Do banks create money or just credit? [Banking 101 Part 5]

Credit risk?

The key thing about ‘credit’ is that it has something called credit risk. Credit risk is the risk that a person, or company, that owes you money won’t pay you back. If you lend £50 to an unreliable friend who still owes you money from the last time you lent to him, then there’s a lot of credit risk attached to that loan, because it’s fairly likely that he won’t repay you on time. So if the numbers that banks add to your bank account are not money, but just credit, then there must be some credit risk attached to that money. In other words, there must be a risk that the bank won’t be able to repay you. And of course, as we saw with Northern Rock, Wachovia and the Icelandic banks, there is a pretty good chance that your bank won’t be able to repay you.

In fact, in a legal sense, the numbers in your bank account aren’t money. They’re just a promise to pay from the bank. The promise is that the bank will either give you cash when you ask for it, or will electronically make payments to other banks when you ask them to. So that would suggest that there is credit risk attached to the numbers in your bank account, because the bank may not be able to repay you. And that would suggest that the numbers banks create of not money, but just credit are credit.

In fact, the Bank of England actually follows this argument and points out a distinction between cash and bank-created money. In their 2010 Q4 Quarterly Bulletin, they say that “Bank of England notes [i.e the cash in your pocket] are a form of ‘central bank money’, which the public holds without incurring credit risk. This is because the central bank is backed by the government.” (p302). Interesting. So cash has no credit risk because it is backed by the central bank, which is backed by the government. But the commercial banks aren’t backed by the government. So that implies that the numbers they type into people’s accounts must be credit, and not money. But hang on a minute…

Government's Guarantee

The government has a scheme called the Financial Services Compensation Scheme – or FSCS. This scheme promises to repay you up to £85,000 if your bank goes bust and loses all your money. In fact, you might have seen them advertising this scheme on the tube or buses. This guarantee is supposed to be funded by contributions pooled across the banks. But if the contributions from the banks aren’t enough – as happened during the financial crisis – then taxpayers have to make up the rest of the money. Just think about what this means for a second. This guarantee scheme amounts to the government saying, you give your money to a bank, let them do whatever they like with it, and if they lose it all, we’ll just use other people’s money to reimburse you and make sure you don’t lose a penny”. In what way does this not count as the banks being backed by the government? Here’s the bottom line.

The numbers that banks type into customers’ accounts would be ‘credit’ and not money IF – and only if – there was a credible risk that you might not get all that money back. If that was the case, then bank deposits – the numbers in your account – would actually be a risky investment, and anyone putting their money into the bank would have to accept that they might lose some or all of the money. IF this was the case, then banks would just be extending credit, even though their payment systems would allow you to use that credit to make payments. But because the government steps in and guarantees all this bank ‘credit’, it completely removes all the risk. In effect, the numbers that banks create are fully backed by the government guarantee, and therefore they don’t have any credit risk. There is absolutely no difference in the riskiness of a banknote created by the Bank of England, and a number typed into a bank account by one of the high-street banks.

So, to sum up, the numbers in your account are just as good and just as safe as the cash created by the Bank of England, because the numbers in your bank account are guaranteed by the government. In other words, what banks create when they type numbers into bank accounts is money, not credit. When the government steps in to guarantee that you won’t lose a penny even if your bank does something stupid and is unable to repay you, then it effectively converts the risky credit of the bank into a risk-free form of money, backed up with taxpayers funds, but which the government permits private companies to create out of nothing.

By the way, probably the main reason why civil servants in the Treasury and the Banking Commission try to argue that banks can’t create money is that, if they acknowledged that banks had acquired the power to create money, then they’d have to deal with the serious implications of giving one of the greatest powers that government has to a private short-term profit-seeking collection of corporations.