Common Misconceptions about Banking

There is significant confusion about banks. Much of the public is unclear about what banks actually do with their money. Economics graduates are slightly better informed, yet many textbooks used in undergraduate economic courses teach a model of banking that has not applied in the UK for a few decades, and unfortunately many policy makers and economists still work on this outdated model.

Here is a brief overview of the common misconceptions about what banks do, and then gives an initial overview of what they actually do.

Popular Perceptions of Banking 1: The ‘Safe Deposit Box’

Most people will have had a ‘piggy bank’ at some point in their childhood. The idea is simple: keep putting small amounts of money into your piggy bank, and the money will just sit there safely until you need to spend it.

For many people, this idea of keeping money safe in some kind of box ready for a ‘rainy day’ persists into adult life. A poll conducted by ICM on behalf of the Cobden Centre[1]found that 33% of people were under the impression that a bank does not make use of the money in customers’ current accounts.

When told the reality – that banks use at least some of the money deposited within current accounts to fund loans – this group of people answered “This is wrong – I have not given them my permission to do so”.

You do not own the money you have put in the bank. 

The ‘custodial’ role that banks are assumed to play by a third of the public is something of an illusion. Similar confusion is found over the ownership of the money that we put into our bank accounts. The ICB/Cobden Centre poll found that 77% of people believed that the money they deposited in banks legally belonged to them.[1]  In fact, the money that you deposited legally belongs to the bank.

When a member of the public makes a deposit of £1000 into the bank, the bank does not hold that money in a safe box with the customer’s name on it (or any digital equivalent).   Whilst banks do have cash vaults, the cash they keep there is not customers’ money.

Instead, the bank takes legal ownership of the cash deposited and records that they owe the customer £1000. In the accounting of the bank, this is recorded as a liability of the bank to the customer. It is liability because at some point in the future it may have to be repaid.

The concept of a ‘liability’ is essential to understanding modern banking, and is actually very simple. If you were to borrow £50 from a friend, you might make a note in your diary to remind you to repay the £50 a couple of weeks later. In the language of accounting, this £50 is a liability of you to your friend.

The balance of your bank account, and indeed the bank account of all members of the public and all businesses, is the bank’s ‘IOU’, and shows that they have a legal obligation (i.e. liability) to pay the money at some point in the future.

Popular Perceptions of Banking 2: Taking Money from Savers and Lending it to Borrowers

The ICM/Cobden Centre poll found that around 61 per cent of the public share a slightly more accurate understanding of banking: the idea that banks take money from savers and lend it to borrowers. When asked if they were concerned about this process, this group answered ‘I don’t mind as long as the banks pay interest and aren’t too reckless.’

This view sees banks as financial intermediaries, recycling and allocating our savings into (we hope) profitable investments that provide us with a financial return in the form of interest. The interest we receive on savings accounts is an incentive to save and a form of compensation for not spending the money immediately. Banks give lower interest to savers than they charge to borrowers in order to make a profit and cover their losses in case of default. The difference
between the interest rate banks pay to savers and the interest they charge to borrowers is called the ‘interest rate spread’ or ‘margin’.

Banks intermediate money across space (savings in London may fund loans in Newcastle); and time (my savings are pooled with those of others and loaned over a longer-term period to enable a borrower to buy a house). Shifting money and capital around the economy, and transforming short-term savings into long-term loans (a process known as ‘maturity transformation’) is very important for the broader economy: it ensures that savings are actively being put to use by the rest of the economy rather than lying dormant under our mattresses. We can also invest our money directly with companies by purchasing shares or bonds issued by them.

Banks, according to this viewpoint, are important, but relatively neutral players in our financial system, almost like the lubricant that enables the cogs of consumption, saving, and production to turn smoothly. So it is perhaps understandable that orthodox economists do not put banks or money at the heart of their models of the economy. Maybe sometimes things go wrong – banks allocate too many savings to a particular industry sector for example that is prone to default – but in the long run, so the theory states, it is not the banks themselves that are really determining economic outcomes.

This theory is incorrect. It also leads to assumptions about the economy that do not hold true in reality, such as the idea that high levels of savings by the public will lead to high investment in productive businesses (and conversely that a lack of savings by the public will choke off investment in productive businesses).

Most importantly, this understanding of banking completely overlooks the question: Where does money come from? Money is implicitly assumed to come from the Bank of England (after all, that’s what it says on every £5 or £10 note), the Royal Mint, or some other part of the state. The reality is quite different…

This was en extract from the book Where Does Money Come From?, which explains exactly how money is created in the UK. Here you can read the Foreword by Prof Charles Goodhart, one of the leading authorities in banking.

The confusion (around banking) comes because the reality of modern banking is complex and partially hidden. In researching for this guide, the authors had to piece together information that was spread across more than 500 documents, guides, manuals and papers from central banks, regulators and other authorities. Few economists have time to do this research first-hand and most individuals in the financial sector only have expertise in a small area of the system, meaning that there is a shortage of people who have a truly accurate and comprehensive understanding of the modern banking and monetary system as a whole.

[1]ESCP Europe/Cobden Centre, ‘Public Attitudes to Banking’, June 2010, www.cobdencentre.org