How is money really made by banks? [Banking 101 Part 3]

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In this video you can learn how commercial banks can create money through the accounting process they use when they make loans, how banks make payments between each other using specially created central bank money, if the Bank of England really can control how much money is in the economy …and more.

Proof & Further Reading:

Bank of England - Money Creation in the Modern Economy

How Banks Create Money:

From the Bank of England’s 2014 Q1 Quarterly Bulletin: “In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” “Commercial [i.e. high-street] banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.(1)” ¬[our addition in brackets] (McLeay, Thomas, & Radia, Money creation in the modern economy, page 1 & 3)

The following paper, from Standard & Poor’s Chief Global Economist, gives a good explanation of how money is created (a bit technical):

Interbank Settlement & Payment Systems

The following two publications from the Bank of England give a good explanation of settlement systems for those who want the technical details:


Before we start looking at how money is really created, we need to have a quick look at what types of money we actually use in the economy.


There’s actually three types of money that we use in the economy. As a member of the public, you will only have ever used two of them. The simplest form is cash – the £5, £10, £20 and £50 bank notes and the metal coins that most of us will have in our wallets at any point in time. As you probably know, only the government, via the Royal Mint and the Bank of England, is allowed to create these. If you try to make your own at home, pretty soon you’ll get the police kicking down your door at 2 in the morning. Now imagine that you need to pay your rent, and your landlord has an account with a different bank to you. When you log into your internet banking and make the payment to your landlord, your bank has to send some money to your landlord’s bank to ‘settle’ and complete the transaction. Of course, the banks don’t want to make these payments to each other in physical cash because carrying all this money around is dangerous, even if they use protected security vans and guards with bullet vests and helmets. So instead, they use a type of electronic money, which is called ‘central bank reserves’. Remember that name because we’ll be using it a lot in this video. Central bank reserves are effectively an electronic version of cash, and banks use these electronic central bank reserves to make payments to each other. The central bank reserves are created by the Bank of England – we’ll cover how later on – and they can only be ‘stored’ in accounts that the big banks have with the Bank of England. To get one of these bank accounts at the Bank of England, you have to be a bank. So as members of the public, we can’t get our hands on any central bank reserves. We just have to use the physical cash.

So the first two types of money are

1) Cash and 2) Central Bank Reserves. Remember that central bank reserves are like an electronic version of cash that only the banks can use to make payments between themselves.

The third type of money

is a type of money that isn’t created by the Bank of England, the Royal Mint or any other part of government. This third type of money is the type of money that’s in your bank account right now. This money is just numbers in a computer system. Bankers and economists refer to this type of money with jargon such as ‘bank deposits’ ‘demand deposits’, ‘sight deposits’ or ‘bank credit’. These terms all mean pretty much the same thing and are used interchangeably. They might also be referred to as bank liabilities – this is the accounting term, because this money is a liability of the bank to you i.e. it’s what the bank needs to repay you at some point in the future. Now in a legal sense, the numbers in your account aren’t really money at all. But despite that, they serve exactly the same purpose as the £10 and £20 notes that you might hold in your wallet. It’s this type of electronic, bank-deposit money that now makes up over 97% of all the money used in the UK economy. Less than 3% of the money supply is cash created by the government. And all this electronic bank-money is created by the banks, as we’ll explain now.

THE BALLOON MODEL (at 03:01 min)

Let’s revisit the multiplier model that we saw in the last video. Remember that it describes the money system as having a base of ‘base money’. In the simplified version, the ‘base’ is made up of cash. In reality, it’s not just cash in this base – it’s also the electronic central bank reserves that banks keep in their accounts at the Bank of England. But it’s true that this base is made up of money – either cash or electronic – that was created by either the Bank of England or the Royal Mint. Now let’s look at the top of the pyramid. The rest of the pyramid is made up of the third type of money – the electronic bank-created money. So the pyramid is split up into a base of government-created money, and a tower of bank-created money at the top. Remember that we said this pyramid, in theory, is limited by the reserve ratio? Well, there is no reserve ratio, and there hasn’t been for years. This means that the total amount of money in the economy isn’t really limited. It can keep expanding without coming to a point at the top. So the pyramid is actually the wrong shape to describe the money system. In reality its closer to a balloon of bank-created money, wrapped around a smaller balloon of base money. In this case, the base money is the electronic central bank reserves and cash. As we’ll see in this video, the Bank of England has relatively little control over the total size of the balloon of bank-created money. They can’t really control how much money is in the economy, even if they claim to be able to. The outer balloon of bank created money could expand out of control and the Bank of England wouldn’t be able to stop it – at least not within the current monetary system. We saw this happen before the crisis. In 2006, the outer balloon of bank-created money was 80 times bigger than the inner balloon of base money. The multiplier wasn’t 10 times, like the textbook models suggest: it was actually 80 times! And then when banks panicked during the crisis and refused to lend, the Bank of England pumped a load of extra base money into the inner balloon, through the scheme known as Quantitative Easing. But this didn’t lead to a massive increase in the size of the outer balloon. Right now the outer balloon – the amount of bank-created money – is only 14 times bigger than the inner balloon. This shows that there is no real connection between the amount of central bank reserves – or base money – and how much money that the banks are able to create.


So what actually affects the ratio between bank-created money in the outer balloon and government-created cash and central bank reserves in the inner balloon? What determines how much money is created for the economy? The research that we have done suggests that the amount of money that banks can create is not determined by reserve ratios, or by regulation, or by the control of the Bank of England. The reality is that the total amount of money depends on the confidence of banks. If they’re feeling confident, banks will create new money by lending more. And when they’re scared, they limit their lending, which limits the creation of money. So the size of the outer balloon really depends on the confidence and incentives of the banks. Or to put it another way, the amount of money in the economy depends on the mood swings of bankers. Given that the amount of money in the economy can determine the health of the economy, does it sound like a good idea to have such an important thing decided by the mood swings of bankers? Probably not!


OK, back to the numbers in your bank account. These numbers are all created by banks. The vast majority of these numbers were created when somebody took out a loan from a bank. Let’s see how this happens. A customer, who we’ll call Robert, walks into a Barclays Bank and asks to borrow £10,000 for home improvements. Barclays runs a quick automated credit check and decides that the customer can be relied on to keep up repayments on the loan. The customer signs a loan contract promising to repay the £10,000, plus the interest, over the next 4 years, according to an agreed monthly schedule. This loan contract is a legal contract that binds the customer to make repayments to the bank. This means that it is a legal contract that is considered to be worth £10,000 (plus the interest). Because it’s an asset, Barclays can record the loan on its balance sheet. Now if you haven’t come across a balance sheet before, don’t worry – it’s pretty simple. There’s two parts to a balance sheet. One half records all the things that the bank owns – this could be money, other financial products like bonds and derivatives, bank buildings, computers, and most importantly, the loans it has made. How can you own a loan? Well, if someone signs a contract promising to pay you money, then that contract is worth something. It’s considered an asset of the bank. In the case of Robert, the contract that he signs promising to pay the bank £10,000, plus interest, over the next few years, is worth at least £10,000 to the bank, and therefore it’s an asset to the bank. So the bank puts an extra £10,000 on its balance sheet, like this:


(Step 1) (Left side) Assets (What the borrowers owe to bank + bank’s money) Loan to Robert: +£10,000 Now what about the other half of the balance sheet? The other half of the balance is what’s called the Liabilities. This is a record of everything the bank owes to other people. On this side, you’ll find a record of money that the bank has borrowed from other banks or large pension funds. You’ll also find all the customers accounts, because – if you remember – the balance of your account is just a number showing what the bank promises to pay you when you ask for your money back. When Robert signed the contract promising to pay the bank £10,000, plus interest, over the next 10 years, he did it because he wanted some money from the bank. So the bank creates a new account for Robert, which is linked to his debit card, and just types £10,000 into their computer records. This £10,000 is a liability from the bank to Robert, and it shows up on the other half of the balance sheet. (Right side) Liabilities (What the bank owes to the depositors + bank’s net worth) Robert’s new account: £10,000 Now when Robert goes to the cash machine to check his balance, he’ll see £10,000 which he didn’t have before. All the bank has done to create this new money is type some numbers into an account. It hasn’t reduced the balance of anyone else’s account, and it hasn’t taken any money from some pensioners and moved it into Robert’s account. So the process of creating commercial bank money – that’s the money that the general public use – is as simple as: 1. a customer signing a loan contract and 2. the bank typing numbers into a new account set up for that customer This new bank-created money represents new spending power – or money – in the economy. Robert can now go and spend his money anywhere in the economy, using his debit card, cheque book, internet banking transfers, or even by taking the cash out of the ATM.


But there’s a small complication. What happens if Robert goes and spends the new bank-created money with a shop that has a bank account with a different bank, say Lloyds? If this happens, then Lloyds will want to see £10,000 of real money from Barclays. Barclays would then need to transfer £10,000 of central bank reserves to Lloyds to settle the transaction. Note that from the point of view of Lloyds, receiving a transfer of £10,000 in central bank reserves into its account at the Bank of England is just as good as Barclays pulling up in a truck and dropping off £10,000 in cash, although it’s much more convenient for the banks to have the electronic central bank reserves than to have to carry around all that cash. This process of banks making payments between themselves is called inter-bank settlement, and it’s really important to understand it, because it’s crucial to the way that banks have been able to gain control of the entire money supply. First, let’s look at the simplest example of inter-bank settlement, with just two banks and two customers. Robert, when he receives his loan, goes straight to a DIY store and spends £10,000 on everything he needs. He gets to the checkout and pays using his visa debit card. Here’s a simplified version of what happens behind the scenes: First, the DIY Store’s debit card machine automatically contacts Visa and say “Please charge £10,000 to this card number: xxxxxx”. Visa’s computer systems then dial up Barclay’s computer systems and say “Robert’s trying to spend £10,000 on his debit card. Is that ok?” Barclays’ computer system checks the balance of the account and says “Yes”. Barclays computer system then reduces the balance of Robert’s account by £10,000. Now, Visa’s computer system contacts the Lloyds, and says “I’m sending you £10,000 for the DIY Store’s account”. Lloyds then updates the balance of the DIY Store by £10,000. However, importantly, when the owners of the DIY store log into their internet banking, they see two figures. One says “Account balance”, and the other says “Available now”. For the next couple of days after Robert has come into the shop, the Account balance will be £10,000 higher than the Available Now balance. The £10,000 that Robert spend isn’t available to the DIY Store for them to spend just yet. Why? Well, behind the scenes, Barclays needs to settle with Lloyds. When Lloyds gets the message that someone has spent £10,000 in the DIY store, it updates their account balance, and then calls Barclays to say “Send me the money…”. Barclays could settle with Lloyds by delivering the £10,000 in cash, but in reality this is just a hassle for both banks. They’d have to find somewhere to store all the cash, and a van with security to transport it. So instead, Barclays will settle by making a £10,000 transfer from its reserve account at the Bank of England, to Lloyds reserve account at the Bank of England. Once Lloyds gets the £10,000 in its account at the Bank of England, then it will update the Available Balance in the DIY Store’s account.


Now, this was a simple example that involved just one payment between two bank customers (Robert and the DIY store). Only two banks are involved. But in the UK right now there’s around 50 million people with bank accounts. Some of these people make more than one electronic payment a day. And they bank with over 50 different banks. In fact, every day over 60 million transactions are made between bank accounts in the UK, through a number of different payments systems including Visa, Mastercard, direct debit and online bank transfers. If banks had to go through the whole hassle in the example with Robert every time someone bought a sandwich from a supermarket using their debit card, it would get very messy very quickly. But there’s a clever way of simplifying the whole thing massively. It’s called multi-lateral net settlement. When you have a lot of individuals and businesses all making payments to each other, that’s a lot of money flowing between the different banks. So what the banks do, especially with systems like BACS (which manages direct debits and the type of bank transfers that you make via internet banking), is this: First, they put all the payments into a big computer database first without actually moving any real money – cash or central bank reserve – about. Then, at the end of the day, or every few hours, they run a process to cancel out all as many of the payment flows as possible. For example, imagine a customer at Lloyds sends his rent – £350 – to his landlord’s account at Barclays. But on the same day, a customer at Barclays sends his own rent – £400 – to his landlord, who happens to be at Lloyds. The two payments almost cancel each other out, so after cancelling out – or ‘netting’ in the official jargon – the only money that really needs to be moved is £50 from Barclays to Lloyds. Because there are millions of payments being cancelled out by this system, the amounts that actually need to be transferred between the banks at the end of the day are usually just a tiny fraction of the total value of the payments made. This is why, even though in 2007 RBS customers had nearly £700 billion in its customers accounts, RBS itself only had £17bn that it could actually use to make payments on behalf of those customers. This £17bn was more than enough for the total netted payments that it would need to make at the end of each day.


This netting out effect means that a bank only needs to have a very small amount of available money compared to the total amount that they owe to customers at any particular time. They know that any payments they make to other banks are likely to be cancelled out by payments coming back to it. On some days, the banks customers will spend more than they receive, and at the end of the day the bank must pay some of its money across to other banks to settle these payments. But on other days, customers will receive more – in salaries and other income – that they pay out, and the bank will end up receiving money from other banks at the end of the day. Over time, the total amount of money needed by the bank doesn’t change much. The only time that they would actually need all the money that they owe to their customers is if customers were to panic and ask for all their money back at the same time. This is what happened to Northern Rock in the UK and Wachovia in the US, and it can destroy a bank very quickly. This process is what gave rise to the term ‘fractional reserve banking’, because banks only keep enough money to repay a fraction of their customers at any time.


We’ve talked about the central bank reserves that banks keep in their accounts at the Bank of England. These ‘reserve accounts’ don’t store cash – just electronic central bank reserves. It’s important to appreciate that, although central bank reserves are created by the Bank of England, they’re still just numbers in a computer system. These numbers are just stored on a file very similar to an Excel spreadsheet, and we could create a billion of them in the time it takes to type out 1,000,000,000. The £150 billion of central bank reserves are no more tangible than the numbers on this screen, and in fact, the entire record of balances of the central bank reserves scheme will take up less space on the Bank of England’s computer hard drive than the average song on an MP3 player! Now the computer system that records all these central bank reserves is referred to the Bank of England as the Real Time Gross Settlement Processor – or RTGS Processor. Now real-time gross settlement isn’t as complicated as it sounds. Settlement simply means that it’s a system that banks can use to settle their payments to each other – in other words, it’s a way for them to transfer money to each other. ‘Real-time gross settlement’ means that any payment instruction sent to the computer system is processed immediately. If a payment of £100,000 is sent to the system, £100,000 will be transferred automatically. This is in contrast to multi-lateral net settlement that we discussed just before, in which all the payments are queued up, cancelled out against each other, and only the final net difference is transferred. When a payment is put through the RTGS processor it’s considered to be final. It’s also considered to be risk-free: If one bank owes money to another bank, there’s always a small chance that it won’t be able to pay the other bank. But once the money has arrived in the central bank reseve account, then the deal is finished, because holding central bank reserves is just like holding cash – it’s the safest asset you can have. So at the end of the day, the multi-lateral net settlement payment systems will cancel out all the smaller payments between different banks, and then they’ll tell the Real Time Gross Settlement Processor how much the net differences owed between the banks should be. The RTGS system will then transfer the central bank reserves from the banks that owe money to the banks that are owed money.


So, let’s recap everything we’ve covered so far, before we look into what actually determines how much money the banks can create. We’ve seen that the textbook model of money creation suggests that there’s a base of central-bank or government created money, on top of which the commercial banks can blow up the total money supply by re-lending the same money over and over again. We saw that this model is actually completely inaccurate. There’s no natural limit to how big the money supply can grow, so it’s actually better to think about this as two balloons rather than a pyramid. We saw that banks can create money by simply typing numbers into a customers’ account when they make a loan. When you sign the contract the bank gets an asset that balances out the new liability they create when they type numbers into your account. When a customer spends the money the bank has just created, and those payments go to customers of other banks, then the other banks will call the bank that created the money and ask for them to settle in central bank reserves. But before this happens, payment systems like BACS and Visa debit will cancel out the payments against each other, so that only the net difference at the end of day has to be ‘settled’ i.e. transferred between the banks. This netting out significantly reduces how much money banks really need to keep at any particular time. In a few minutes, we’ll see what actually limits how much money the banks can create. But first, it’s worth asking whether the numbers that banks create can really be considered money…

[WpProQuiz 3]

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  • Stanstan

    This video does not explain how the Bank of England creates central bank reserves. Where did the £17bn of reserves held at the BoE by RBS come from? Was it gifted by the BoE or did Rbs give something in return?

  • Andrea Barbon

    The linked paper from S&P does not exist. I could find it from some other sources, but as long as I can’t download it from the S&P servers, how can I be sure it is not a fake?
    Please fix this issue, otherwise your sources are definitely not reliable.

  • kiskrof

    Thanks for these wonderful videos. However, I am not convinced that the quantity of money depends only on the confidence of the bankers. Credit money is actually like babies: you need two partners to make them. Banks are like males: they hardly do anything and provide just a little bit of information (I consider that money is information, a language more than a real thing, just like a sperm is just genetic information, while the ovum contains the whole cell machinery), while companies create real things(though some of them create bad things). We leave in an age of low interest rates: doesn’t it mean that bankers are ready to lend money quite easily, while companies do not want to borrow? Doesn’t it mean that while bankers are not using condoms, companies are on the pill?

  • kiskrof

    Most people make a big deal of the difference between paper money and electronic money and your video does not destroy this wrong belief with sufficient emphasis. Paper money is completely virtual too. It has value only because the people believe so, exactly as electronic money. To people from a few centuries ago, the idea a settling transactions with pieces of paper would have seemed utterly extravagant. The belief in a fundamental difference between paper and spreadsheets stops people understanding the essential difference: legal money vs private money (of course in your videos private money is called credit money, it is just a matter of emphasis)

  • Veri Tas

    Hmmm, now I know why most banking decision-makers are men – their moods are more stable than that of women, of course!

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