Monday, 16 August 2010

I know how much money you've got in your bank account

The answer, assuming you're not a bank or the government, is none at all. Let me explain.

A long time ago, banks used to issue their own bank notes. The banks promised to pay the bearer of the notes, on demand, the amount of "real" money that the note promised, say in silver coins. It was the bank that guaranteed the value of the notes, and if the bank became insolvent (i.e. owed more than what it was owed plus what it had in its vaults), the bank notes could not be paid in full. But since the advent of central banking, with Bank of England bank notes, that arrangement is long gone. Or is it?

What happens when you open a new bank account? Actually it's quite simple.

You go to your local branch of Lloydclay's Bank of Corporation, and ask to open a current account. They say, "certainly" (as long as you promise to deposit £1,000 per month). You decide to hand over two £10 Bank of England notes. What happens then? Are those notes stored somewhere for you, so that when you ask for them later, you can get them back?

No. That's not the way it works. What happens is that the bank makes a note in a book (or these days in a computer database) that it owes you £20. It then uses the £20 in Bank of England notes in whatever way it decides to. For example, it could lend them to someone else, or give them to someone else who wishes to withdraw £20 which they deposited earlier. What you've actually done is exchanged money (Bank of England notes) for bank credit. The bank promises to pay you money if you ask for it. But it can only do that if it hasn't lost the money which you deposited.

Imagine you're the first depositor. The bank then lends the £20 you deposited to someone who is setting up a company to manufacture pins. But instead of buying a pin-making machine, the borrower instead goes out, buys 10 pints of lager and drinks them. Now there's a problem. The borrower can't make pins, so he can't sell pins to make £21 to pay back to the bank (£20 plus interest). So when you walk into the bank to ask for your £20 back, the bank can't pay. So the bank credit is worthless. You exchanged some money (Bank of England notes) for a promise by the retail bank to pay you money later, but the retail bank can't pay you, so you lose. You'd have been better off stuffing the money in your mattress. Bank credit is directly analogous to a bank note issued by the retail bank - it is a promise by the bank to pay you in money (Bank of England notes) when you ask for it. But the value of the bank credit is entirely predicated on the ability of the retail bank to pay.

So having a positive balance in an account at a retail bank doesn't mean that you have money. All you have is a promise by the bank to pay you money if you ask for it and if the bank has enough money to pay you.

This situation is highly unsatisfactory - it (rightly) causes people to panic easily. If a rumour goes around that bank X only has £1 million, but owes £2 million to depositors, then people who rush to withdraw their deposits will get all their money back, while the slower ones will get nothing, so a bank run ensues. Two important safeguards are in place for (some) depositors:

1. Banks are required by law to maintain capital. This is a certain amount of money (or investments which can easily be sold for money, such as risk-free (cough!) government bonds) which the bank must keep in order to pay depositors in the event of losing money on their loans. In the case above, the bank made a bad loan to the supposed pin-maker, and so the owners of the bank (the shareholders) have to pay the £20 to you. As long as the losses do not exceed the capital, only the shareholders will lose money. But if the losses are greater than capital, someone else will lose money. This requires a second line of defence for the depositor:

2. In the UK, the Financial Services Compensation Scheme (FSCS) is a government-run guarantee of some deposits for individual and some other types of depositor. (Similar schemes operate in other countries e.g. FDIC in the USA). When a bank cannot meet its obligations, the government takes money from other banks and building societies to pay back the depositors of the failed bank, or if absolutely necessary takes money through taxation to pay.

I want to emphasise again: if the bank's losses are greater than the bank's capital, someone else will lose money. The only question at this point is who. Because the government has decided that depositors will be protected, the money is instead taken from other banks or building societies, or from taxpayers. This is actually a subsidy from good banks and building societies which manage their risks well and/or from taxpayers to bad banks which chase slightly higher returns with much greater risk.

In principle, the FSCS ought never to be invoked. The shareholders, who would lose their capital in the event of the FSCS being used, should prevent the bank from losing this much money. But if the bank's directors and employees can make high-yielding loans that look like a reasonable risk-reward compromise to shareholders in the short run, and they pay themselves big bonuses as a result, then the shareholders may not be able to organise themselves quickly enough to prevent the losses.

This blog has looked at money and bank credit. In a later post, I'll discuss the different forms of money. It's not just bank notes, you know, but it's not much more than that.

Update [2015-03-23]: Removed description of Bank of England notes as "real" money, as it is controversial, but not particularly important here.

My use of the terms "money" and "bank credit" have also lead to some controversy, as people have (rightly) pointed out that bank credit is a form of money. (In the UK, bank credit is counted in the M4 measure of the money "supply" or, as I prefer to say, the quantity or stock of money. What I have called money in my blog is the monetary base – money created by the central bank.) My intention is to use simpler non-technical terms here, since terms like "monetary base" used to make my eyes glaze over. But I do need to distinguish between central bank money and retail bank credit, since it is very important in understanding why the ability of banks to create money does not allow them to consume without producing.


  1. Sorry, but this account is flawed by reason of its omitting one entire step.

    The opening passage describes loan banking, by which money loaned is exactly matched by money owed (IOU's). If the borrower (your pinmaker) can't repay, that IOU is worthless and the bank has to write it off. So far so simple. That's 100% reserve banking.

    You then switch to fractional reserve banking, without any accompanying explanation, and this is a fatal omission because the two forms of banking are chalk and cheese.

    With FRB, and reserve ratios at or above 20%, bad debts can be shrugged-off. All the bank loses is the interest on them. The money loaned came out of thin air not out of the bank's capital, and there's nothing to stop the bank immediately making another loan (this time, it hopes, good) of exactly the same amount to someone else, and earning the interest on that instead.

    Obviously, banks seek to minimize the number of bad loans they make so as not to alarm their shareholders (or the markets) too much. But that's e separate matter entirely.

  2. First, thanks for your comment, and sorry for the delay in responding. This blogging lark's new to me, and after not getting any comments for a long time I'd not been checking them very frequently.

    While you're right that the first example shows 100% reserve banking, it doesn't actually matter, as the later posts show. Bad debts simply can't be shrugged off - making a loan (creating bank credit) allows the borrower to spend some money which the bank previously had. Once the borrower has withdrawn the money, it's gone, and can only be recovered if the borrower repays it.

    This is described in some detail in the later post:

  3. I'm not getting through to you, am I?

  4. OK. Not to give up in despair, I'll make another try :-)

    Can I put a straight question to you:- have you grasped the difference between 100% reserve banking and fractional reserve banking?

    Since you say above "it doesn't actually matter" I'm forced to conclude that you haven't - and other things you've written tend to reinforce this suspicion. Until you have grasped it, you have no business to be holding forth on the subject, I would - regretfully - suggest.

    Under FRB, banks are currently legally entitled to lend out 34 times the amount of money they actually own. Since they don't own it, if a borrower defaults they can't lose it because it was never there in the first place to be lost! It's nothing more than a book-keeping entry. They also acquire title to whatever was pledged by the borrower as security for the loan - a car, a house, whatever.

    Naturally they get worried if the volume/value of bad debts is on a rising trend because that casts doubts on their judgment. This is exactly what has happened since the current debt crisis broke, and Northern Rock was busted by it (because NR borrowed short and lent long). All the large banks hold unquantified amounts of so-called "toxic" assets at the present time.

    It's the volume and the unquantified nature of these bad debts which is causing them problems. Most of them are "off balance-sheet" anyway we are told. Furthermore they are held by the investment banking arms of these banks and in principle have nothing to do with deposit banking, to which the concept of 100% reserves pertains. Investment is speculation (aka betting) and as we've all been warned "the value of investments can go down as well as up".

    Or is the distinction between investment banking and deposit banking yet another that you haven't grasped or choose not to acknowledge?

  5. Robert - I appreciate you taking your time to read and criticise what I have written, and to debate with me, but please be patient and don't assume that I don't know things just because I haven't explicitly written about them yet.

    I assure you that I do understand what fractional reserve banking is. Thanks for pointing out that I haven't actually done an example yet where the amount of bank credit outstanding is greater than the amount of money which the bank holds. I'll be sure to do one soon.

    I suppose the posts so far have been refuting the suggestion that creating bank credit 'out of thin air' is fraudulent. I still need to make an explicit argument to justify that fractional reserve banking is also perfectly reasonable.

    It wouldn't be very effective responding to your other points in detail here because I'm going to need some HTML. But I will challenge your idea here that banks don't lose anything if a borrower defaults. As I've discussed already, when a bank makes a loan to someone who then spends it, the bank must transfer that amount of money at the borrower's request. If the borrower then defaults, there's no way for the bank to get that money back - they have lost it and are now poorer. The promissory note asset is removed from the balance sheet, and to maintain balance the shareholder equity (amount owed to shareholders) liability is decreased by the same amount. Therefore the owners of the bank are poorer.

    In that argument, I have not needed to discuss reserve requirements at all. Whether you have fractional reserve requirements or full reserve requirements, the default by a borrower leads to a loss to the bank, and consequently the bank's owners.

  6. And the collateral pledged by the borrower as security for the loan...? certificates...?

  7. "Thanks for pointing out that I haven't actually done an example yet where the amount of bank credit outstanding is greater than the amount of money which the bank holds. I'll be sure to do one soon".

    So, you blithely acknowledge that you have not yet got around to dealing with fractional reserve banking in the same format as you have used in your illustrative examples. You will, you say, be getting around to that.

    But meanwhile you have gone ahead to make a whole series of assertions about the way banking works, many of which have no validity in regard to the banking practice you have not yet dealt with - fractional reserve banking. What is your purpose in doing this, given that 100% reserve banking is virtually non-existent? Has it somehow escaped your notice that in the world we actually inhabit fractional reserve banking is the system (for all practical purposes the only system) of banking that is available?

    What is the relevance of a study which purports to discuss banking - and more importantly purports to have refuted the criticisms which are made of fractional reserve banking - without first having explored with at least equal thoroughness as that devoted to 100% banking - how fractional reserve banking works? Such an approach strikes me as either perverse or as intended to mislead.

    You lightly brush aside this stunning omission, as if it had no bearing on the arguments you have advanced. In fact, it is absolutely crucial to the whole debate.

    I must admit I have begun to wonder what your motives might be.

  8. "And the collateral pledged by the borrower as security for the loan...? certificates...? "

    If you have a loan secured against collateral, the bank can recover (some of) its loan. That's why secured loans have significantly lower rates of interest.

  9. "So, you blithely acknowledge that you have not yet got around to dealing with fractional reserve banking in the same format as you have used in your illustrative examples. You will, you say, be getting around to that."

    Robert, first I want to say that while I very much appreciate your feedback, can I just ask you to use a less sarcastic tone? I find it grates rather a lot. While I don't mind in the slightest that you don't believe my arguments, I'd appreciate it if you would at least be prepared to accept that I might have thought about this whole subject in depth.

    As to your specific criticism above, when I responded to one of your other comments, I realised that the case of fractional reserve banking requires almost no change to the example in the "Creation of bank credit" post, and the change that it does require is entirely incidental. The argument that the bank is risking its own money is independent of the reserve requirements.

    In that example, the bank has 100,000 shillings in the BoS, and lends 10,000 to Mr Smith. To illustrate fractional reserve banking, we could simply add another loan to the balance sheet:

    Deposit at BoS: 100,000
    Promissory note (Mr Smith): 10,000
    Promissory note (Mr Lettuce): 500,000

    Money owed to bank owners: 100,000
    Deposit (Mr Smith): 10,000
    Deposit (Mr Lettuce): 500,000

    The bank has created more bank credit than it has in money. It has a fractional reserve.

    If Mr Smith withdraws his 10,000 shilling deposit, the bank's deposit at BoS drops to 90,000 shillings. If Mr Smith then defaults, the bank writes off his promissory note, and then reduces its shareholder equity (money owed to bank owners) liability, so the owners are now owed just 90,000 shillings. The bank owners have therefore lost 10,000 shillings.

  10. I've realised by now that it's by no means a case of any inability on your part to understand, but of a conscious decision to refuse to understand. I aplogise for the sarcasm, which was the outcome of sheer frustration on my part.

    The issue is a moral one, and if you can't or won't see that then I can only conclude, sadly, that you are morally blind. Needless to say - though I'll say it anyway, - that has no correlation with intelligence, and I'm certainly not questioning yours. But in my eyes you have somewhere gone horribly wrong.

    Thinking about it further what seems to me to have happened is that at some point you have decided that what you're examining is an ethically-neutral "sytems" problem reducible to balance-sheet analysis. That's your prerogative of course. But I'd like to leave you in no doubt that that isn't the way I (or a lot of other people) see it. We see it as entirely unethical from top to bottom, as having had disastrous social and economic consequences and (as if all that weren't already bad enough) as having come about as an almost incidental consequence of a completely mistaken legal judgment - judges after all being only human, like the rest of us. The system, in other words, cries out on social and practical grounds for root-and-branch reform.

    Forgive me, but you seem to me to inhabit a value-free universe.

  11. Do you know about the court cases which during the 19th century created the legal basis for fractional reserve banking? If you do you will be aware that the issue in dispute was whether money on deposit in a bank (and that meant gold, then) was a debt or a bailment. The decision was that because it was not discretely identifiable (by being contained in its own marked bag) but was fungible, it was no longer the depositor's property but was instead a loan made by him to the bank which the bank was entitled to make use of in any way it wished in the course of its business. In the event of the bank's failure the depositor became merely one among the creditors and would be most unlikely to recover more than a fraction of his money.

    This judgment meant that a sum deposited could legitimately be taken onto the bank's balance-sheet, as an asset, and the obligation to repay that same sum on demand appear as a liability. Fractional reserve banking was thereby legalized; all that remained to be decided was what the ratio of loans made to cash deposited was to be (and that never became a matter for the courts anyway).

    So much is history. In no way does simply re-telling it provide an answer to the question:- was the judges' decision right? That is an ethical question, as well as a legal one.

    Even from the narrowly technical legal point of view, many people would say it was wrong and arose from the judges' misdirecting themselves as to what had been the purpose of depositing money in a bank on the first place: it had been in fact for safekeeping. Depositors had certainly not perceived it as a loan to the banker because - unlike a loan - its return could be demanded at any time, just like that of a piece of furniture deposited in a furniture depository. By the same token, rather than that any interest could be demanded on it by a depositor, he had traditionally been charged for its safekeeping. In the law relating to deposits of grain (fungible just like gold) the exactly opposite judgment was made: it was a bailment not a debt.

    As to the ethical or philosophical rightness of the judgment, that is an entirely different issue, as to which everyone is at liberty to come to his own conclusion. Suffice to say that the practice of fractional reserve banking has in the 160 years since the House of Lords decision in Foley v. Hill and Others (1848) led inexorably to 97% of all money being issued as interest-bearing debt by private banks and it is arguable that by far the greater part of the catastrophic debasement of our money over that period has been attributable to it, as well as much of the speculation which has led to the recurrent, and worsening, booms and depressions which have occurred - notably the current debt crisis. On bankers alone was this legal immunity bestowed, to appropriate to their own use (to embezzle, in other words) other people's money. How could that be justifiable? To whose financial benefit has the rampant speculation to which it has given rise been, if not solely to the bankers'? Fractional reserve banking has been condemned both ethically and in terms of its social utility by many among the most distinguished thinkers, industrialists, economists and monetary experts (as well as by not a few leading bankers) of the past century and a half.

    That's all I have to say on the subject. I don't think you and I are going to get any further. I wish I could say I wish you well but that wouldn't be true, because I see the view you are expressing as pernicious, devoid as it is of any moral dimension

  12. Please forgive the repetitiveness/redundancy of much of the above.

    It occurred because Blogspot first displayed, then subsequently deleted (and has now re-displayed) successive comments.

    I've now attempted to sum-up what I believe is the nub of the disagreement we have. I've added this as a comment to your "introduction". At least, I've tried to! (I suspect that Blogspot will delete it at some stage, as "spam" - God knows why).

  13. Robert,

    I've just come back from a long break from blogging, and am re-reading the comments to get back into it. I'd just like to make a general reply to several of your comments on this thread.

    You claim that I inhabit a value-free universe and that my view is devoid of any moral dimension, whereas all I have done so far is to describe how banking works. My purpose here is to inform debate, and my reason for doing so is because I have seen an awful lot of statements around which are simply incorrect, and if not countered could lead to what I believe are some very poor decisions being made.

    For example, your first comment here said "With FRB, and reserve ratios at or above 20%, bad debts can be shrugged-off. All the bank loses is the interest on them." I don't need to make any form of moral judgement to show that that statement is simply untrue, as shown by my comment of 17 September 2010 09:39.

    Moral judgements have to be informed by objective truth. By all means criticise fractional reserve banking - I believe that there are valid criticisms to make. And the issue of bailment versus debt is an interesting discussion, and has important consequences in the case of bank insolvency. But making incorrect statements such as your one above, and employing ad hominem attacks against people who don't appear to agree with you doesn't strengthen your argument.

    Again, I want to say that I do appreciate your comments, and I do like to be challenged on my arguments - I find that when intelligent people have disagreements there's usually something to be learned. I just hope that people will be open to debate without taking criticism of their beliefs as criticism of them personally.

    Even though I hope your arguments don't gain widespread acceptance, I wish you well personally.