Banks don’t lend money

Home » Blog » 2013 » June » 24 » Banks don’t lend…

Professor Hyman Minsky once wrote “Banking is not money lending; to lend, a money lender must have money. The fundamental banking activity is accepting, that is, guaranteeing that some party is creditworthy. A bank, by accepting a debt instrument, agrees to make specified payments if the debtor will not or cannot”.

“Banking is not money lending”? Surely some mistake! Why would an economist as famous as Professor  Minsky make such an outrageous sounding statement?… Well the answer is that its perfectly true. Crazy though it sounds, banks don’t lend money at all. To understand why this is the case we must understand some technicalities about money.

Most people imagine that money is simply a system of government-created tokens (physical or electronic) that get passed form person to person as trade is carried out. Money of this kind does indeed exist, so called “central bank money” is of this type. However the vast majority of the money we spend day today is a second type, technically known as “broad money” or “cheque book money” which can best be described as “spendable bank IOUs”. The concept of a spendable IOU may sound rather strange, and in order to explain it, we must first consider some characteristics of an ordinary IOU, the kind you or I might use…

Say that Mick wanted to borrow £10 from Jim. Jim could give Mick a £10 note in return for a piece of paper with “I.O.U. £10, signed.. Mick” written on it. The IOU would then have some value to Jim as a legal record of the loan. At some later time Mick would repay the loan. At this point Jim should no longer keep the IOU because Mick would no longer owe Jim any money. The IOU has now done its job and may be disposed of. To summarise, the lifecycle of an ordinary IOU is as follows:

  1. Creation (out of nothing. It did not exist previously)
  2. It now has value as a legal record of the loan.
  3. It expires (back out of existence) when the loan is repaid.

Note that even though the IOU has value during stage 2, it is not easily spendable. If Jim went into a grocery shop and said “I’d like to have £10 worth of food, here’s an IOU from Mick, he’ll pay you back later”, the shopkeeper would almost certainly  refuse. This is because the shopkeeper has no idea if Mick is creditworthy, the shopkeeper would be worried he may never receive £10 from Mick. Now imagine for a moment that it could somehow be arranged to have a guarantee from a famous high street bank, that Mick would indeed pay £10 to the holder of the IOU. Then the shopkeepers fears would be allayed and he would have no reason not to accept Mick’s IOU as payment for food. To summarise, a bank guarantee could convert a non-spendable IOU into a spendable IOU.

So far this has all been hypothetical, but to see a non-spendable IOU get converted into a spendable one in the real world, look no further than the process of getting a “bank loan”. The term “bank loan” is in fact highly misleading. What is actually going on is not lending at all, it is in fact an IOU swapping arrangement. If Mick went to borrow £1000 from a bank, the first thing that would happen is that the bank would asses Mick’s creditworthiness. Assuming it was good enough, then the bank would ask Mick to sign a “loan agreement” which is essentially an IOU from Mick to the bank. What the bank would give Mick would generally not be “central bank money”, but instead its own IOUs (i.e. cheque book money). And just like ordinary IOUs, bank IOUs do not have to be obtained from anybody else. They are just created on the spot. No “lending” is going on. In order to “lend”, the bank would have had to have been in possession of the money beforehand, and they were not.

So there you have the layman’s explanation. But some people are still not convinced. Many people have heard a different explanation of the money creation process at university or from textbooks and so assume that this explanation is somehow wrong. But let me assure you that it is the textbook explanation that is wrong. I do realise that “extraordinary claims require extraordinary evidence”. So here goes…

The first thing to say is that the explanation given here is indeed a simplification of the money creation process as it occurs in the real world. The full details of which are so complex and so frequently changing that they are not taught to undergraduate students as part of economics degrees. What students are often taught instead is a toy model of reality. A not-actually-true teaching aid. The idea of using a not-actually-true teaching aid is not unique to economics, in the field of chemistry a similar thing occurs with regard the behaviour of electrons around atomic nuclei. The real world behaviour is too complex for undergraduate students, so they are taught a not-actually-true story of “electron shells”. Its in virtually all the textbooks.

The standard not-actually-true method for teaching students about the workings of our monetary system is an explanation called the “money multiplier model” in which banks appear to lend out money that has been deposited with them. When some economists finish their degrees and subsequently go on to specialise in the monetary system and finally learn the full details of the process, they occasionally have some choice words to say about the undergraduate textbook model:

  • “The way monetary economics and banking is taught in many, maybe most, universities is very misleading”. Professor David Miles, Monetary Policy Committee, Bank of England.
  • “The old pedagogical analytical approach that centred around the money multiplier was misleading, atheoretical and has recently been shown to be without predictive value. It should be discarded immediately.” Professor Charles Goodhart CBE, FBA, ex Monetary Policy Committee, Bank of England.
  • “The textbook treatment of money in the transmission mechanism can be rejected”. Michael Kumhof, Deputy Division Chief, Modelling Unit, Research Department, International Monetary Fund.
  • “Textbooks assume that money is exogenous.” … “In the United Kingdom, money is endogenous” Mervyn King, Governor of the Bank of England.

Notice the extremely high calibre of the economists being quoted. These are all economists that specialise in the workings of our monetary system.

Is this issue controversial? Well yes and no (but mainly no)… let me explain. the issue is only controversial in as much as non-experts (that have just learned the textbook story) may say things that contradict the experts that have a detailed knowledge of the system in reality. But amongst the experts, it is not controversial at all.

I shall finish with a quote form Professor  Victoria Chick, Emeritus Professor of Economics, University College London:  “Banks do not lend money. It may feel like it when you get a ‘loan’, but that’s not what they are doing. They don’t have a pot of money which they are passing on. What they are doing is accepting your IOU… they simply write up your account”.

So there you have it, banks do not lend money. And if you want to argue against this on academic grounds, please only quote economists that specialise in the monetary system.

Mick’s Blog: http://mickanomics.blogspot.co.uk/

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  • http://ralphanomics.blogspot.com/ Ralph Musgrave

    Hi Michael,

    Any thoughts on this:

    I’ve got doubts about the idea that commercial banks charge interest on the “spendable IOUs” or “money” they issue. They’ll certainly charge for the ADMINISTRATION COSTS involved in assessing Mick’s creditworthiness plus they’ll charge something to cover bad debts, and they may well call those charges “interest”. But genuine interest is a charge made by a lender for foregoing consumption so that the borrower CAN CONSUME goods and services. And when a bank issues spendable IOUs/money out of thin air, the bank does not forego consumption.

    As distinct from creating spendable IOUs/money, banks engage in another and totally different activity as follows.

    A commercial bank has to attract some minimum amount of deposits, else it runs out of reserves. And those depositors demand interest. So in addition to creating spendable IOUs, banks also engage in the activity which they are traditionally seen as engaging in: connecting lenders and borrowers. So when a bank attracts £X of deposits and lends that on, no money creation takes place, but interest WILL BE charged to the borrower to cover the interest demanded by the depositor.

    So to summarise, I’m saying that banks DON’T charge interest on the money they create, but in as far as they’re engaged in lending depositors’ “already created money” to borrowers, they DO CHARGE interest.

    • M Reiss

      I’m not going to argue against you on that point, you may well be right. The things a bank has to do when they make a “loan” are quite complex, so exactly what the “interest” charge is for is unclear. The banks could say almost anything. Its a bit like when a shop sells something, it can always claim that a component of that thing is “free”… its kind of arbitrary.

    • John Anderson

      The problem with this scenario at the moment is that commercial banks no longer need to attract deposits from savers as QE is free money, whereas savers require interest. This has led banks away from attracting money as they are being given it by the Central Bank.

  • Speedfriend

    “What the bank would give Mick would generally not be “central bank money”, but instead its own IOUs (i.e. cheque book money). ”

    Actually in general, the bank would give Mick centeral bank money.

    When I get a mortgage which is paid over to muy solictor, the bank ghiveds me central bank money (as no deposit is created at my bank)

    When I spend on my credit card, the bank gives me central bank money (as no deposit is created at my bank).

    When I spend on my overdraft, the bank gives me central bank money (as no deposit is created at my bank).
    In fact it is the exceptional case where the bank doesn’t give me central bank money.
    Please don’t confuse the money creation by the banking system with what an individual bank does.

    • Graham Hodgson

      Speedfriend paints a picture of banks as moneylenders, which is what all of the authorities quoted above agree they are not.

      As well as the deposits banks hold at the central bank (“reserves”), banks hold deposits with each other for the purpose of settling bilateral payments. And these deposits have not been granted in exchange for central bank money or other third party assets but, as with deposits for the general public as a whole, over 95% of them are created in exchange for reciprocal loan undertakings. Bank A’s deposit with Bank B is a spendable IOU from bank B, which bank B has created in exchange for a straight IOU from bank A. Even central bank reserves are just spendable IOUs like any other bank deposit, only there is a restricted circle of who can accept them and they are created primarily in exchange for third party assets.

      Up to 2001, before the interbank lending spree took off in its race to the great 2007 credit crunch, interbank loans and deposits totalled a steady 17% of all deposit liabilities, compared with holdings of cash and central bank reserves of just 0.5% of total deposits (these figures are taken from BoE’s web site and all relate to sterling balances). Quantitative easing has inflated banks’ holdings of central bank money to 9% of deposits now, but interbank loans and deposits are still around the 17% mark, although the proportion with unrelated banks has dropped from 40% at the time of the credit crunch to 10% now.

      The point is that banks don’t settle payments by paying over money, they settle by calling in IOUs.

      • Speedfriend

        Bank don’t settle balances with deposits at another bank, they settle them with central bank money. That is how the payments system. If I transfer money from my Natwest account to my HSBC account, that transfer happens instantaneously in central bank money, not by someone at Natwest ringing up HSBC and ask for a loan.

        Interbank lending is a form of bank funding, allowing banks with excess deposits to lend to banks that need more funding so that they can make loans. In fact a bank doesn’t ever need deposits to lend money, it could operate entirely by borrowing on the interbank market and never have a customer deposit on its balance sheet. Which shoots the argument that bank create a deposit ever time they lend argument in the foot.

        • http://www.economania.co.uk Bill Kruse

          “If I transfer money from my Natwest account to my HSBC account, that transfer happens instantaneously in central bank money,” Are we sure that’s what happens? Do they not settle it ll up at the end of the day?

          • Speedfriend

            All large payments and time sensitive payments (such as house purchase) are done real-time through chaps. Most banks now offer faster payment for smaller payments, which is sent same day.

          • http://www.economania.co.uk Bill Kruse

            Which doesn’t mean banks don’t effect this by adjusting their central bank reserves at the end of the day to compensate for any imbalances.

          • Speedfriend

            Yes it does, since 1996 the real time gross settlement system has been in place which settle each and every Chaps and Crest transaction in central bank reserves as they take place. These account for 97% of daily payment value. Only smaller retail payments that go through Bacs would settle in the old DNS (deferred net settlement) method, where the banks merely settle the net amounts at then end of the day.
            Real time settlement is crucial to a properly functioning payments system otherwise in times of stress, banks would simply stop accepting payments from other banks if there was daily net settlement (as youi could effectively be lending money to a bankrupt bank)

  • Terry

    Let’s take it a step further back than the ‘Central Bank’. Where does the Central Bank get it’s ”Money”? Who actually guarantees Central Bank Money? Is Central Bank Money ”real money” instead of an IOU? If Central Bank Money is not an IOU and is ”real money” then what backs up the real money value? Is Central Bank Money guaranteed by the the Tax Payer? or is Central Bank Money just privately produced money/credit figures on a screen from a widget factory whose widgets are paper with pictures on it and numbers on a screen? If the ‘People’ are the Guarantee for the Central Bank Money via Taxes (which I tend not to believe) then the people are the source and value of all Credit, not Central Banks or the Private owners. Therefore why are the people and their families being thrown from their homes by Banks who claim to have ”lent” funds that belong to a Central Bank that is either privately owned by a money widget producing factory, or, the very people being thrown from their houses are the very source and value of the ”Credit” in the first place. (Cred = believe, It = it), Therefore we have a system that demands ”Belief” and money ends up like a religion.

  • Stuart

    Yes it’s all a big con, that’s why people should get out loans and not pay them back. We create the money not the banks. You would think they would just lend to anyone, however the reason they don’t which is an assumption of mine is that they need the loans they make to have a good rating or they can’t sell them as Special Purpose Vehicles. Back around 2008 when they where giving mortgages to just about anyone and some 110% they where using fraud to disguise these loans as good loans and then betting against them (Short selling) it is a fact however that the average Joe who takes out a Wonga loan gets charged at 51% while banks actually get paid to borrow money from each other. How nice would it be if we got actually paid money to take out a loan. Really that’s how it should be since we are creating money for them. Good for Goose.

    All banks are scum and have been ripping off the people. They lend you nothing and we make them rich. Then they take tax payers money when they cry because they bet on risky investments. How nice would it be to go to Vegas, you loose and you and get your money back. You win and you get to keep it. While all the time the Government sells off our essential services, demoralises the poor disabled and sick by taking away there money. While the banks happily wallow in shit.

    I happily try to rip them off as much as I can. It’s time people stopped being concerned about their debts and take back their power.

    Banks sell on your credit agreements called (Promissory Notes) package these up into SPV’s (Special purpose vehicles) then continue to charge you even though they have already sold your credit agreement. All these debt consolidation companies and supposed charities that say they can help with your debts are approaching it the wrong way. All these debts are unenforceable.

    Ask for the orgional credit agreement you signed to be sent to you. The will not have this because they sold it. Then use http://www.oft.gov.uk/about-the-oft/legal-powers/legal/cca/unenforceable-credit-agreements#.UeplAKzvgSc

    and stop paying them

  • itdoesntaddup

    The most forensic analysis of money that I know is Martin Shubik’s. Perhaps beyond most, because much of it is couched in the language of mathematical economics. This paper is largely non-mathematical, but gives a good tour of many of the issues:

    http://cowles.econ.yale.edu/P/cd/d13a/d1343.pdf

    It is of course a small step from disavowing money multipliers to approving of highly geared bank balance sheets – a hazardous position for a central banker. In that context, it is interesting to note that Haldane has concluded that simple rules are probably far more effective in preventing banking collapse than modern risk management models. For example, his speech here:

    http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech657.pdf

  • Dan

    Assuming this article is correct – and I have no reason not to believe it – where can I get a better explanation of why this is the case? I’d like to know exactly what’s wrong with the money multiplier model and why it doesn’t hold true, rather than just a few quotes from a few expert, but seemingly minority voices?

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  • Ginger Sarmento

    For more than 15 years, Steve Keen, the Australian Economist, has been trying to get people to undertand that Milton Keynes’ Economic System does not work. The “Keynes” system has gradually put the world into the financial mess which it is in today. To find out why, read “Debunking Economics” by Steve Keen.

    “The answer lies in the way Economics is taught in the world’s universities. Economics students graduate from Masters & PhD programs with an effectively vacuous understanting of economics, no appreciation of the intellectual history of their discipline, and an approach to mathematics which hobbles both their critical understanding of economics, and their ability to appreciate the latest advances in mathematics and other sciences. Many of these ill-informed students go on to become Economics professors, then repeating the process. Ignorance is perpetuated.”

    Even though the Keynes economics is flawed, it still takes intellectual muscle to master its principles so economists refused to consider any criticisms of economic theory, even when they emanated from other economists, and met rigorous intellectual standards, most of them sincerely believed that, if people followed the principles of economic theory, the world would be a better place. Virtually everything they recommended favored rich over poor, capitalist over worker, privileged over dispossessed.” (profit over customer service).

    Well, as a result of not questionning the “experts” we are now in a serious crisis where the Elite 1% have taken over everything and own more than the combined wealth of the remaining 99% …and they haven’t quit yet! Because GREED begets more GREED–the inability to be satisfied. They cannot understand that it is impossible to be happy by screwing others. And so they continue to seek happiness through acquisition, although it can only come by leading a life that acquires “Inner Peace.” The question is: “Why have we handed over the running of the world to economists?”

  • Adam Phelps

    I think you are incorrect in your claim that modern undergrad Chemistry textbooks teach the shell theory as true. Perhaps you can cite an example or two?

  • James

    So if this is the case why do we have to pay the bank back on my mortgage? To legally lend something or loan something we need to first own it?

    The money created out of nothing has no intrinsic value and does not exists for any purpose other than me buying my home. My home has real value the loan has no value.

    Have they not broken one of primary rules in contract law.. They don’t actually own what they are lending out?

    • Gabor

      Hi James..I have a friend who was recently in 41k of debt. After doing some research on the subject, he managed to clear his loan once realising that, indeed, the bank never owned the money they lent out.

  • Gabor

    Do I then have to pay my bank loan back if the bank didn’t own the money in the first place?

    • James

      Hello, thank you for informing me. Do you have the name of the legal case? I’m assuming that would be a precident for many legal claims. I’ve been searching for such cases and have found none to date. Was this recently? If you could please provide me with as much details on the case for reference I would be extremely greatful.

      Thank you.

      Kind regards,

      James

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