Modern banking: how does it work?

Most of us rely on our banking arrangements without giving great thought to the structure of modern banking.   We dreamily assume that our bank provides a safe place to store our money, and that the money it lends to us or to others is ‘real’ money.  We assume that this money has been ‘earned’ in some way through the honest toil of other bank depositers, or has been generated through some process organised and overseen by the sovereign state. 

It can come as a shock to realise that the process of generating money is one that now rests largely in private hands (those of the banks) and that it consists of creating debt. The New Economics Foundation publication Good Banking explains this well.   This is the relevant section of their report, and forms part of their critique of the Vickers Commission.

‘We have become dependent on the banking sector to provide the money supply for the nation. That means that an essential economic utility that should function for public benefit, is operated by private hands and motivated by the maximisation and capture of profits privately. Money is put in to the economy as debt. We should take away the virtual monopoly enjoyed by the banks over the creation of money, so that its benefits can be captured for public benefit by other actors including the state. Banks could then have their original function, more as intermediaries restored.

The ICB appears to have misunderstood this fundamental issue about how modern banks actually operate. On page 16 of their report there is definition of lending which states the following:

‘However, banks do not take deposits simply to provide safety for the savings of the public. They use funds that are deposited with them to provide loans to businesses to allow them to undertake productive economic activities, and also to consumers…’

But this is just a remarkably resilient fiction, and has been since the birth of modern banking in the UK in the second half of the seventeenth century.

When a bank makes a loan it does not take other people’s deposits and lend them out. This would imply that no new bank deposits are created in the economy when a bank makes a loan. When a bank makes a ‘loan’ it simply types in to its account that the borrower owes it a sum of money – this is the bank’s asset. It also types into the customer’s account that he has a bank deposit of the same amount – this is the bank’s liability. No other customers’ deposits are altered in any way.

The borrower then spends that loan somewhere else. The bank has thus created new purchasing power without removing purchasing power from anyone else. After the loan has been spent, it ends up in another (or even the same) bank as a deposit. An electronic demand deposit in a bank is money. It will be accepted by everyone in the UK economy because it carries the same status as sterling paper notes and is accepted to pay tax. Deregulation and advances in technology (in particular debit and credit cards) mean that 97% of the money in the UK is this ‘bank-money’; only 3% is created by the central bank as paper notes.

The implications of this fact are enormous. Banks create nearly all of the new ‘money’ in our economy through their loan activity. They play an absolutely central macroeconomic role. The tens of thousands of loan officers making decisions everyday about who should receive loans are shaping the outcomes of the economy. The Bank of England is barely able to affect the amount of credit, or money, that the banks create and no authority has any say over how banks allocate this new credit.

The ICB’s suggestion that banks allocate money to ‘productive economic activities’, has no basis in empirical reality. The last two decades of actual banking activity in the UK tells us that banks tend to prefer creating credit for either short term speculative returns (financial market trading) or longer term non-productive credit creation (mortgages and commercial property).

nef advocate an approach close to ‘Full Reserve Banking’ as opposed to the ’Fractional Reserve Banking’ as has operated in virtually all economies for a very long time.  Full Reserve Banking is viewed by most mainstream economists as impractical and inefficient, although it has gained more supporters since the credit crunch.

Wikipedia gives a more mainstream account of the creation of money:

In economics, money creation is the process by which the money supply of a country or a monetary region (such as the Eurozone) is increased due to some reason. There are two principal stages of money creation. First, the central bank introduces new money into the economy (termed ‘expansionary monetary policy‘) by purchasing financial assets or lending money to financial institutions. Second, the new money introduced by the central bank is multiplied by commercial banks through fractional reserve banking; this expands the amount of broad money (i.e. cash plus demand deposits) in the economy so that it is a multiple (known as the money multiplier) of the amount originally created by the central bank.

Through fractional-reserve banking, the modern banking system expands the money supply of a country beyond the amount initially created by the central bank.[4] There are two types of money in a fractional-reserve banking system, currency originally issued by the central bank, and bank deposits at commercial banks:[5][6]

1.    central bank money (all money created by the central bank regardless of its form, e.g. banknotes, coins, electronic money)

2.    commercial bank money (money created in the banking system through borrowing and lending) – sometimes referred to as checkbook money[7]

When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, more commercial bank money disappears from existence. Since loans are continually being issued in a normally functioning economy, the amount of broad money in the economy remains relatively stable. Because of this money creation process by the commercial banks, the money supply of a country is usually a multiple larger than the money issued by the central bank; that multiple is determined by the reserve ratio or other financial ratios (primarily the capital adequacy ratio that limits the overall credit creation of a bank) set by the relevant banking regulators in the jurisdiction.

What is clear is that the UK has moved to a scenario in which a far higher proportion of money is created via private banks than was the case 50 years ago.

The New Economics Foundation claims that the loans of the top ten UK banks are 450% of national annual output, whereas in 1960 it was 60%.  No Government asked the public whether we wanted to see this change, or what it might mean for us in the long-term.   We are now faced with a very uphill struggle to regain control from an embedded and powerful part of the economy, seemingly beyond the reach of any government.


Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>