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Banks don't work the way you think – but they should


Fears over the euro's future, the strength of banks, and the sovereign guarantees attached to them have driven savers to take moves to protect money on deposit

Fears over the euro's future, the strength of banks, and the sovereign guarantees attached to them have driven savers to take moves to protect money on deposit


Fears over the euro's future, the strength of banks, and the sovereign guarantees attached to them have driven savers to take moves to protect money on deposit

While the EU toils over legislation aimed at improving the safety nets around banks, it's worth asking why banks are such inherently dangerous institutions in the first place.

Most of us are of the impression that banks are intermediaries of money that welcome deposits, keep some aside and lend out the rest. Looking after the keeping-some-aside bit thus becomes the primary concern.

Others think that banks must first borrow from their central bank before lending the same money out to customers. Therefore, ensuring banks secure sufficient quantities of central-bank money backed by collateral that holds its value becomes the priority.

However, both ideas about banking are inaccurate, not least because banks actually create the money they lend. Of course they cannot conjure cash into existence but in a digital world in which over 90pc of euros exist electronically as the numbers in our banks accounts, creating cashless money is no problem for financial institutions.

In the modern economy, money comes not from the printing press; it comes from bank loans. Unbelievable as that may sound to the uninitiated, if you acquire a loan from a bank they simply type new money into your account and record a matching debt. They have created the money. The consequences of this simple process are far-reaching. Among other things, issuing money in tandem with interest-bearing debt can lead to an over-indebted economy that's unfit for purpose.

If you're struggling with the idea that banks create the money they lend, you definitely won't believe the next part, but it is absolutely true: If you repay a loan to a bank, the money that you borrowed no longer exists. This is why there can be less money during a recession and it also explains why reducing the debt of the economy doesn't leave it in a better position.

In a nutshell: money comes from bank loans, every euro has a matching debt, and if we reduce our borrowings money disappears. We cannot resolve the debt crisis under this system per se. If we wish to grow the economy and expand our stock of money in the process, we must take on a euro of debt for every one we gain. If we wish to reduce our debts to more manageable levels, we must delete that quantity of bank-account money from the economy too.

Neoclassical economics, the strand in vogue, is very outdated in its teachings on money creation/destruction because it focuses on the issuance of cash by central banks. It is not just the layperson; the system is taken for granted by most academics. Indeed, the theory goes that money doesn't matter as it acts as a neutral veil over free-market activities.

But money, the lifeblood of the economy, does matter – as we at Sensible Money have been arguing for over two years. Thankfully, economists are beginning to look at the haphazard creation/destruction of money in tandem with debt as the source of our financial woes. In its latest quarterly bulletin, the Bank of England published the ground-breaking money creation in the modern economy, which debunks some common misconceptions around banking. They write: "Money creation in practice differs from some popular misconceptions – banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they 'multiply up' central bank money to create new loans and deposits.

"The act of lending creates deposits – the reverse of the sequence typically described in textbooks."

On the destruction of money, they confirm: "Just as taking out a new loan creates money, the repayment of bank loans destroys money."

This is an inherently unstable way to try to run an economy. Banks create too much money in the good times and destroy too much in the bad times. To have something as important as the amount of money in the economy decided by the mood swings of bankers can never form the basis of a stable economy, as the test of time has shown. Banks have been creating and destroying money for a long time. We've legalised and regulated the practice for over 300 years and during that time we've tried many things to maintain stability, with very limited success.

We've tried correlating money with restricted commodities such as gold. We've tried the same links for international trade only. We've tried keeping bank-created money in check by correlating it with central-bank-created cash. We've tried strict limits on how much banks can create and then gradually removed almost all parameters through the deregulation in the 1980s.

We've tried prohibiting banks from creating money for projects that don't involve an increase in GDP. We've tried public and private insurance on bank 'deposits'. We've tried entrusting central banks, financial regulators and financial services authorities with monitoring stability and have put various tools at their disposal.

Other attempts include adjusting and abolishing minimum reserves to be held at the central bank, minimum liquidity ratios, liquidity coverage ratios, capital adequacy ratios and now risk-weighted capital adequacy ratios.

We've tried encouraging businesses to take on more debt, then governments and then households, until all three have approached their limits. We've tried adjusting the money stock through tweaking interest rates and adding 'whatever it takes' to the central banks' box of economic tricks. After all this time and all these attempts, here we are with the ultimate money mess. It seems unlikely that the latest plan, a eurozone banking union, was the key to stability all along.

While the debate over what makes it into the legislation unfolds, perhaps we should consider a safer system altogether. We could run the economy the way most of us imagine it is run, and have the European Central Bank issue all euros – the electronic ones as well as the notes and coins. Once we halt the routine deletion of money by banks, we'd have a more permanent and stable stock of money. At that point, banks could concentrate solely on banking.

On the payments side, we could record current accounts in-house and at the central bank. Once off the banks' balance sheet, money would be protected against the banks' insolvency.

On the investments side, savings-account holders could become actual creditors of the banks and thereby fund their lending activities.

A mismanaged bank could thus go bust without fear of contagion. There would be no need for deposit insurance or stress tests. We would never entertain a bank run, bailout or bail-in again and there would be no concerns over 'money in the ATMs'.

While a banking union would aim to adequately capitalise the banks, reform of the system could capitalise them completely, in every sense of the word.


  • Paul Ferguson manages the research and campaign group Sensible Money. For more information visit www.sensiblemoney.ie.

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