This post is sparked by the debate that there has been in the last few days around Positive Money's proposals for reform of the monetary system in the UK. You can read their proposals here. I'm not in this post aiming to debunk Positive Money's ideas so much as to clarify for people's benefit the nature of our debt money system and how fractional reserve banking works in practice. If more people understood how things REALLY work (rather than what the textbooks say) we would be better able to have a sensible debate about how we want it to work in future.
The matter I want to address in this post is relationship between debt and savings. Positive Money correctly describe the way bank lending works, but they ignore the impact on savings, and therefore tell only half the story. And in the course of the debate it became apparent that there are many people who simply don't understand the relationship between debt and savings. Yet the relationship between debt and savings is fundamental to our monetary system. The other side of debt is savings. For every debt there are equivalent savings, so across the monetary system as a whole debt and savings are equal
Now before someone screams at me that it's obvious that there's more debt than savings, innit, because bank lending far exceeds bank deposits, let me define what I mean by debt and savings.
Debt is deferred payment for goods or services desired now, or in economics-speak, "consumption brought forward". For example, you need a new car, now, but you haven't saved up enough money to pay for it outright. So you borrow the money. You are prepared to pay more for the car than the current price, because you benefit from being able to use the car now and defer part of the payment until later. You therefore pay your lender interest on that borrowing. The total cost to you of that car is not the amount you pay to your dealer, it is the loan principal plus all the interest payments over the course of the loan, discounted by the rate of inflation over the period of the loan, minus any deposit you pay now from your own savings.
There are many different forms of bank lending. From an economic point of view, though, the major difference is between committed and uncommitted lending. In committed lending, such as a bank loan, the money is legally committed to you at the time the agreement is signed and cannot subsequently be withdrawn without notice. In uncommitted lending, such as an overdraft, a credit facility is granted to you which you MAY use, but the undrawn portion of the facility can be withdrawn at any time without notice. I've generalised here considerably, and legal eagles out there will no doubt say I've simplified far too much - bank lending agreements are far more complex and the distinction between committed and uncommitted lending is not always clear. But it will do as a general principle.
Banks aren't the only source of debt. Issuing bonds is a form of debt financing for large corporations and governments. Any individual or financial institution that purchases and holds bonds is in effect lending to the issuers of those bonds. I'm not in this post going to address how bond issuance and trading works, but corporate and government bonds make up a significant part of global debt. And they are important to ordinary people: anyone with a private or corporate pension almost certainly has significant holdings of government and blue-chip corporate debt.
Savings are deferred spending (deferred consumption). You don't need to spend all of your wages this month (lucky you), so you put some of it in the bank. Or you choose not to spend all of your wages in order to put money aside for spending at a later date - for example, when you are too old to work. You want to put your money somewhere that will earn you a return on your deferred spending, partly to compensate for the erosion of the value of those savings by inflation, and partly because by choosing not to spend that money now you are forgoing the pleasure you might receive from, for example, having a fantastic holiday.
There are many forms of saving. Bank deposit accounts (including current accounts) are one form. Others are pensions, ISAs, long-term savings plans (endowments), shares and bonds, gold and other precious metals, art, wine and property. The last of these - property - is particularly important because a high proportion of the UK's population have their savings principally tied up in the house they live in. Even if they have a mortgage, the difference between the present value of the house and the amount outstanding on the mortgage - their "equity" - is their savings. When house prices rise, existing home owners benefit because their savings increase. Conversely, new buyers have to take on more debt. The increase in debt among new home owners balances the increased savings of existing home owners.
Overall, the people of the UK now have far more savings outside bank deposit accounts than they have in them. That's why, if you only look at banks, it looks as if there is far more debt than savings. But when you take into account other forms of saving - including tax, which is government savings (tax extinguishes government debt obligations, which is equivalent to saving), and bank and corporate retained earnings, which are the savings of shareholders - it becomes evident that globally, debt=savings. That is why it is very wrong, and very dangerous, to suggest (as some have done) that debt is made of "imaginary money" which can simply be wiped out cost-free. No it isn't, and it can't. Wipe out debt, and you also wipe out savings.
Financial intermediation is the process by which borrowers obtain from savers the money they need to buy things. Or alternatively, the process by which savers obtain from borrowers the interest they need to maintain the value of their savings over time and compensate them for not spending that money themselves. Banks and other financial institutions act as financial intermediaries, lending to borrowers at interest and paying interest to savers. They make money by paying less to savers than they charge to borrowers - that is known as the "spread". And they accept and manage the risks inherent in lending to borrowers over a long period of time while allowing savers to remove their funds if they wish.
The money supply is the total amount of various types of money in circulation. "Money" in this case pretty much means anything that will be accepted by somebody as payment for a product or service. "Base money" is notes & coins plus bank reserve balances at the Bank of England (more on this later). "Broad money" is all other versions of money, including balances in bank deposit accounts and various types of commercial paper.
Fractional reserve banking
"Fractional reserve banking" is the process by which banks intermediate between borrowers and savers. It is commonly believed that banks "lend out" deposits. Banking and economic textbooks are full of descriptions of banks lending and re-lending fractions of deposits. Sadly those textbooks are wrong in one important respect: they assume that deposits precede lending. No, they don't.
What actually happens, as I've explained previously, is that banks lend, and then look for reserves to settle the drawdown of that lending. The accounting entries for a new bank loan for £10,000 are as follows:
Customer loan account: £10,000 DR
Customer deposit account: £10,000 CR
The loan account debit represents the customer's DEBT, which is the bank's ASSET.
The balancing customer deposit account credit is the actual money advanced by the bank, which is the bank's LIABILITY. It is usually a credit to a demand deposit account such as a current account, and can be drawn in cash or paid out by bank transfer or cheque in the same way as any other deposit. It is not possible to distinguish in any meaningful way between a deposit created from a bank loan and a deposit made by the customer.
Demand deposit account balances form part of bank reserves - not capital. This distinction is important, as I describe here. Bank reserves are required to settle deposit withdrawals, including loan settlement, but they are not referenced at the time the loan is granted. And demand deposit balances are included in the measures of "broad money" supply in the economy. So the creation of a new deposit without drawing on underlying reserves has the effect of increasing the amount of money in circulation - as Positive Money correctly claim. Therefore, in my example above, when these accounting entries are made "broad money" increases by the amount of the deposit.
That new deposit behaves in all respects like any other sort of deposit. You can draw it in cash or you can pay your car dealer by bank transfer or cheque. If you draw cash the bank must physically have cash to pay you – as with any other deposit withdrawal. Banks estimate their cash requirements on a daily basis based on withdrawal patterns across their customer base. Sometimes they do run out, of course. I’m sure you have all experienced trying to get money out of an ATM over a bank holiday weekend. And most banks require notice of large cash withdrawals.
If you pay your car dealer by bank transfer or cheque then no cash is involved. The accounting entries are as follows:
Customer deposit (current) account £10,000 DR
Interbank settlement account £10,000CR
Your bank could of course borrow your deposit back from your car dealer's bank to clear its reserve overdraft. It's sort of circular. And it gets even more circular if you and your car dealer bank at the same bank and you pay him by bank transfer, which clears during the day. In this case there is no impact on interbank settlement or BoE reserve accounts. Your loan is in effect funded by its own deposit. But the bank still pays interest on that funding - even current accounts attract interest, pitiful though it is.
The example I have given above is of a committed loan, of course. In uncommitted lending no deposit is created and the liability remains off balance sheet until it is drawn. On drawdown settlement funding applies as I have described. Whether or not drawdown of uncommitted facilities increases the money supply is a matter of debate: personally I think it does, because a new deposit is created in the recipient's bank for the amount of the drawdown.
I hope I have shown through the example above how lending creates new money that then inflates savings as well. Overall, household debt has increased by £10,000, small business savings have increased by £10,000, and broad money supply has increased by £10,000. But to argue, as some have done, that banks don't need to borrow to settle loans because they can invent the money, is simply wrong.
Reserve and capital constraints on lending
Since banks lend in advance of obtaining reserves for settlement, it's not in any way meaningful to regard bank lending as constrained by the availability of reserves. And because of the money creation involved in lending, there is NEVER a shortage of reserves for settlement provided banks are willing to lend to each other. If for any reason banks become unwilling to lend to each other - as we are seeing at the moment in the Eurozone - central banks provide settlement funding ("liquidity") at penalty rates.
Under the present system bank lending is capital constrained, not reserve constrained. How much credit a bank can create is governed by the ratio of shareholders’ funds and retained earnings (money it DOESN’T OWE TO ANYONE, which is its capital base) to what we call “risk weighted assets”, which are a way of valuing loans by their risk. Each new loan drains an amount of capital proportionate to its risk weighted amount. Banks can only lend within their capital ratios. In the run up to the 2007 crash the capital ratios were much lower than they are now and were widely ignored anyway. Now capital requirements are much higher, which limits lending, and hopefully regulators are being tougher about enforcing them. The problem with this is of course that calculating risk weightings is a bit of a black art, and risk classifications can be intrinsically wrong: e.g. sovereign debt is weighted at zero, which means banks can lend unlimited amounts to governments because their debt is assumed to be risk free – but we all know that’s not true, don’t we? So regulators are trying to move towards constraining leverage as well, which is the ratio of capital to deposits. As each loan creates an equal deposit, forcing banks to restrict their leverage would also have the effect of limiting lending.