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29 April 2013
Misconceptions Around Banking [Banking 101 – Part 1]
There’s a lot of confusion about how banks work and where money comes from.
There’s a lot of confusion about how banks work and where money comes from. Very few members of the public really understand it. Economics graduates have a slightly better idea, but many university economics courses still teach a model of banking that hasn’t applied to the real world for decades. The worrying thing is that many policy makers and economist still work on this outdated model.
In this video course we’ll discover how banks really work, and how money is created. But first, to clear up any confusion, we need to see what’s wrong about the way that most people think banks work:
Proof & Further Reading:
Are Bank Deposits really just IOUs?
From the Bank of England’s 2014 Q1 Quarterly Bulletin:
“Economic commentators and academics often pay close attention to the amount of ‘broad money’ circulating in the economy. This can be thought of as the money that consumers have available for transactions, and comprises: currency (banknotes and coin) — an IOU from the central bank, mostly to consumers in the economy; and bank deposits — an IOU from commercial banks to consumers.” (McLeay, Thomas, & Radia, Money in the modern economy: an introduction, page 4)
Banks are NOT Middlemen between Savers and Borrowers:
From the Bank of England’s 2014 Q1 Quarterly Bulletin:
“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.
“In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 2)
Transcript
Public perception of banking number 1: the 'safe deposit box'
Most of us had a piggy bank when we were kids. The idea is really simple: keep putting small amounts of money into your piggy bank, and when a rainy day comes along, the money will still be sat there waiting for you. For a lot of people, this idea of keeping your money safe sticks with them into adult life. A poll done by ICM on behalf the Cobden Centre found that a third of the UK public still believe that this is how banks work. When they were told that actually the bank doesn’t just keep your money safe waiting for you to return and collect it, they answered “This is wrong – I haven’t given them my permission to do so.”
So this idea that the banks keep our money safe is a bit of an illusion. Your bank account isn’t a safe deposit box. The bank doesn’t take your money, carry it down to the vault and put it in a box with your name written on the front. And it doesn’t store it in any digital equivalent of a safe deposit box either.
What actually happens is that, when you put money into a bank, that money becomes the property of the bank. That’s right. The money that you put into the bank isn’t even your money. When your salary gets paid into your account, that money actually becomes the legal property of the bank. Because it becomes their property, the bank can use it for effectively anything it likes.
But what are those numbers that appear in your account? Is that not money? In a legal sense, no. Those numbers in your account are just a record that the bank needs to repay you some money at some point in the future. In the accounting of the bank, this is recorded as a liability of the bank to the customer. It’s a liability because the money has to be repaid at some point in the future. This concept of a liability is actually very simple – and very important if you want to understand banking. Just think of it like this: if you borrowed £50 from a friend, you might make a note in your diary to remind you to repay the £50 in the near future. In the language of accounting, this is a liability from you, to your friend. So the balance of your bank account doesn’t actually represent the money that the bank is holding on your behalf. It just shows that they have a legal obligation – or liability – to repay you the money at some point in the future. Whether they will actually have that money when you ask for it is a different issue, but we’ll talk about that later.
Public perception of banking number 2: the middle man
Now the other two thirds of the UK public have a slightly better understanding of how banks really work. These people think that banks take money from savers and lend it to borrowers. The Cobden Centre poll that we mentioned earlier asked people if they were worried about this process: around 61% of people said they didn’t mind so long as they get some interest and the bank isn’t too reckless.
This idea of banks as middle-men between people with spare money and people who need to borrow money is very common. In this idea, banks borrow money from people who want to save it, such as pensioners and wealthy individuals, and they then use that money to lend it to people who need to borrow, such as young families that want to buy houses or small businesses that want to invest and grow. The banks in this model make their money by charging the borrowers slightly more than they pay to the savers. The difference between the interest rates makes up their profit. In this model, banks just provide a service by getting money from people who don’t need it at the time, to people who do. This implies that if there’s no-one who wants to save, then no-one will be able to borrow. After all, if nobody came to the bank with savings, then the bank wouldn’t be able to make any loans. It also implies that if the banks lend far too much far too quickly, then they’ll eventually run out of money to lend. If that was the case, then reckless lending would only last for a short time, and then the banks would have to stop once they ran out of people’s savings to invest. That means it’s good for the country if we save, because it will provide more money for businesses to grow, which will lead to more jobs and a healthier economy. This is the way that a lot of economists think as well. In fact, a lot of economics courses at universites still teach that the amount of investment in the economy depends on how much we have in savings. But this is completely wrong, as we’ll see shortly. Let me point out that, so far, we haven’t talked at all about where the money really comes from. Most people just assume that money comes from the government or the Bank of England – after all, that’s what’s written on every £5, £10 or £20 note.