This blog is part of a series on the veracity of various bits of information floating around the topic of Monetary Reform….
Update: This is a UK website, and I am referring to the UK banking system only in this article…
“A bank keeps a 10% fraction of its deposits in reserve, and lends out the other 90%, this then arrives in another bank account, 10% is kept back, and it continues until there is nothing left”
This is perhaps the most commonly citied misnomer in Monetary Reform circles here in the UK. Due to partially incorrect (Update 2: certainly when referring to the UK system – for an academic challenge to the veracity of this “money multiplier” theory in the US, see Steve Keen’s paper – available here) analyses in films like Money as Debt & Zeitgeist it still persists despite the inaccuracies, and in the absence of an analogue for either film in the UK. Banking used to work in this way, but has not done so for over 20 years. Unfortunately, things are now a little bit more complicated.
1. Bank A receives a deposit from Person A of £1000
2. Bank A keeps £100 in reserve (a 10% reserve ratio), and lends £900 to Person B
3. Person B uses the £900 to buy a car from Person C
4. Person C deposits the £900 into Bank B
5. Bank B keeps £90 in reserve, and lends £810 to Person D
6. The process continues until only 1p is kept in reserve
Before we continue, it is important to understand the difference between liquidity and solvency.
Liquidity – for a bank – is the ability to be able to meet demand for withdrawals when lots of people want to withdraw money at the same time, and this is what banks get to decide for themselves.
Solvency is the long-term stability of the banks finances, and is what “capital requirements” are designed to ensure. The theory goes that by making banks hold some capital back in reserve, they should be able to survive if somebody goes bust and cannot pay their loans back.
This old process above was designed to keep the bank both solvent and liquid.
The regulations were designed to cover the risk of a bank run, a liquidity buffer of 10% to ensure that there was enough money set aside to cover an unusual level of transfers or withdrawals in normal business. When there was a significant panic, however, Person A would find that his money was not actually available for spending as it had been put on loan, and there was not enough of somebody else’s money to cover their withdrawal request.
Banks ceased to use this system upon the switchover to the Basel Accords, and the loan process works differently now…
The Basel Accords
Liquidity buffers have now been done away with – you would think that this means that banks can now make as many loans as they wish, which is more or less the case, but not for this reason.
Banks get to decide their own levels of liquidity, and can decide themselves how much cash they keep set aside to cover an unusual spike in withdrawals. During times where there is a problem with liquidity banks can temporarily borrow from other banks on the “LIBOR” market (London Inter Bank Offered Rate) or be given some extra money from the Bank of England.
Extra regulation has now been put in place to limit the amount that banks can lend, to try to limit the level of money creation. Banks must now set aside a certain amount of “capital” every time they make a loan.
Capital can be in the form of interest bearing instruments such as Government Bonds, or a variety of other things. Government Bonds are pieces of paper that the government will exchange for money, and can be used to claim back the money over a period of time with some interest on top. This is how the government borrows money.
Capital can consist of many things, also including retained profits. Being able to use retained profits as capital means that every time a bank makes a profit, it can set some aside and use it as capital to make even more loans, on top of the additional loans it can make every time a customer repays and more capital is free to fund a loan.
In the current system of regulation, loans are given a “risk-weighting” depending on how risky the regulators perceive the loan to be. Business loans are given a 100% risk weighting, meaning that for regulatory purposes the level of capital currently required must be, for instance 8%, of the real value of the loan. The level of capital required is set to go up, and is being discussed currently by international regulators.
So, if a business borrows £1000, £80 of capital must be kept aside for a capital requirement of 8%, as the loan is risk-weighted at 100%. Mortgages are given a lower risk weighting, as if the homeowner cannot pay, the house can be sold to someone else. Mortgages are currently weighted at 35%. This means that a £1000 mortgage would only require the same level of capital that a £350 business loan would. It also means that a business loan must make a bank three times as much profit as a mortgage would, otherwise it will be a bad investment. It is not hard to see why so much money is pumped into housing with this situation.
This process is known as “capital adequacy”, supposedly ensuring that banks have enough capital to cover losses.
How banks get around the rules
I mentioned earlier that the level of money creation is effectively unrestrained; there are two particular regulatory practices that enable this. I talked about “capital” earlier, and certain things that it can consist of, one being retained profit. Banks are more or less guaranteed to make profit, and vast amounts of it, after all the bonuses and dividends have been paid and the rent for the branches is in order, there is some left over. This is added to the pile of existing capital, and can be used to make further loans. This in itself would not allow unlimited levels of loans to be made, only more and more as the banking sector grows in profitability.
The other factor is in something called securitization. This is the practice of effectively selling on a loan, passing the risk & reward onto someone else in exchange for cash, which can be used as capital. A bank packages up a large amount of loans, and sells them onto somebody else at a discount, the interest is then paid to the new owner of the loan, and the bank has freed up more capital by selling on the loan and can then make more loans.
The new process is slightly harder to understand, as the liquidity and solvency measures are now separate. The capital requirement is 8%, so a bank will be able to create 92% of the value of a loan for a business out of nothing, as the loan is weighted at 100%. For a mortgage, which is weighted at 35%, a bank can create over 97% of the value of the loan.
When we talk about banks “creating money” by putting aside capital and adding numbers into a bank account for a loan, people sometimes say that the extra numbers are “credit”, and not “money”.
The clearing system is how this “credit” is transformed into money. When a bank makes a loan, and the loan is then spent and transferred into another bank account, the corresponding bank accounts decrease and increase respectively. Further to this, “base money” moves around. Base money is a special kind of money that only banks have access to, and in “clearing” it, they get to create the kind of money you and I use.
- Imagine two sets of customers, two at HSBC, and two at Barclays. They are both making opposite transactions.
- So for the first set of customers, £100 is going from HSBC to Barclays, and for the other set, £100 from Barclays to HSBC.
- HSBC must transfer across £100 of base money to Barclays, and in the other transaction, Barclays sends £100 across to HSBC.
- By using the clearing system, the banks can both keep their base money because in this transaction everything cancels out.
- This means the banks didn’t need to have any base money to begin with to do the transaction.
- Now imagine millions of people across the country all transferring money to each other across only a few major banks.
- These banks can keep a tally in their computer systems, and usually the same situation above results at the end of each day, the banks don’t need to move around very much base money because it all cancels out.
Having access to this clearing system and the base money used within it means that banks can make loans many times greater than their stock of base money, as long as everything clears at the end of the day, banks can lend almost as much money as they like. If something goes wrong and for some reason everything doesn’t clear, the Bank of England can help out.
The Quantitative easing programme added hundreds of billions in base money to the system, meaning that at the time clearing became easier, but it has also meant that when confidence is restored, banks will be able to create a much greater quantity of money, because higher stocks of base money will make clearing safer for them.