If banks can create money, how come Northern Rock went bust?

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Banks obviously can’t create money, say Tim Worstall in his blog ‘Ms Orr succumbs to the Positive Money loons‘, in response to Deborah Orr’s article in the Guardian.

Now, how to show that banks do not in fact just create money? Well, if they did then Northern Rock would not have gone bust, would it? … Think through this for a moment. If Northern Rock could just print money on its own computers then could they have gone bust in this manner?

Tim Worstall

Let’s see why it’s entirely possible for banks to be able to create money and still run out of the stuff in the style of Northern Rock.

The Different Types of Money Used in Banking

There are actually two types of money in the banking system.

Firstly, there’s the type of money that appears in your bank account – a number in a computer system, or in banking jargon, ‘bank credit’ or ‘bank deposits’. Banks can create this money through the accounting process they use when they make loans. A full explanation of this process showing balance sheets is available here, but for now let’s just see a couple of quotes from the Bank of England:

By far the largest role in creating broad money is played by the banking sector… When banks make loans they create additional deposits for those that have borrowed the money

Bank of England, Interpreting movements in broad money, p.377

Banks extend credit by simply increasing the borrowing customer’s current account … That is, banks extend credit [i.e. make loans] by creating money

Paul Tucker, Deputy Governor for Financial Stability, Bank of England. Speech: 'Money and Credit: Banking and the Macroeconomy'

[Banks] can lend simply by expanding the two sides of their balance sheet simultaneously, creating (broad) money.

Paul Tucker, Deputy Governor for Financial Stability, Bank of England. Speech: 'Shadow Banking: thoughts for a possible policy agenda'

As the last quote explains, when a bank makes a loan it makes two balancing entries in its books: 1) the asset, which is the loan contract, and 2) a liability, which is the bank credit – or numbers in someone’s account – in the account of the borrower. This is newly-created bank credit, which functions as money and can be used to make payments.

There’s another form of money, known as ‘central bank money‘. This can either be physical cash, or an electronic equivalent held in accounts at the Bank of England. Cash is used mainly by the public, and considered to be ‘risk-free':

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)'

The electronic equivalent of cash is known as ‘central bank reserves’, and in practice banks use this type of money to settle transactions between them:

Reserves accounts are effectively sterling current accounts for commercial banks – they are among the safest assets a bank can hold and are the ultimate means of payment between banks. Whenever payments are made between the accounts of customers at different commercial banks, they are ultimately settled by transferring central bank money (reserves) between the reserves accounts of those banks.

Bank of England

To recap:

  1. Cash is issued by the state (via the Bank of England) and is used by the public to make payments.
  2. Bank credit – the numbers in your account – is used by members of the public and businesses to make payments between each other. It is created by banks whenever they make loans. But most members of the public consider that the balance of their bank account represents ‘cash in the bank’, rather than being simply a number that can lose all its value if the bank goes bust.
  3. Central bank reserves are an electronic equivalent of cash, held in accounts at the Bank of England. But central bank reserves can only be used by banks to make payments between themselves; no member of the public can get an account at the Bank of England.

Why Northern Rock Went Bust

In normal times, the payments between customers of different banks (using bank-created bank credit) tend to cancel each other out, and only a small amount of central bank money would be needed to settle the difference between banks at the end of each day. As a prime example of this, before quantitative easing, the total amount of central bank reserves that were used by the banks to settle between themselves was around the £20bn mark ((Bank of England figures for Central Bank sterling reserve balances)). This was enough to settle over £704billion of daily transactions((See the 2006 Payments Systems Oversight Report for figures on average payment flows)).

But Northern Rock went on a lending binge. Every new loan made created new money in the form of numbers in people’s accounts. These numbers could be used to make purchases, with payments using central bank reserves via payments systems such as Visa, Mastercard, BACS, direct debit, Faster Payments or any electronic funds transfer. Because Northern Rock was expanding its lending faster than other banks, at the end of each day it would find that it ends up with a net outflow of central bank reserves. That is why it would borrow money (in the form of central bank reserves) from other banks, and indirectly from pension funds and other large investors. The borrowing was a way of bringing in central bank reserves to settle the huge outflows that lending at such a rate would have caused.

Northern Rock eventually went bust when, for a variety of reasons, no-one would lend central bank reserves back to it, and it was unable to make its outward payments through the settlement system. In this situation, the Bank of England lent Northern Rock more central bank reserves, in its role as lender of last resort.

Had Northern Rock instead expanded its lending – and created the type of money used by the public  – at the same rate as other banks, it would have found that its daily inflows of central bank reserves roughly matched its outflows (since the payments from its customers to other banks would be cancelled out by payments from other banks to customers of Northern Rock). It is unlikely that it would have become so dependent then on interbank lending to be able to make its payments. The very reason why Northern Rock went bust was the sheer speed at which it was creating money through issuing loans, which created a massive outflow of deposits which had to be settled by securing the reserves from somewhere.

Why Tim (and many others) get it wrong

Banking is a complex subject,  especially when liquidity, inter-bank settlement, and solvency issues come into play. Not many economists – and even fewer journalists – actually understand it.

Because it is such a complex subject, facile thought experiments like the one Tim Worstall gives below can be completely misleading.

Think through this for a moment. If Northern Rock could just print money on its own computers then could they have gone bust in this manner?

No, clearly not.

Did Northern Rock go bust in this manner?

Yes, clearly so.

Therefore, Northern Rock could not print money on its own computers.

Death of the Positive Money thesis.

Tim Worstall

Misleading and logically flawed, but very convincing, especially to the slightly confused commentors who follow Tim’s post. One even goes to great lengths to argue that banks don’t create money, but concludes that ‘all electronic money that ordinary people use is FR bank-created leverage. Therfore 97% of the money used by ordinary people is indeed created by bank lending.  But that’s not the same as the money supply.” Bizarre.

It’s worth considering who’s most likely to be accurate: a Daily Telegraph journalists and the commenters on his blog, or the Deputy Governor of the Bank of England and other banking officials quoted here.

One final quote relevant to the issue under discussion:

The world is flat.

Anyone, anywhere, before anyone checked

Where To Learn More

The book Where Does Money Come From? is the most accurate account of the UK monetary system available at the moment, with a foreword by Professor Charles Goodhart, one of the UK’s leading moentary economists. The rear cover includes recommendations from Prof Victoria Chick, Emeritus Professor at University College London, and Professor David Miles, current member of the Monetary Policy Committee. One has to wonder if Tim also considers these people to be ‘loons’.

And in a couple of days I’ll release a paper answering the common objections and questions to the idea that banks create money. Watch this space.

 

 

 

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Ben Dyson (Positive Money)

Ben is Positive Money's Head of Research. He founded Positive Money in 2010 and is a co-author of Modernising Money. Ben's research focuses on potential reforms better forms of monetary policy, structural reforms to the banking system, and the potential for technology to disrupt the payment and banking systems.
  • Alan D’Arcy

    Why are you being so polite to this Tim fellow. He is obviously of “the blind who will not see”, and an apologist of the current system. He insults you – so he is obviously weak and unsure of his subject.

    I don’t mind if you do not treat him with the courtesy he does not deserve. So don’t do so.

    Alan D’Arcy

  • BrightMusic

    Interesting site, and trying to get to understand all this stuff better – in the meantime, I’ll just note that it’s infuriating that your links all open in new windows, in defiance of normal good Internet practice.

    • ben_dyson

      Noted re: the links @BrightMusic – we’ll make it so only external links open in new windows from now on.

      • Edwardtjoyce

        This really is an excellent thread. There may be some errors but all of the posters here have shown a very deep understanding of the subject. Please try to explore this argument. There are many people lurking on these threads who are greatly educated by the discussion. I really don’t think anyone reading this thread will be influenced or bothered by any insults. We are followibg the arguments which inevitably get heated. Please keep up the goid work.

      • Edwardtjoyce

        This really is an excellent thread. There may be some errors but all of the posters here have shown a very deep understanding of the subject. Please try to explore this argument. There are many people lurking on these threads who are greatly educated by the discussion. I really don’t think anyone reading this thread will be influenced or bothered by any insults. We are followibg the arguments which inevitably get heated. Please keep up the goid work.

  • Frances_Coppola

    You do talk rubbish. The broadest measure of money, M4, which is what is normally called the “money supply”, includes notes & coins and bank reserves (i.e. central bank created money) plus all money on deposit in financial institutions (i.e. commercial bank created money). So the “money supply”, sterling M4, is not 97% commercial bank created credit, because that ignores most of the central bank created money reserves. It is total central bank liabilities (from the Bank of England’s accounts) plus deposits at financial institutions. Sterling M4 figures and the Bank of England’s accounts are both available from the Bank of England’s website. I suggest you do some calculations before you start saying that commentors who point out your mistakes are “slightly confused”. 

    • John Morrison

      Frances – ‘You do talk rubbish’ is not a great way to start a dialogue. It makes you sound full of prejudice before you get started.

      It is true that the popular figure of 97% is slightly incorrect because it overlooks reserves at the central ban. Until recently I think central bank reserves in the UK were roughly equal to cash in circulation but quantitative easing has changed that by roughly doubling bank reserves.

      Taking this into account, roughly 90% of money is circulation is in the form of privately created credit, 3% is cash in circulation and 7% is held as by banks electronic cash at the central bank.
      This hardly changes the argument except to highlight that the banks hold most of our national currency.

      • Frances_Coppola

        You are out of order. The prejudice was first on Positive Money’s side. Ben described me as “confused”, which was inaccurate and pejorative. I’m not confused at all and my remark was correct. Ben’s figures were wrong, because he had omitted reserves. It’s not the only mistake he has made.  It would be far better if he – and you – simply held up your hands and admitted it, instead of resorting to insults.

        As most of our national income is held in bank accounts, OF COURSE the banks hold most of our national currency. Would you rather people stuffed their mattresses instead?  

        In days gone by, considerably more of our national currency was held as notes & coins and much less by banks. That is because far fewer people had bank accounts and most working-class people were paid in cash. As bank access has extended itself to more of the population, so more of our national currency is held by banks – because all money eventually comes to rest in a bank deposit account somewhere.

        This little factoid is hardly a “shock, horror” issue, is it?

        • John Morrison

          rances, lighten up!

          My post is in no way an escalation of insults. It is a challenge to the idea and practise of exchanging insults, especially complete and unspecific ones such as ”You do talk rubbish” that add no information to the dialogue and only insult. I have not accused you of prejudice, rather I have advised you that such a statement creates an impression of prejudice.

          “You are out of order”

          No, I think it is very important to challenge and defuse bullying by insulting but meaningless put-downs and I believe in solidarity on this.

          • John Morrison

            N.B. I am against anyone being described as simply confused. It is more constructive to describe the particular paradigm that they are confused by. If you cannot do that then you have no right to call them confused.

          • Frances_Coppola

            I apologise, I was irritated by Ben’s description of me as “confused” when he was the one who was wrong. 

          • John Morrison

            Frances, I wasn’t
            expecting an apology. I was bracing myself for a further outburst of
            rage.

            Well done!

            Describing
            someone as confused is a underhand technique used to marginalise them
            without bothering to de-reconstruct their argument. It is widely used
            and passes almost unnoticed as if no blow was thrown, even creating
            the impression that the author is being as sympathetic as possible.
            It is definitely below the belt and it has an effect.    

    • http://bsd.wpengine.com.uk/ Ben Dyson

      @Frances_Coppola:disqus  – here is the Bank of England’s own definition of M4:

      http://www.bankofengland.co.uk/statistics/Pages/iadb/notesiadb/m4.aspx

      If you can see central bank reserves included in this definition, then please let me know. As far as I can tell (and admittedly Bank of England publications can be a bit cryptic), central bank reserves are not counted in M4. 

      The reason for this is that central bank reserves are a liability of the central bank to a commercial bank (or the government). But the Bank of England does not provide accounts to members of the public or businesses (the ‘private sector’ referred to in the definition), so it cannot have a liability to the public (at least, on the Banking Department Balance Sheet). 

      In short, central bank reserves are never held directly by the public, and therefore aren’t included in the M4 measure of money supply. 

      Frances – if you don’t mind I suggest we drop the name calling and discuss it like mature adults. I think it would be fair to say that ‘fruitcake’ and ‘loonie’ is slightly more pejorative than ‘confused’. 

  • Frances_Coppola

    In practice it is impossible to distinguish between central bank created money and commercial bank created money, unless the central bank issues money in the form of bills – which is not what we are discussing here. One electronic sterling balance looks just like another. As far as purchasing power is concerned, there is no difference. Whether it is central bank liabilities or commercial bank liabilities is purely dependent on which account the balance is sitting in. In the absence of a Gold Standard, there is no intrinsic difference between “reserves” and any other kind of money except actual notes & coins. Economists find it helpful to distinguish between the two but it’s not a real difference.  

    Therefore I dispute your assertion that banks lend central bank reserves to each other. No they don’t. They lend excess deposits to each other so that central bank reserve requirements can be met across the system as a whole. If they didn’t do that they would either have to invest those deposits by buying securities, or they would park those deposits at the central bank as excess reserves. Those deposits are of course (mostly) created by lending – you are at least correct in that. The evidence is that M4 does inflate as a consequence of lending even when M0 (central bank created money) is steady. If there is a positive reserve requirement (which we don’t have in the UK at the moment) M0 eventually inflates too, because reserve requirements are a proportion of eligible commercial bank liabilities, including deposits created through lending: the larger the balance sheet, the higher the reserve amount. This is a consequence of reserve accounting and happens whether or not the central bank actually puts new money into the system. 

    You really need to rethink how this actually works. It’s all about liquidity, and the whole thing is constantly moving, which is why it is difficult to pin down exactly what the reserve situation is on a day-to-day basis and why, for example, the ECB averages reserve holdings over the course of a month. The central bank creates enough liquidity to keep the whole ship afloat – to ensure that all banks can meet their reserve requirements. It does this through open market operations and similar tools. Open market operations are not lending and don’t directly credit bank reserve accounts: instead, the central bank purchases securities from the market for cash, which then of course finds its way into a bank deposit account – like very small-scale QE. It’s the one exception to the general rule that deposits are directly or indirectly a consequence of lending, and the only form of deposit that can be truly said to be “central bank money”. 

    Commercial banks meet their reserve requirements by lending a proportion of their eligible liabilities to the central bank. If an individual bank cannot meet its reserve requirement, because too many deposit drawdowns have occurred, the central bank will lend to it at a penalty rate – this may involve new money creation, or it may simply be intermediation of excess funds deposited at the central bank by other banks, as happens at the ECB at the moment.

    You are correct that Northern Rock’s original request for emergency funding from the Bank of England arose because of the freezing of interbank markets after the collapse of Bear Sterns. Northern Rock’s excessive lending was mainly mortgages, actually – not consumer spending, as you suggest. But it had become very dependent on interbank lending, so when other banks refused to lend to it, it suffered a catastrophic liquidity shortage, which was met by the Bank of England with permission from the Treasury. It wasn’t the lending itself that was the problem, of course – it was the drawdown of those loans as people completed on their house purchases. 

    You may have spent four years studying this, Ben, but you still have much more to learn.

    • http://bsd.wpengine.com.uk/ Ben Dyson

      @Frances_Coppola:disqus  – “In practice it is impossible to distinguish between central bank created money and commercial bank created money, unless the central bank issues money in the form of bills – which is not what we are discussing here. One electronic sterling balance looks just like another.”
      Consider for a minute that that your perspective, and the idea that there’s no way to distinguish between central bank reserves and commercial bank money, could be due to the way things were presented on the computer terminal that you were using when you (I assume) worked in treasury for a bank. 

      From the Bank of England’s perspective, there is obviously a complete and distinct difference between central bank reserves (a liability from them to the banking sector), and commercial-bank created money (a liability from a commercial bank to another entity). They sit on different balance sheets, and they’re not fungible at all. 

      I’m afraid there’s a lot to learn on both sides here. Some of your statements are inaccurate according to the Bank of England’s own records. For example: 

      “Commercial banks meet their reserve requirements by lending a proportion of their eligible liabilities to the central bank.”

      No, they engage in repos, where they temporarily ‘sell’ an ASSET (not liability) to the Bank of England, in exchange for central bank reserves, which are new credits in their account at the Bank of England. They cannot ‘lend a liability’. 

      Unless you distinguish between central bank reserves and commercial bank deposits, then you won’t be able to make sense of this. Whatever terminal you used  in your job may not have distinguished between central bank reserves and commercial bank deposits, but I assure you the Bank of England treats them as completely different things. I can point you in the direction of the relevant papers if you’re interested. 

      • Frances_Coppola

        Ben, I’ve replied to most of this in an earlier comment. But I’d like to pick you up on your assertion that banks can’t lend to the central bank. Yes they can, and the Bank of England pays them interest on those balances. 

        I’ve given a detailed explanation of how settlement through Bank of England reserve accounts works in my reply to Andrew Jackson,. including accounting entries. I’ve not included the use of reserve balances to fund settlement shortfalls, but you should be aware that some banks choose to maintain positive deposit balances in their reserve accounts precisely so that they do not have to borrow to fund settlement account overdrafts. The BoE pays interest on these at Bank Rate. 

        Intraday, the BoE supplies liquidity as required to support intraday payments. It does this by lending against collateral at zero interest (intraday repo). It will also lend to banks to fund their settlement accounts overnight (overnight repo). If banks have positive reserve balances they don’t have to use these lending facilities. 

        http://www.bankofengland.co.uk/markets/Documents/money/publications/redbookreserves.pdf 

  • Frances_Coppola

    By the way, the statement on your Banking 101 that:

    “Central bank reserves are not usually counted as part of the money supply for the economy, due to the fact they are only used by banks to make payments between themselves.”

    ….is simply wrong. From the Bank of England’s definition of Sterling M4:

    “Monetary Financial Institutions With effect from April 1998, a new monetary financial institutions (MFI) sector was introduced, comprising the central bank (the Banking Department and the Issue Department of the Bank of England), other banks and building societies. UK monetary statistics (other than M0) were already compiled on the basis of the MFI sector and there was no change in the definition of the monetary data. This was because the Bank of England Banking Department had always been part of the UK banks’ sector and the Issue Department’s transactions with the M4 private sector (including transactions associated with its money market operations as well as the note issue) were already included in broad money and its counterparts. Unless otherwise stated, banks will include the central bank sub-sector.”

    Link here: http://www.bankofengland.co.uk/statistics/Pages/iadb/notesiadb/m4.aspx

    You also make no mention of central banks’ creation of money through open market operations. By omitting that you imply that the only means by which the central bank provides money to the banking system is via repo lending to individual banks, which is not true. Can I suggest you correct this?

    I should clarify my comment below about central bank “created money” reserves. Although reserve requirements in the UK are zero, financial insitutions may voluntarily hold reserve balances at the Bank of England. The measure of “narrow money” produced by the Bank of England, which is notes & coins plus reserve balances, is a reasonable representation of the amount of base money in circulation, simply because voluntary reserve balances are sensitive to interest rate policy – as you correctly point out in your 101 post.  Therefore, if banks are voluntarily holding balances at the Bank of England the proportion of sterling M4 that is made up of commercial bank created money will be less than 97%. Only if reserve balances are zero will your assertion that “97% of money in circulation is created by commercial bank lending” be true.

     

    • http://bsd.wpengine.com.uk/ Ben Dyson

      @Frances_Coppola:disqus  – I’ll ask the Bank of England for clarification on this. There’s two potential problems here: 

      1. The Issue Department’s balance sheets are equal to (and synonymous with) the amount of cash in circulation. So including both Issue Department liabilities AND Notes & Coin in Circulation in the measure of M4 would count as obvious miscounting, and I’d be surprised if the Bank of England hadn’t accounted for that.  

      2. Central bank reserves are the Banking Department’s liabilities to other banks and financial institutions. For example, see the liabilities on page 54 of the Bank of England’s Annual Report 2012: 

      http://www.bankofengland.co.uk/publications/Documents/annualreport/2012/ar2012.pdf 

      Therefore they are interbank liabilities, not liabilities to the private sector, and should be cancelled out as with other interbank liabilities. Again, I’d be surprised if the Bank of England hadn’t done this, therefore erasing central bank reserves from the measure of M4. 

      I appreciate that the Bank of England can often be very unclear in their explanations of how they work, so I will ask them for specific clarification. 

      • http://bsd.wpengine.com.uk/ Ben Dyson

        I received a response from the Bank of England. In short, “Only notes and coin issued by the BoE and held by the private sector, as well as any sterling deposits held with the BoE by the private sector (as defined and shown in Bankstats B2.2.1) will contribute to M4.”. The table recommended, B2.2.1, which you can download from the following page, shows the level of deposits at the central bank that show up in M4 (see the ‘Private Sector’ column):

        http://www.bankofengland.co.uk/statistics/Pages/bankstats/current/default.aspx

        There are £6 billion of deposits at the central bank which are included in M4. With that exception, it appears that we were correct to say (in our Banking 101 course) that:

        “”Central bank reserves are not usually counted as part of the money supply for the economy, due to the fact they are only used by banks to make payments between themselves.”

  • Andrew Jackson

    .

    Francis:

    You say:

    “In practice
    it is impossible to distinguish between central bank created money and
    commercial bank created money, unless the central bank issues money in the form
    of bills – which is not what we are discussing here. One electronic sterling
    balance looks just like another. ”

    and:

    “They lend
    excess deposits to each other so that central bank reserve requirements can be
    met across the system as a whole. ”

    I disagree. As a
    banker (e.g. at RBS) you may have a number in front of you that says I have X
    amount of sterling at my disposal. Now some of this may be deposits RBS holds
    at other banks  (Say HSBC), whereas some
    of it will be reserves at the central bank. From this perspective it may
    superficially appear you are borrowing deposits from HSBC. But you are not. You
    are borrowing the right to use HSBCs reserves to settle payments – ergo, you
    are borrowing reserves.

    Now while an
    individual banker may not be able to tell the difference, the bank itself will
    of course know what the balance of its accounts are with other banks, and also
    what the balance of its account at the central bank is.

    The alternative,
    as you seem to be suggesting, is that banks don’t know either what their bank
    accounts are at the central bank. Think about the implication of what this
    phrase is saying – if HSBC is owed money by Lloyds, and Lloyds settles through
    the clearing system, the sentence below implies that Lloyds doesn’t know
    whether the balance of it’s risk free reserve account at the Bank of England
    has gone up, or whether the balance of HSBC’s deposit account at Lloyd’s has
    gone up. Therefore it wouldn’t know a) the balance of its reserve account
    (which is risk-free) or b) the balance of its account at Lloyds. It also
    wouldn’t know if the ‘settlement’ is risk-bearing (i.e. a liability of Lloyds)
    or risk-free (i.e. central bank reserves).

    It also seems to
    be suggesting that as this money is fungible anyone can create central bank
    reserves. Which also would not make any sense, if they
    are so important to the settlement proces.

    The BoE has several
    papers on this. We also consulted BoE employees about how this all works
    (including Charles Goodhart) when we wrote ‘where does money come from’. For
    example, from (http://www.bankofengland.co.uk/markets/Documents/money/smmreform050404.pdf)

    “47 All reserve accounts
    will be held in the RTGS processor, with information on scheme members’ reserve
    accounts provided via the Enquiry Link Service. The Enquiry Link Service, which
    will need to be used by all scheme members, is provided over the SWIFT network.(21)

    48 For CHAPS and CREST
    sterling settlement banks, their existing RTGS accounts — Sterling Settlement
    and Sterling Ordinary Accounts respectively — will be used as reserve accounts.(23)
    This will facilitate the use of reserves to fund payments during the day.(24)”

    These quotes show that
    banks do have reserve accounts with the BoE, they know their balance, and that can distinguish them from their balances they hold at other banks. However, as I mentioned before individual bankers working at these banks would not necessarily know this information (and would not need to).

    • Frances_Coppola

      You’re a bit confused about deposits, aren’t you? Try to remember that a deposit is LENDING TO a bank, so is a liability from the bank’s point of view: a loan is BORROWING FROM a bank, so is an asset from the bank’s point of view. The same applies between banks: if a bank deposits funds at another bank it is LENDING TO that bank. If RBS has a deposit at HSBC that is RBS’s ASSET, not a liability. If it recalled it, it would simply be doing a deposit withdrawal – recalling its own money.  

      Since the UK has a zero reserve requirement and the interest the Bank of England pays on deposits is below LIBOR, normally banks prefer to lend to each other rather than parking excess funds at the central bank.  If a bank chose to keep voluntary reserves as a liquidity buffer, it would be very unlikely to lend those to other banks – it would only lend funds in excess of the balance it wished to keep at the central bank. Nor would a bank lend funds to another bank if it meant that it would have to borrow from the central bank to avoid overdrawing its reserve account, because the central bank charges a penalty rate for such borrowing. So at the point at which RBS would be seeking to borrow, HSBC would have excess deposits on its OWN books, not parked at the central bank. RBS would be borrowing HSBC’s funds, not central bank funds. This borrowing would be settled via the central bank reserve accounts – as all large value transactions are – but it would not be central bank money as such.Only if HSBC ALREADY HAD excess reserves parked at the central bank and RBS borrowed them could RBS be said to be borrowing central bank funds. But that would probably be done as a central bank repo transaction anyway – so it would be explicitly borrowing from the central bank. Incidentally, I’ve worked at both RBS and HSBC!

      • Andrew Jackson

        No I am not confused about deposits or liabilities. A liability is what a bank owes, lending to a bank is a much narrower definition. When a bank makes a loan it makes a deposit for the borrower. It has agreed to make payments on that persons behalf – it owes someone. No one has lent anything to the bank.

        I will have to reiterate my point because you are moving the goalposts. You state:

        “In practice it is impossible to distinguish between central bank created money and commercial bank created money, unless the central bank issues money in the form of bills – which is not what we are discussing here.”

        To which I replied that they are distinguishable, quoting a bank of England paper:

        “47 All reserve accounts will be held in the RTGS processor, with information on scheme members’ reserve accounts provided via the Enquiry Link Service. The Enquiry Link Service, which will need to be used by all scheme members, is provided over the SWIFT network.(21)…

        48 For CHAPS and CREST sterling settlement banks, their existing RTGS accounts — Sterling Settlement and Sterling Ordinary Accounts respectively — will be used as reserve accounts.(23) This will facilitate the use of reserves to fund payments during the day.(24)”

        These quotes show that banks do have reserve accounts with the BoE, they know their balance, and that can distinguish them from their balances they hold at other banks.

        And from another paper (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100404.pdf):

        “Only central banks can alter the supply of reserves.”

        So as I said before, banks do have reserve accounts at the bank of England that they know the balance to, and this money is not fungible with the deposits that banks create. This directly contradicts your point that it is impossible to distinguish the two.

        As to the idea that a bank can lend its deposits to another bank: true, a bank may have deposits at another bank. But this is not lending excess deposits, there is no such thing, as no ones deposits are decreased when a bank lends another bank a deposit. It is lending excess reserves – holding a deposit allows you to demand that a bank settles a payment on your behalf – using central bank reserves.

        • Frances_Coppola

          Andrew,

          Do you know what RTGS means? It means “real time gross settlement”. SWIFT, CREST, CHAPS are various types of payment system that use the central bank to fund payments. These reserve accounts are SETTLEMENT accounts – similar to private bank current accounts. They contain money in transit between one bank and another bank via the central bank. This money moves in response to customer demand – deposit drawdown – and it happens when the deposit is drawn (hence “real time”). If the deposit that is being drawn is a loan, then the money that “moves” through the RTGS reserve accounts is private bank created money. Any residual balance in the RTGS reserve accounts is money that has effectively been “lent” to the central bank.

          The central bank creation process here is to do with double entry accounting. Let me give you an example. Here is a loan at a private bank:

          DR  Customer loan account          100.00
          CR  Customer deposit account     100.00  (this is the created deposit)

          When the loan is drawn (payment made to a customer of another bank), the settlement accounting entries are as follows:

          At private bank A:

          DR Customer deposit account     100.00
          CR BoE Settlement account A       100.00

          At Bank of England:

          DR BoE Settlement account A      100.00
          CR BoE Settlement account B       100.00

          At private bank B:

          DR BoE Settlement account B       100.00
          CR Customer deposit account      100.00

          You will note that at the end of this process, bank A will have a  settlement account balance of 100.00DR and bank B will have a settlement account balance of 100.00DR. The Bank of England has created new money of 100.00 because of the credit to Bank B’s reserve account, which is counted in central bank liabilities. But it is balanced by a new cash asset of 100.00 in Bank A’s settlement account. The Bank of England’s balance sheet is inflated by 100.00 overall but there is no real new money in the system: all that has happened is that a payment has been made from Bank A to Bank B via central bank settlement accounts. 

          Bank A must return its settlement account to zero or above at the end of the day. To do this it may have to borrow, either from other banks or directly from the central bank. Bank B, meanwhile, may not wish to maintain the positive balance in its settlement account since the BoE pays rubbish interest on positive reserve account balances, so it may wish to place those balances into a deposit facility either at the central bank or at another bank. It could lend them to bank A, of course. If it did so, the settlement accounting entries would be as follows:

          At bank A:  

          CR Bank B deposit account               100.00
          DR BoE settlement account A            100.00

          At BoE:

          CR BoE Settlement account A             100.00
          DR BoE settlement account B             100.00

          At bank B:

          DR Bank A deposit account                100.00
          CR BoE settlement account B              100.00

          (For simplicity I’ve omitted interest charges on interbank lending). You will note that this is effectively a deposit drawdown in the opposite direction. It leaves both banks with zero balances in their BoE settlement accounts, but the BoE’s balance sheet is effectively inflated by £200. Ben argued that money supply figures don’t include this money. I bet they don’t, because it is an entirely artificial inflationary effect that has nothing whatsoever to do with the actual amount of money in circulation. But if Bank A or Bank B leave a positive balance in their settlement account, I would hope that that money IS included in money supply figures, because in effect those banks have “lent” that money to the central bank. And it pays interest on it, too. 

          I’m sorry to answer at such length, but you don’t seem to understand settlement accounting. 

          You should appreciate that double entry accounting inflates money supply figures all over the place. All of the example entries I have given above effectively inflate money supply figures. Most of them are eliminated, because the Bank of England only includes 35% of interbank balances in M4. But customer deposits and positive settlement account balances at the end of the day both inflate the money supply and give the impression that new money has been created. 

          As I said in my original comment on Tim Worstall’s blog, the problem is how we measure money in a double-entry accounting world. 

          • Frances_Coppola

            Sorry, typo about halfway through that. At the end of the original deposit drawdown Bank B has a central bank settlement account balance of 100.00 CR, of course.

          • Frances_Coppola

            oh and another typo – Bank A and Bank B could leave positive balances in their Ordinary accounts, not their settlement accounts. Settlement accounts only contain moving money. Ordinary accounts contain money that is used to support payments (liquidity) – they are in effect deposit balances at the Bank of England and the BoE pays interest on them. They should be included in money supply figures. 

          • Frances_Coppola

            Sorry, typo about halfway through that. At the end of the original deposit drawdown Bank B has a central bank settlement account balance of 100.00 CR, of course.

          • Frances_Coppola

            oh and another typo – Bank A and Bank B could leave positive balances in their Ordinary accounts, not their settlement accounts. Settlement accounts only contain moving money. Ordinary accounts contain money that is used to support payments (liquidity) – they are in effect deposit balances at the Bank of England and the BoE pays interest on them. They should be included in money supply figures. 

          • Andrew Jackson

             Francis,
            Yes I do know what RGTS means, and I am aware of how reserve accounting works, having worked on this very subject for the book ‘where does money come from’. Incidentally, the book was checked for accuracy by Bank of England economists before publication.

            The point I was trying to make was that something you said was incorrect, namely that banks cannot tell central bank reserves from deposits at other banks.

            Anyway, moving on, I have to say I disagree with you analysis of reserve accounting.  However, I don’t want this to descend into:

            You: “I’m right”, Me: “No, I’m right!”

             So I am going to source everything to the BoE.

            You state: “If the deposit that is being drawn is a loan, then the money that “moves” through the RTGS reserve accounts is private bank created money.”

            No its not. The only money in these accounts is created by the central bank, You can’t get commercial bank money into the reserve accounts at the BoE any more than you can get central bank money into commercial bank account on their balance sheets – reserves are an asset of the commercial banks, whereas deposits are their liabilities.

            The BoE states: “Reserves accounts are effectively sterling current accounts for banks. Reserves balances can be varied freely to meet day to day liquidity needs, for example to accommodate unexpected end of day payment flows.” (http://www.bankofengland.co.uk/markets/Documents/money/publications/redbookreserves.pdf)

            Ok, so what are reserves then?

             “Reserves are overnight balances that banks hold in an account at the central bank. As such, they are a claim on the central bank. Together with banknotes, reserves are the most liquid, risk-free asset in the economy. And they are the ultimate asset for settling payments; banking transactions between customers of different banks are either directly or indirectly settled through transfers between reserves accounts at the central bank…..

            Only central banks can alter the supply of reserves.” (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100404.pdf)

            They do this through two methods:

            “OMOs are designed as multilateral transactions in which the central bank, at its own initiative, deals in the market, affecting the banking system as a whole. If it buys assets or makes loans, it puts reserves into the banks’ accounts held at the central bank. If it sells assets or borrows in the market, these transactions are settled by reducing the banks’ reserves accounts.

            Standing facilities are designed to facilitate bilateral transactions in which a bank at its own initiative deals with the central bank. Lending facilities allow banks to borrow reserves directly from the central bank, potentially in very large amounts. Deposit facilities allow banks to deposit reserves in interest-bearing accounts at the central bank.” (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100404.pdf)

            So, no private bank created money is transferred through reserve accounts at all. The central bank creates by lending it to commercial banks, and they use it to settle payments between themselves, across the BoEs balance sheet.

            You also seem to be implying that the transfer of funds between banks creates money at the Bank of England. This is incorrect.

            As stated before, commercial banks have bank accounts at the bank of England. The act of a customer of bank A transferring money to a customer of bank B does not create new deposits at the BoE, all that happens is bank As account decreases and bank Bs account is increases as the payment is made. The aggregate level of reserves in the system is not altered by this process. This is all outlined here: http://bsd.wpengine.com.uk/how-banks-create-money/balance-sheets/#centralbankreservepayments

            The only entity that can alter the supply of reserves is the central bank, and it does this by lending money to commercial banks (usually via repos), or engaging in asset purchases. This is all outlined here: http://bsd.wpengine.com.uk/how-banks-create-money/balance-sheets/#reserves

            You also said in your first (?) post:

            “Therefore I dispute your assertion that banks lend central bank reserves to each other. No they don’t. They lend excess deposits to each other so that central bank reserve requirements can be met across the system as a whole.”

            But the BoE flatly contradicts you here:

            “The interbank money market is the market in which banks borrow and lend short-term funds between each other. Since these transactions have ultimately to be settled via banks’ reserves accounts, the interbank money market is also the market for reserves. It follows that banks’ incentives to trade in the interbank market are affected by the terms on which reserves are available from the central bank.” (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100404.pdf)

            Incidentally, the system that I am describing has been in place since 2006 (although we have moved from a corridor to a floor system, the principle is the same). The Bank of England has several papers on this, for example see here:
            http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100404.pdf,

            here:
            http://www.bankofengland.co.uk/publications/Documents/speeches/2011/speech487.pdf

            And here:
            http://www.bankofengland.co.uk/markets/Documents/money/publications/redbookreserves.pdf

          • Frances_Coppola

            Andrew.

            If you could please get the Bank of England and the terminology it uses out of your head and look at the way money flows through the banking system as a whole, you will see that the effect of the drawdown of the created deposit at bank A is to create an equal deposit at bank B. The created deposit at bank A has effectively moved from bank A to bank B. It has done this via the reserve accounts at the Bank of England and using liquidity created by the Bank of England to cover temporary reserve account shortfalls. Those are transparent to the system. What matters is that a customer deposit created as part of lending by the first bank has become a customer deposit in a second bank. Therefore private bank created money has in effect “moved through” central bank reserve accounts. 

            I showed how that deposit can effectively be “borrowed” back by the first bank at the end of the day. That movement is transparent to the customer, but it is real as far as the banks are concerned. There are not two different lots of money involved. There is ONE DEPOSIT which is created as a consequence of lending by bank A. That deposit is paid to bank B and then borrowed by bank A. (It’s a completely artificial example, of course, because it assumes there is no other activity at either bank that day.) The Bank of England does not “flatly contradict” me on this. It says that the process by which banks lend funds to each other is ALSO the process by which reserve accounts are adjusted to target. Which is what I said. 

            Only central banks can alter the total supply of reserves IN THE SYSTEM at any one time. But private banks absolutely can deposit money into central bank accounts. When they do that, those deposits become liabilities of the central bank, i.e. reserves. That doesn’t mean that any more reserves have been created: one bank’s excess deposit (the credit balance remaining when it has received more in deposits during the day than it has paid out in drawdowns) placed in reserve at the Bank of England is another bank’s shortfall.   

            The trouble with looking at things exclusively from the central bank’s perspective is that you don’t see how the banks and the central bank operate together as a system. 

            The process of transferring money through the reserve accounts can involve creation of new reserves. Intraday repos cover funding shortfalls: if at the end of the day these are not repaid the deficit bank must borrow overnight from the central bank, which as you’ve already said, means the central bank creates new money in the deficit bank’s reserve account. If there has been a lot of new lending activity resulting in more movements through the reserve accounts than the reserve accounts can support, the central bank must either create them or allow negative balances on reserve accounts (the only other alternative is payment failures). Forcing the private banks to borrow from the central bank to fund their settlement accounts ensures that the liquidity risk from deposit drawdown is borne by the private banks, not the central bank. In the ECB’s Target system this is a completely automatic process, which is pretty much what all the brouhaha about Target balances is about. I’m not sure whether the Bank of England’s RTGS system is quite so automated.

            The reason why “reserves are the most liquid, risk-free asset in the economy” is because they are balances at the central bank, which cannot be allowed to fail. It is the ultimate TBTF bank and therefore completely risk-free. But to suggest therefore that private banks can’t put any money in or draw any money out is nonsense.  Of course they can – just as you can put money into your current account or draw money out of your current account. When you put money into your current account it becomes a liability of the bank. When a bank puts money into its current account it becomes a liability of the central bank. And as I said above, that deposit will be balanced across the banking system by an equivalent withdrawal from central bank reserve accounts somewhere else – unless the central bank puts more money into the system as a whole. It doesn’t really want to do this unless it has to, which is why it encourages banks to lend to each other. From the banks’ perspective, interbank lending is lending of excess deposits. From the central bank’s perspective, interbank lending is lending of excess reserves. From the point of view of the banking system as a whole, the two are the same and it doesn’t matter which you call them. Which is pretty much what the Bank of England said, isn’t it?

            Your problem is that you are trying to make a case for there being two types of money in the economy – “reserves”, created by central banks, and “money”, created by private banks – while at the same time arguing that those who already say there are two types of money in the economy – “money”, created by central banks, and “credit” created by private banks – are wrong. Can’t you see that you are actually saying exactly the same, but using different terminology? 

  • http://twitter.com/granchinhojp João Granchinho

    Good article. Another good reference. Keep up the good work Ben and team.

  • GWHodgson

    I’m coming in here late as usual, so it’s probable that the principals have moved on. Anyway, for what it’s worth, here’s my take on the debate, taking points from Frances Copploa’s posts.

    In practice it is impossible to distinguish between central bank created money and commercial bank created money, unless the central bank issues money in the form of bills – which is not what we are discussing here. One electronic sterling balance looks just like another. As far as purchasing power is concerned, there is no difference. Whether it is central bank liabilities or commercial bank liabilities is purely dependent on which account the balance is sitting in.

    Let’s explore this a bit further. Central bank created money other than banknotes is the sterling account balances of depositors at the central bank, principally the government, the major settlement banks and foreign central banks. Sterling payments between settlement banks, government and foreign central banks are made by transferring balances between these deposit accounts. These accounts are held on the books of the Bank of England, and are private to those books (they can’t be transferred off to some other institution’s accounts). They are accessible to the Real Time Gross Settlement System. An RTGS payment is taken there and then (real time) in full (gross) from the account of the BoE depositor making the payment and transferred directly to the account of the BoE depositor receiving the payment. No other set of accounts is accessible directly from the RTGS.

    Banks also have accounts with each other. These are private to those banks’ sets of books. The account bank A holds with bank B represents bank B’s promise to use its account at the BoE to settle payments on A’s behalf. A can’t spend its account with B to buy computers, for example, unless the computer supplier also has an account with B (in which case B reduces its liability to A and increases its liability to the computer supplier). Failing that A can only call on B to fulfil its promise and use its reserves to settle payment by transferring the amount of the payment from the account B holds at the BoE to the account held at the BoE by the computer supplier’s bank (C), on condition that C then credits the account of the computer supplier with amount of the payment. An alternative route, in theory, is that B would authorise C to transfer the payment from B’s deposit with C to the account of the computer supplier, but in practice this isn’t what happens with a retail transaction.

    What makes these independent sets of books unique for monetary purposes (and thus at first glance indistinguishable) is that a £1 deposit at A is worth precisely as much as a £1 deposit at B or C, and precisely as much as a £1 deposit in an account at the Bank of England. And this is because when a customer of A makes a payment to a customer of C, C is expected to take on an additional liability to its customer for which it requires A to transfer a balancing asset. In theory, any asset worth the amount of the payment will do, but asset valuations are subjective, and unstable. Central bank reserves provide risk-free assets of defined and persistent nominal value. All banks agree that a £1 payment leaving the reserves of one bank will be worth precisely £1 when it arrives in the reserves of another bank. All banks agree therefore that they will credit the account of a customer receiving payment pound for pound with the amount leaving the account of the customer making the payment, even though those two sums are in separate independent accounting systems subject to independent asset valuation methods.

    Therefore I dispute your assertion that banks lend central bank reserves to each other. No they don’t. They lend excess deposits to each other so that central bank reserve requirements can be met across the system as a whole. If they didn’t do that they would either have to invest those deposits by buying securities, or they would park those deposits at the central bank as excess reserves. Those deposits are of course (mostly) created by lending – you are at least correct in that.

    Now here we have to consider what is meant by “excess deposits”. If these are excess deposits at the Bank of England, then that’s reserves. If these are deposits created by one bank taking out a loan with another bank then the only way these could end up at the BoE would be if the borrowing bank asked the lending bank to discharge its deposit liability by transferring reserves from its own account at the BoE to the borrowing bank’s account at the BoE, i.e., lending the reserves. I won’t even consider the possibility that it might be customer deposits that are being talked about.

    the central bank will lend to it at a penalty rate – this may involve new money creation, or it may simply be intermediation of excess funds deposited at the central bank by other banks

    Intermediation is the presumed role of high street banks in arranging for third parties (their depositors) to lend their money to other third parties (their borrowers). It is widely acknowledged that this doesn’t happen at all, no money leaves the depositors’ accounts. The money advanced is created by the bank. But in the case of borrowing from the central bank we see that intermediation is put forward as an alternative to money creation, which must mean that money does leave other banks’ reserves for which they must acquire a replacement asset, the borrowing bank’s loan agreement. Sounds like banks lending their reserves to each other to me.

    You’re a bit confused about deposits, aren’t you? Try to remember that a deposit is LENDING TO a bank, so is a liability from the bank’s point of view: a loan is BORROWING FROM a bank, so is an asset from the bank’s point of view.

    LENDING TO and BORROWING FROM both contain prepositions, they imply direction, movement. Nothing moves when a bank advances a loan. It simply creates an asset from the borrower’s undertaking to make future payments, and a balancing liability where the bank undertakes to make future payments. Some deposits are indeed acquired for cash or other securities or through the provision of goods and services, but none of these are LENT, they are EXCHANGED.

    So at the point at which RBS would be seeking to borrow, HSBC would have excess deposits on its OWN books, not parked at the central bank. RBS would be borrowing HSBC’s funds, not central bank funds. This borrowing would be settled via the central bank reserve accounts – as all large value transactions are – but it would not be central bank money as such.

    I’m guessing that these excess deposits refer to deposits that HSBC has with other banks, enabling it to require them to make payments on its behalf. HSBC could “park” these at the central bank as above, by requiring the deposit taking bank to make payment in reserves to HSBC’s central bank account. HSBC can acquire a deposit at Barclays, for example, by transferring an existing financial asset, securities or reserves, or by agreeing to a loan from Barclays which, as with all commercial bank loans would consist simply of the creation of balancing assets and liabilities with nothing actually flowing from lender to borrower.

    On the subject of the acounting transactions surrounding payment settlement, the subsequent flurry of corrections and retractions only makes it more imperative that people go to the source: Where does money come from?

     

  • Usefulmusic

    My layman’s observation on Northern Rock from around 2004m to 2008: 
    Every now and then I would browse through the ‘Money’ section of the Observer to see who gave the best rates on my savings. Northern Rock consistently offered the best rates week by week, month by month, year by year. One day I thought I would look at their rates for borrowers, expecting them to be higher so Northern Rock could balance the books. Blow me down, week by week, etc., they were higher; Northern Rock were offering both savers AND borrowers the most attractive rates. Thus Northern Sand paid out more then any other bank and took in in less. Never mind, Libor, inter-bank lending, and so on; paying more for a product and taking in less than your commercial rivals is a sure-fire way to go bust. If I noticed this over four years, how was it that a financial regulator didn’t get suspicious?

  • Andrew Jackson

    Francis,

    I couldn’t respond under you last comment…

    I’m going to take your points in turn, rather than try to write a long response, so we can see exactly where we differ.

    “the effect of the drawdown of the created deposit at bank A is to create an equal deposit at bank B. The created deposit at bank A has effectively moved from bank A to bank B.”

    We are in agreement on this point.

    “The created deposit at bank A has effectively moved from bank A to bank B. It has done this via the reserve accounts at the Bank of England and using liquidity created by the Bank of England to cover temporary reserve account shortfalls. Therefore private bank created money has in effect “moved through” central bank reserve accounts.”

    No I disagree. A deposit at a bank is a liability of that bank: it is what the bank owes. Central bank reserves are assets of private banks.

    Why is this important? When payment is made between banks, the bank the payment is being made from (Bank A) loses a deposit, and bank the payment is being made to gains a deposit (Bank B). Bank A’s liabilities have therefore decreased, whereas Bank B’s have increased. This is great for bank A – it now owes less – but why would Bank B ever agree to this – it now owes more than it did before the payment was made. The only way bank B will agree to this is if it receives an asset of equivalent value to the new deposit. This is the role of central bank reserves – they are valuable to private banks (they are private bank assets), and as such are used to balance the increase in liabilities.

    So, your point that private bank money has ‘moved through’ reserves accounts is incorrect – reserves are transferred from Bank As account at the central bank to bank B’s account at the central bank. This appears on bank A’s balance sheet as a decrease in their liabilities (due to the reduction in their deposits) and a decrease in their assets (due to the transfer of reserves out of their account at the central bank.) Meanwhile, bank Bs liabilities increases (due to the deposit), but at the same time they receive the transfer of reserves from bank A to their account at the central bank, increasing their assets.

    You then state:   

    “There are not two different lots of money involved. There is ONE DEPOSIT which is created as a consequence of lending by bank A. That deposit is paid to bank B and then borrowed by bank A.”

    I am afraid there are two distinct types of money involved. And there are broadly three distinct  types of money in the economy, 2 of which are created by the central bank. The first of these is central bank reserves. These are only available to banks (because they are liabilities of the central bank, and only banks bank at the central bank.) They appear as assets on a banks balance sheet. This is the same point I made above. There is also cash. This is also an asset of private banks and a liability of commercial banks, but people can also hold this form of money. Finally there is commercial bank created money, which is the deposit that is created when private banks make loans.

    To quote the BoE: “The Bank’s two main liabilities are banknotes in circulation (currently around £50billion) and the reserve balances held by commercial banks.  You can think of these balances as the commercial banks’ current accounts with the Bank of England. Together with banknotes, reserves balances are the most liquid, risk-free asset in the economy. The aggregate balance on reserves accounts stood at around £36billion before the start of the asset purchase programme in March 2009 and the current total stands at around £140billion.”( http://www.bankofengland.co.uk/publications/Documents/speeches/2011/speech487.pdf)

    Moving on, you say the Bank of England do not contradict you when you said banks do not lend reserves to each other: “The Bank of England does not “flatly contradict” me on this. It says that the process by which banks lend funds to each other is ALSO the process by which reserve accounts are adjusted to target. Which is what I said.”

     Well, to for a bank to “adjust reserves accounts to target” a bank must increase it reserves holdings (in its account at the central bank) if it is below target, and decrease them if it is above target. How does it do this? Quite simply, it borrows reserves if it is short and lends if it is high.

    For example from the BoE:  “If a bank has excess reserves, it should be willing to lend in the interbank market at less than Bank Rate in order to shed them.”

    So banks do lend reserves to each other.

    You then say: “Only central banks can alter the total supply of reserves IN THE SYSTEM at any one time. But private banks absolutely can deposit money into central bank accounts.”

    Reserves are liabilities of the central bank – they are deposit money – they only exist on the central bank’s balance sheet. Banks can’t “deposit” money into central bank accounts – they can request reserves be transferred from one bank’s account to another, but that is all. They can’t remove it from the BoEs balance sheet and then put it back later.

    And then: “The process of transferring money through the reserve accounts can involve creation of new reserves. Intraday repos cover funding shortfalls: if at the end of the day these are not repaid the deficit bank must borrow overnight from the central bank, which as you’ve already said, means the central bank creates new money in the deficit bank’s reserve account.”

    Here you are describing the pre 2006 system. Interday repos were suspended in 2006, with the shortest maturity before QE started being one week repos. After QE (I think I am not 100% sure) there have been no repos from the central banks for liquidity purposes at all – the asset purchases have put such a large quantity of reserves into the system that extra reserves through repos are not required.

    You go on to say: “But to suggest therefore that private banks can’t put any money in or draw any money out is nonsense.  Of course they can – just as you can put money into your current account or draw money out of your current account. When you put money into your current account it becomes a liability of the bank. When a bank puts money into its current account it becomes a liability of the central bank.”

    This is the crux of the matter. When you put money into your bank account what kind of money does your bank accept? It will only increase your account if you give it an asset – you either put cash in or transfer central bank reserves from another bank. This is because for them to increase their liabilities (give you a deposit) they have to get an asset. However, taken as a whole the balance sheet of the private banking system has not changed (abstracting from cash) – someweher else in the system a bank has decreased its assets and its liabilities.
    Likewise, under what conditions will the central bank increase the balance of a banks reserve account with it? Only through the direct transfer of reserves from another banks reserves account. This is simply a liability swap (changing the ownership of reserves) on the central banks balance sheet. Or they might give them cash, which is a swap of one liability cash for another, reserves.  The Key point is that no bank can expand the central banks balance sheet through the transfer of reserves – they all have to go somewhere and come from somewhere.

    Of course, as you point out, banks can request reserves due to liquidity shortfalls, however this is the central bank lending to the private sector

    “From the banks’ perspective, interbank lending is lending of excess deposits. From the central bank’s perspective, interbank lending is lending of excess reserves. From the point of view of the banking system as a whole, the two are the same and it doesn’t matter which you call them. Which is pretty much what the Bank of England said, isn’t it?”

    Well, you are talking about banks lending excess deposits at the central bank then I agree.

    Honestly Francis I think some of our differences come from the change to the monetary system that occurred in 2006.  I do also think it is important to distinguish between reserves (which are settlement assets of banks) and cash (which is both a settlement asset and a physical substitute for deposit money), but that’s just me. 
     

  • James Murphy

    Gentlemen, much of this argument is, though articulately expressed, surely unnecessary rocket science. The fact of the matter is that the actual (as opposed to threatened)  financial crisis happened exceedingly quickly: it broke like a wave, as crises ultimately always do. Thus, when push came to shove in 2008, Northern Rock could not put its grubby, greedy hands quickly enough on a sufficient amount of real collateral to back up its own claims to liquidity. 
         As Lehman and Bear Stearns went under, the big players began to call in their loans, Northern Rock suddenly found itself massively over-extended, having equally massively over-reached itself in the mortgage loans market. It simply did not possess anything like the reserves needed to meet its own liabilities. And when it turned around to the other banks they simply washed their hands of Northern Rock. ‘Don’t look at us chum!’      The same fate would have befallen Lloyds, after the HBOS farce, and NatWest had the markets’ basic price discovery mechanism been allowed to function. Of course it wasn’t: too many reputations and riches were riding on it.      Indeed, the run on banks would – and should – have brought all these corrupt institutions down. Their bankruptcy would have cleansed the system and thus prepared the ground for the return of proper capitalism rather than the phony corporate kleptocracy we see operating today.  

  • andycfc

    Worstall is wrong (no change there then at least hes consistant)
     

  • James Murphy

    Ben, reviewing the whole thrust of these exchanges, especially your generous-hearted and patient dialogue with the bizarre ‘Apocalypse-Not-Necessarily-Now’ Coppola fella, you seem to have fallen into the trap of arguing with these types on their terms. Result? being bogged down in the pseudo science of their numbers game.

       Suffice to say that Worstall’s argument reveals a ludicrous ignorance of the basics: commercial banks have never been allowed to print their own money (The BOE does that for them through QE!) – what banks HAVE done, via the ‘fractional reserve principle’ is make an exaggerated number of loans disproportionate to the capital they actually hold.    In this context, a loan made by the bank is not an asset to that bank in the same way that QE printed money from the BOE is. QE adds real (!) government-backed value to that bank’s capital reserves, whereas a loan only adds potential value based on the probability (or not) of repayment by the borrower. Northern Rock sank because it played the fractional reserve roulette table to suicidal levels, lending god knows how many times its capital reserves AND its calculated income from (bad) loans.   No doubt Northern Rock (amongst others) thought it could get away with making these loans (which it had no mathematical right to offer) because it was firmly in the grip of a collective fiscal insanity generated by a belief in the efficacy of the corrupt derivatives market.    But like all fiat currency madness, the high-rolling bets were bound to go bad at some stage, and they did – hideously. Nevertheless, even the banksters were playing the roulette table by certain rules, and when the debts started being called in, Worstall’s idea that Northern Rock might have continued to play with its own pretend monopoly money is ludicrous. – Even the banksters would have drawn the line at the obviousness of this particular crime!   My main plea, Ben, is that we (You and Positive Money) on this side of the argument do not fall into the trap of trying to reason with these crooks on their warped terms.       Ultimately, the arcane pseudo-subtleties of M1, 2,3 or 4 matter not one jot. The only question demanding an answer is whether or not the issuance of money is executed honestly, with a direct, traceable relation to a bank’s real capital reserves. In this context, the fractional reserve system, whereby banks in the current crisis recently lent 10, 20, 200 times the money they actually owned, is corruption incarnate and an open goal to the kind of shysters who have currently brought us all so low without a shred of compunction.     

  • fraccy

    I think what stands out about this interesting exchange between Tim and Ben is the way it highlights the very core of the problem, which is accessibility and widespread understanding. If the legitimacy of positive money’s message can be so easily undermined because of the cognitive distance required to properly comprehend it, it makes it impossible for the general public to be energised and mobilised in a particular direction, which is what it will take for real changes to occur. Its what the Occupy movements were *really* getting at, but most of them never knew it, nor could it be turned into a real slogan. Can this issue ever truly be resolved through simple message, rather than intellectual debate?

  • Stevejh

    Worstall’s little thought experiment is a powerful and
    compelling argument – unfortunately it is based on a very basic error, and his
    inability to understand a simple fact.

    Banks create money by making LOANS against an asset called an agreement. In other words they create credit, which the
    borrower can then spend as new money.

    They cannot just create new credit for their own use. That is a totally different scenario.

    What is so difficult to understand?

  • Tom

    Ben, I’m no economist but isn’t there a simple answer to your long debate with Frances over central bank reserves and M4? As I understand it there is some wrangling over whether 97% or 90% of the money supply is created by bank credit. That is a straw man objection if ever I saw one, but humouring it all the same… ISTM the whole point of the PM argument is to identify the proportion of the money in the economy that is owed to private banks i.e. on which interest is due. As far as I know central bank reserves aren’t available to the economy. And whether credit money is ‘backed’ by central bank reserves is just splitting hairs – we’re still paying commercial bank interest on it.

    Apologies if this is confused – I’m trying to learn. Positive Money, Steve Keen and others have been an eye opener and I admire the way you guys stand up to the apologists for the status quo. The immense complexity they have had to engineer in order to preserve this unnatural state of affairs… They must be horrified by the lack of nonsense in what you are proposing.

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