Understanding How Banks Create Money: A Comprehensive Guide

1. Monetary reform

2. What is money?

3. What is money?

4. What is money?

5. What is money?

6. What is money?

7. What is money?

8. How banks ‘create’ money

9. How banks ‘create’ money

10. How banks ‘create’ money

11. How banks ‘create’ money

12. How banks ‘create’ money Bank owes Zane: £2,100 - This is added to Zane’s current account at Barclays

13. How banks ‘create’ money Barclays owes Zane: £2,100 - This is added to Zane’s current account at Barclays Zane owes Barclays: £2,100 + interest - Bank adds this to its list of assets

14. How banks ‘create’ money

15. How banks ‘create’ money

16. How banks ‘create’ money

17. How banks ‘create’ money Barclays reduces amount it owes Zane by: £1,000 - This is taken away from Zane’s current account at Barclays

18. How banks ‘create’ money Barclays reduces amount it owes Zane by: £1,000 - This is taken away from Zane’s current account at Barclays Barclays increases amount it owes Cyclelab by: £1,000 - This is added to Cyclelab’s current account at Barclays

19. How banks ‘create’ money

20. How banks ‘create’ money

21. How banks ‘create’ money Barclays reduces amount it owes Zane by: £1,000 - This is taken away from Zane’s current account at Barclays

22. How banks ‘create’ money Barclays reduces amount it owes Zane by: £1,000 - This is taken away from Zane’s current account at Barclays Barclays reduces amount of deposits it has at Bank of England by: £1,000

23. How banks ‘create’ money Barclays reduces amount it owes Zane by: £1,000 - This is taken away from Zane’s current account at Barclays Barclays reduces amount of deposits it has at Bank of England by: £1,000 Cooperative Bank increases amount of deposits it has at Bank of England by: £1,000

24. How banks ‘create’ money Barclays reduces amount it owes Zane by: £1,000 - This is taken away from Zane’s current account at Barclays Cooperative Bank increases amount it owes Look Mum No Hands by: £1,000 - This is added to Look Mum No Hands current account at the Cooperative Barclays reduces amount of deposits it has at Bank of England by: £1,000 Cooperative Bank increases amount of deposits it has at Bank of England by: £1,000

25. How banks ‘create’ money • In reality:

26. How banks ‘create’ money • In reality: • Banks cancel out transactions between each other at the end of the day

27. How banks ‘create’ money • In reality: • Banks cancel out transactions between each other at the end of the day • Then work out how much in Bank of England reserve deposits they need to transfer to each other

28. How banks ‘create’ money • In reality: • Banks cancel out transactions between each other at the end of the day • Then work out how much in Bank of England reserve deposits they need to transfer to each other • The larger the bank, the fewer reserves it needs in comparison to its lending, because more transactions take place within it

29. What are central bank reserves?

30. What are central bank reserves? They are created by the Bank of England to enable banks to complete transactions with each other.

31. What are central bank reserves? They are created by the Bank of England to enable banks to complete transactions with each other. They originally enter the system by banks borrowing them from the Central Bank.

32. What are central bank reserves? They are created by the Bank of England to enable banks to complete transactions with each other. They originally enter the system by banks borrowing them from the Central Bank. Banks can borrow from the Bank of England ‘overnight’, at the interest rate set by the Monetary Policy Committee.

33. What are central bank reserves? They are created by the Bank of England to enable banks to complete transactions with each other. They originally enter the system by banks borrowing them from the Central Bank. Banks can borrow from the Bank of England ‘overnight’, at the interest rate set by the Monetary Policy Committee. To do so, banks must have UK government bonds as collateral.

34. What about cash? The Bank of England will swap central bank reserves for cash, and cash for central bank reserves, with banks. Banks need to hold cash in order to meet demands on it from depositors – ie, to pay debts that they owe.

35. What about cash? Barclays gives Zane £100 in cash • Barclays replaces £100 cash by: • Taking £100 in deposits from businesses it is spent in • Turning central bank reserves into cash • - If needed, it may need to borrow more central bank reserves from other banks, or Bank of England Barclays reduces amount it owes Zane by: £100 - This is taken away from Zane’s current account at Barclays

36. Can banks ‘create’ money? They can create deposits in accounts of customers They cannot create reserve bank deposits or cash But they need reserve bank deposits or cash whenever their customers want to buy things

37. What happens when Zane repays loan? Barclays gets: £2,100 + £400 interest in reserve bank money - Bank removes this from its list of assets Barclays gets: Most of this reserve bank money always existed somewhere in system But deposit which was created no longer exists. Money has been deleted.

38. How much money is there in the UK?

39. What if Zane does not repay the loan? • If Zane hasn’t spent the money: • No problem. But he has: Barclays has to remove £2,100 from its list of assets But Barclays has lost £2,100 in central bank reserves

40. How do banks go bust? • Owing more than they are owed • If a bank has more liabilities than assets, it is bankrupt • Banks are not allowed to trade in the UK if they are bankrupt

41. How do banks go bust? 2) Not being able to make debt payments when they come due Eg, a cash withdrawal, repayment of central bank reserve loan, not having enough central bank reserves to move a deposit to another bank In reality, the Central Bank can provide new loans to ensure bank can do all these things, but not if the bank is bankrupt

42. How do banks go bust?

43. How do banks go bust?

44. How do banks go bust?

45. What limits how much banks lend? • Likelihood of being repaid • Banks risk being bankrupt if too many of their loans are not repaid (in UK, in reality managers of banks lost little, and lenders to banks nothing. Shareholders did lose out) • 2) Having enough central bank reserves and cash to meet payments and cash withdrawals

46. Regulations • Reserve requirements (apply to how deposits are used) • These say that banks need to hold a percentage of deposits in reserve rather than lending it out, say 10% • None exist in the UK • Therefore, fractional reserve banking does not exist in the UK • They do exist elsewhere, including the US and China

47. Regulations 2) Capital adequacy requirements (apply when loans are given) Money set-aside in order to pay for defaults on loans – ie, to ensure assets are more than liabilities Come from equity investments, and retained profits (money which has not been lent to the bank) International agreement first introduced in 1988, Basel I. Basel III recently agreed.

48. Regulations • 2) Capital adequacy requirements (apply when loans are given) • Loans given a risk weighting. Business loans 100% risk. Mortgage loans 35% risk (because bank owns the house if a default – there is collateral) • So, if capital adequacy ratio of 8% • For £100,000 business loan, need £8,000 of capital in reserve • For £100,000 mortgage loan, need £2,800 of capital in reserve

49. Regulations 2) Capital adequacy requirements (apply when loans are given) Exist to prevent banks becoming bankrupt (!), not to control lending

50. 1) Positive money: Full reserve banking • Money in current accounts cannot be lent to anyone else. It sits as electronic cash at the Bank of England. • Money for lending is put in an ‘investment accounts’. Savers choose how long they are willing to be without their money – say two years. The money is then lent to someone for two years. The lender can’t access the money in the meantime, the borrower has to repay after two years. • If loan not repaid, saver loses money (two year loans could be pooled, so lose a proportion depending on how many not repaid).