
an asset of the bank. In the case of Robert, the contract that he
signs promising to pay the bank £10,000, plus interest, over the next few years, is
worth at least £10,000 to the bank, and therefore it’s an asset to the bank. So the bank puts an extra £10,000 on its
balance sheet, like this: BARCLAYS BANK BALANCE SHEET (Step 1) (Left side) Assets
(What the borrowers owe to bank + bank’s money)
Loan to Robert: +£10,000 Now what about the other half of the balance
sheet? The other half of the balance is what’s
called the Liabilities. This is a record of everything the bank owes to other people.
On this side, you’ll find a record of money that the bank has borrowed from other banks
or large pension funds. You’ll also find all the customers accounts, because — if
you remember — the balance of your account is just a number showing what the bank promises
to pay you when you ask for your money back. When Robert signed the contract promising
to pay the bank £10,000, plus interest, over the next 10 years, he did it because he wanted
some money from the bank. So the bank creates a new account for Robert, which is linked
to his debit card, and just types £10,000 into their computer records. This £10,000
is a liability from the bank to Robert, and it shows up on the other half of the balance
sheet. (Right side) Liabilities
(What the bank owes to the depositors + bank’s net worth)
Robert’s new account: £10,000 Now when Robert goes to the cash machine to
check his balance, he’ll see £10,000 which he didn’t have before. All the bank has done to create this new money
is type some numbers into an account. It hasn’t reduced the balance of anyone else’s account,
and it hasn’t taken any money from some pensioners and moved it into Robert’s account. So the process of creating commercial bank
money — that’s the money that the general public use — is as simple as: 1. a customer signing a loan contract and
2. the bank typing numbers into a new account set up for that customer This new bank-created money represents new
spending power — or money – in the economy. Robert can now go and spend his money anywhere
in the economy, using his debit card, cheque book, internet banking transfers, or even
by taking the cash out of the ATM. INTER-BANK SETTLEMENT: ONE PAYMENT But there’s a small complication. What happens
if Robert goes and spends the new bank-created money with a shop that has a bank account
with a different bank, say Lloyds? If this happens, then Lloyds will want to
see £10,000 of real money from Barclays. Barclays would then need to transfer £10,000
of central bank reserves to Lloyds to settle the transaction. Note that from the point
of view of Lloyds, receiving a transfer of £10,000 in central bank reserves into its
account at the Bank of England is just as good as Barclays pulling up in a truck and
dropping off £10,000 in cash, although it’s much more convenient for the banks to have
the electronic central bank reserves than to have to carry around all that cash. This process of banks making payments between
themselves is called inter-bank settlement, and it’s really important to understand
it, because it’s crucial to the way that banks have been able to gain control of the
entire money supply. First, let’s look at the simplest example
of inter-bank settlement, with just two banks and two customers. Robert, when he receives his loan, goes straight
to a DIY store and spends £10,000 on everything he needs. He gets to the checkout and pays
using his visa debit card. Here’s a simplified version of what happens behind the scenes: First, the DIY Store’s debit card machine
automatically contacts Visa and say “Please charge £10,000 to this card number: xxxxxx”. Visa’s computer systems then dial up Barclay’s
computer systems and say “Robert’s trying to spend £10,000 on his debit card. Is that
ok?” Barclays’ computer system checks the balance of the account and says “Yes”.
Barclays computer system then reduces the balance of Robert’s account by £10,000. Now, Visa’s computer system contacts the
Lloyds, and says “I’m sending you £10,000 for the DIY Store’s account”. Lloyds then
updates the balance of the DIY Store by £10,000. However, importantly, when the owners of the
DIY store log into their internet banking, they see two figures. One says “Account
balance”, and the other says “Available now”. For the next couple of days after
Robert has come into the shop, the Account balance will be £10,000 higher than the Available
Now balance. The £10,000 that Robert spend isn’t available to the DIY Store for them
to spend just yet. Why? Well, behind the scenes, Barclays needs to
settle with Lloyds. When Lloyds gets the message that someone has spent £10,000 in the DIY
store, it updates their account balance, and then calls Barclays to say “Send me the
money…”. Barclays could settle with Lloyds by delivering
the £10,000 in cash, but in reality this is just a hassle for both banks. They’d
have to find somewhere to store all the cash, and a van with security to transport it. So
instead, Barclays will settle by making a £10,000 transfer from its reserve account
at the Bank of England, to Lloyds reserve account at the Bank of England. Once Lloyds gets the £10,000 in its account
at the Bank of England, then it will update the Available Balance in the DIY Store’s
account. INTER-BANK SETTLEMENT: MULTIPLE PAYMENTS Now, this was a simple example that involved
just one payment between two bank customers (Robert and the DIY store). Only two banks
are involved. But in the UK right now there’s around 50
million people with bank accounts. Some of these people make more than one electronic
payment a day. And they bank with over 50 different banks. In fact, every day over 60 million transactions
are made between bank accounts in the UK, through a number of different payments systems
including Visa, Mastercard, direct debit and online bank transfers. If banks had to go through the whole hassle
in the example with Robert every time someone bought a sandwich from a supermarket using
their debit card, it would get very messy very quickly. But there’s a clever way of simplifying
the whole thing massively. It’s called multi-lateral net settlement. When you have a lot of individuals and businesses
all making payments to each other, that’s a lot of money flowing between the different
banks. So what the banks do, especially with systems
like BACS (which manages direct debits and the type of bank transfers that you make via
internet banking), is this: First, they put all the payments into a big computer database
first without actually moving any real money — cash or central bank reserve — about. Then, at the end of the day, or every few
hours, they run a process to cancel out all as many of the payment flows as possible. For example, imagine a customer at Lloyds
sends his rent – £350 — to his landlord’s account at Barclays. But on the same day,
a customer at Barclays sends his own rent – £400 — to his landlord, who happens to
be at Lloyds. The two payments almost cancel each other out, so after cancelling out — or
‘netting’ in the official jargon — the only money that really needs to be moved is
£50 from Barclays to Lloyds. Because there are millions of payments being
cancelled out by this system, the amounts that actually need to be transferred between
the banks at the end of the day are usually just a tiny fraction of the total value of
the payments made. This is why, even though in 2007 RBS customers
had nearly £700 billion in its customers accounts, RBS itself only had £17bn that
it could actually use to make payments on behalf of those customers. This £17bn was
more than enough for the total netted payments that it would need to make at the end of each
day. FRACTIONAL RESERVE BANKING This netting out effect means that a bank
only needs to have a very small amount of available money compared to the total amount
that they owe to customers at any particular time. They know that any payments they make
to other banks are likely to be cancelled out by payments coming back to it. On some days, the banks customers will spend
more than they receive, and at the end of the day the bank must pay some of its money
across to other banks to settle these payments. But on other days, customers will receive
more — in salaries and other income — that they pay out, and the bank will end up receiving
money from other banks at the end of the day. Over time, the total amount of money needed
by the bank doesn’t change much. The only time that they would actually need all the
money that they owe to their customers is if customers were to panic and ask for all
their money back at the same time. This is what happened to Northern Rock in the UK and
Wachovia in the US, and it can destroy a bank very quickly. This process is what gave rise to the term
‘fractional reserve banking’, because banks only keep enough money to repay a fraction
of their customers at any time. RESERVE ACCOUNTS & REAL-TIME GROSS SETTLEMENT We’ve talked about the central bank reserves
that banks keep in their accounts at the Bank of England. These ‘reserve accounts’ don’t
store cash — just electronic central bank reserves. It’s important to appreciate that, although
central bank reserves are created by the Bank of England, they’re still just numbers in
a computer system. These numbers are just stored on a file very similar to an Excel
spreadsheet, and we could create a billion of them in the time it takes to type out 1,000,000,000. The £150 billion of central bank reserves
are no more tangible than the numbers on this screen, and in fact, the entire record of
balances of the central bank reserves scheme will take up less space on the Bank of England’s
computer hard drive than the average song on an MP3 player! Now the computer system that records all these
central bank reserves is referred to the Bank of England as the Real Time Gross Settlement
Processor — or RTGS Processor. Now real-time gross settlement isn’t as
complicated as it sounds. Settlement simply means that it’s a system
that banks can use to settle their payments to each other — in other words, it’s a
way for them to transfer money to each other. ‘Real-time gross settlement’ means that
any payment instruction sent to the computer system is processed immediately. If a payment
of £100,000 is sent to the system, £100,000 will be transferred automatically. This is
in contrast to multi-lateral net settlement that we discussed just before, in which all
the payments are queued up, cancelled out against each other, and only the final net
difference is transferred. When a payment is put through the RTGS processor
it’s considered to be final. It’s also considered to be risk-free: If one bank owes
money to another bank, there’s always a small chance that it won’t be able to pay
the other bank. But once the money has arrived in the central bank reseve account, then the
deal is finished, because holding central bank reserves is just like holding cash — it’s
the safest asset you can have. So at the end of the day, the multi-lateral
net settlement payment systems will cancel out all the smaller payments between different
banks, and then they’ll tell the Real Time Gross Settlement Processor how much the net
differences owed between the banks should be. The RTGS system will then transfer the
central bank reserves from the banks that owe money to the banks that are owed money. RECAP So, let’s recap everything we’ve covered
so far, before we look into what actually determines how much money the banks can create. We’ve seen that the textbook model of money
creation suggests that there’s a base of central-bank or government created money,
on top of which the commercial banks can blow up the total money supply by re-lending the
same money over and over again. We saw that this model is actually completely
inaccurate. There’s no natural limit to how big the money supply can grow, so it’s
actually better to think about this as two balloons rather than a pyramid. We saw that banks can create money by simply
typing numbers into a customers’ account when they make a loan. When you sign the contract
the bank gets an asset that balances out the new liability they create when they type numbers
into your account. When a customer spends the money the bank
has just created, and those payments go to customers of other banks, then the other banks
will call the bank that created the money and ask for them to settle in central bank
reserves. But before this happens, payment systems like BACS and Visa debit will cancel
out the payments against each other, so that only the net difference at the end of day
has to be ‘settled’ i.e. transferred between the banks. This netting out significantly reduces how
much money banks really need to keep at any particular time. In a few minutes, we’ll see what actually
limits how much money the banks can create. But first, it’s worth asking whether the
numbers that banks create can really be considered money…

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