Introduction
I keep getting comments from people who claim that my suggestion that banks do not use funds deposited with them to make loans is wrong.
They are adamant that this claim is wrong. They are usually quite rude about it, and when presenting their arguments, they claim that their argument must be right because banks pay interest on deposits, and if banks did not make money from those deposits by lending them out, they would not do so. Quite how that is proof, I do not know, but they say it, nonetheless.
At the same time, they also say that I do not understand how bank balance sheets work, because if I did, I would realise that when a bank makes a payment on behalf of a customer using funds that were created by loans in the way I have so often described, thereafter the bank balance sheet could not balance, so I must be wrong.
Let me try to address these issues.
Preamble – the nature of money as debt
Almost everyone who makes these claims to me appears to have made a fundamental error in understanding when making their claim.
It would seem as if they, without exception, think that there is something real, distinct, tangible, and possibly asset‑backed which represents money. At the very least, it seems that they think that money is always made up of either banknotes or “funds” which somehow have a real, distinct, tangible, and identifiable existence. It seems that they believe it is one of these two, but most probably cash, that banks always deal with.
Let me set the record straight. Banknotes are a most unusual form of money, if not the most distinctive form. With that, I would agree. They are the only part of base money that is accessible to the public in the UK. And, if you do not know what base money is, please follow the link in the previous sentence for a detailed explanation, but in short, base money is the money created by the government to, in most cases, enable the banking system to work.
That said, the vast majority of base money is electronic, or entirely digital, like all other modern money, but banknotes are also a part of this base money supply and, at present, there are about £85 billion of banknotes in circulation, although it would seem that a significant part of this total is essentially stashed out of use at any point in time. It is, in other words, the proverbial money under the mattress. As a result, it might be that just 1.5% of the active money supply in the UK is in the form of cash, despite which people persistently think that banknotes are what money is, when that is not the case.
But, perhaps most importantly, banknotes conform to my description of money as debt for two reasons.
The first is that they say so on the note itself. They declare themselves to be an IOU by saying, “I promise to pay the bearer on demand the sum of [whatever].”
Secondly, the Bank of England confirms this by including them on its balance sheet as liabilities, a point I have previously proven, albeit that the method of demonstrating this is quite torturous due to the Bank of England's unusual presentation of its accounts.
The point is, however, clear: like all money, banknotes are just representations of debt and have no inherent worth in themselves. As a result, just like all other forms of money, including all that of the electronic variety that is created under licence by the UK commercial banks when undertaking their commercial activities through the making of loans, they are debt.
As for “funds”, I will address this issue below, but first let me address another key foundational issue.
How banks create money
As I have said many times before, banks create loans by simply marking up a customer's current account with the amount that they borrow (a credit entry in the bank's books) and by marking up their loan account in a similar amount (a debit entry in the bank's books).
Bankers the world over have confirmed this case, as have all central banks that have commented on the issue. The Bank of England confirmed this in 2014. The Bank of Canada did in 2015. Money creation is that simple. In fact, it is so obscenely simple that people recoil from the idea that this is all there is to bank lending, but that is what happens. It simply involves tapping a few entries on a computer keyboard and then charging a great deal for having done so. Money creation is an exercise in double‑entry bookkeeping on a computer keyboard. There is no other way in which bank loans can be created.
I would also add that UK bank loans are now never made by advancing cash and, therefore, there is no reason to explain what the double entry of those transactions is: if you want a cash advance now, the transaction would be as I describe above, and you would then have to draw the cash out of your current account. We can, therefore, ignore this issue.
Do, then, let me summarise what the entries in the bank records it has created are:
-
The bank has recorded a debit, which creates an asset in its books, representing the sum that the person borrowing funds from it now owes it.
-
It has also created a credit entry in its books, representing the increased current account balance of the person who has borrowed money, to whom it now owes that borrowed money, which means that this balance is now available for them to spend.
That, quite literally, is all that happens.
Are other customers' funds involved in the creation of new bank money?
Note that there are no entries in what I suggest happens when banks create new money that in any way imply that the bank has depleted its cash reserves when providing a customer with a loan. That is because no cash was involved in these transactions. Everything I have explained relates to debt, and nothing else, because that is what a loan is, and that is what money is. The bank's cash reserves are not in any way altered by the creation of a new bank loan.
Similarly, no balance that anybody else might have with the bank that created the loan is in any way altered as a consequence of the creation of this new loan. In fact, it is not possible that any such balance could be in any way altered as a result of this new loan being made. In other words, other customers' funds (which are what commentators seem to think exist in a bank) are never involved in bank loan creation.
Testing the “loanable funds” model
To test this suggestion, suppose, as my critics claim, that funds deposited with the bank are used to make the new loan to a customer of the bank who asks for an advance to be made to them.
Firstly, note that this presumes that there is something in existence in the bank independent of the deposit that a person has made with it. In other words, there is an implicit claim that a depositor has something called “funds” which they have made available to the bank. This, quite specifically, is not true. Even if the depositor had, quite unusually, deposited cash, the transaction to record that deposit would be as follows:
-
A credit to the customer's current account for the amount of cash deposited, representing an increased sum that the bank now owes back to the customer.
-
A debit of the amount of cash that the bank now owns in its cash account.
There are no other possible entries.
Importantly, though, and by definition, the cash now deposited with the bank does not now belong to the customer. It belongs to the bank.
If it belonged to the customer because, for example, it was placed in a deposit box, then the bank would not have a liability to repay it, but that liability to repay is what is reflected in the bank balance shown on the customer's current account statement, which is in credit as far as the bank is concerned because it has a liability due back to the customer. That credit balance can only exist if the property previously belonging to the customer now belongs to the bank. If the cash were held in a deposit box at a bank, the transaction would only exist in the books of the customer, and the sole duty of the bank would be to physically protect that cash from being stolen, which is a quite different exercise from managing a bank account, not least because legal title to the money has not changed in the deposit‑box case: it remains the property of the customer. If, instead, the customer wants to pay cash into their account, they necessarily give up ownership of that cash to the bank. This is the necessary corollary of obtaining an entry in the customer's bank statement, which shows that they are now owed the sum they deposited in cash back from the bank.
In summary, and ignoring this use of safe deposit boxes (and I have never come across the actual practice of doing so in my whole career), in reality, the moment a person pays cash into their current account, that cash ceases to be their property, and in exchange for giving up that asset to the bank, they get an alternative asset, which is the liability that the bank owes to them as shown on their bank statement.
What this means is that if the bank did use those funds to make a loan (and I stress, banks do not make loans in cash these days), they would still not be using the funds of the customer who deposited cash with them to make that loan. That is because the funds in question ceased to belong to the customer the moment they were deposited, at which point they became the property of the bank.
The bank cannot use depositor funds to make loans in that case, even if cash is deposited, quite simply because there are, in fact, no depositor funds in a bank. There are only cash balances belonging to the bank, and assets and liabilities representing funds owed to or by the bank. Depositor funds, as such, do not in that case exist. Understanding this is vital to understanding how banks operate.
Let me also stress that this is also true, of course, if cash is not involved. To be clear, if someone has made a deposit in a bank, they must, first of all, have an account with it, and secondly, that account must have an increased credit balance (or at least a reduced debit balance) on it after the deposit because the deposit in question is always owed back to the customer. That means it either increases their credit balance or it reduces their liability to the bank if they were overdrawn both before and after the deposit was made. As such, deposits in something other than cash never create something distinct and separate from the depositor which might be called depositors' funds that are located and identifiable within a bank, which is what those who claim that depositors' funds are used to make loans suggest exists.
To reiterate: there are no such things as depositors' funds. All that a depositor has with the bank is an account balance, and that is it. In that case, of course, their funds cannot be lent, because there are no such funds.
Why one customer's account balance cannot be lent to another customer
The question that has to be asked in that case is: how can it be suggested that a bank can lend the account balance owed to one customer to another customer without their consent and without altering the balance in question? That question is, of course, impossible to answer, because it cannot be done.
So let me be clear what would have to happen if a bank was to lend what are supposedly called depositors' funds when there is quite literally no such identifiable item in existence in a bank because the only relationship that exists between a depositor, or a borrower, and a bank is the balance on their account as printed on a bank statement. Depositors are creditors of banks. Borrowers are debtors of banks, and that is it.
Despite that, if anybody wishes to suggest that a bank could lend something called depositors' funds to a person who wants to borrow from the bank, they would have to suggest that a bank could, without a customer's permission, reduce the balance on the deposit that they have with the bank to then supposedly advance what they describe as depositors' funds to the new borrower, who they suggest is taking out a loan with the bank.
However, that is not how banks work. They are not peer‑to‑peer loan brokers. They operate discrete banking arrangements with each customer, respecting the right to privacy of each and every one of them, without ever giving one customer access to another person's account, or the sums they might have saved with the bank. To do so would be a direct contravention of every established banking arrangement and banking regulation. In other words, to appear to alter one customer's balance to then provide the funds removed from one customer's account to another customer is simply not technically possible within the regulated structure of banking.
To be clear, it is not possible that the funds deposited by someone we might call Customer A might be reduced by, say, £5,000 so that an equivalent balance might be credited to the account of Customer B, who can now spend it. That is not only because the reduction in the balance of Customer A would amount to theft, but absolutely essentially, if this transaction did take place, no asset would be created in the bank's books indicating the obligation of Customer B to make repayment to the bank of the loan that has been advanced to them. The debit entry in the bank's books, to which I referred near the start of this note, that records the existence of that loan asset, could not exist because if Customer A's funds were lent to Customer B then the debit representing the credit on Customer B's current account, which they could spend as a consequence of being offered a loan by the bank, would in fact be in Customer A's account, actually precluding the possibility of any record existing of a loan between Customer B and the bank. The bank would have simply been eliminated from the transaction, making it very difficult (if not impossible, I suggest) for them to charge any interest on the resulting outstanding balance, which I very strongly suspect is something that the bank would not want.
It would, of course, be possible to suggest a longer version of the double entry in question. For example, Customer A could have their bank balance seized, or otherwise be deemed to be the property of the bank, cancelling the bank's liability to Customer A as a consequence, and in effect increasing the property owned by the bank through the recording of new income for it resulting from the sequestering of the property of that customer, which income could then be matched with an expense incurred by the bank of equal and opposite sum, which would be a debit, with its matching credit being in the account of Customer B. In this way, Customer A and Customer B might not know each other's identity, but the effect is that Customer A has still, in effect, involuntarily lent their balance to Customer B, and there is still no asset balance in the bank's books representing a loan from it to the customer. That essential debti balance representing the loan in the books of the bank can only be created if the balance in question is represented by the double entry that I explained right at the beginning of this post, where two entries are made, one being a debit of the sum borrowed to the customer's loan account, and the other being an equal and opposite entry as a credit in the bank's books representing the current account of the customer who has taken out the loan. Money does, in other words, have to be created out of thin air using double-entry bookkeeping. There is no other way in which it can be done.
Summary
In summary, there is no technical possibility of a bank making loans out of so‑called customers' funds when undertaking banking transactions in the form in which they are regulated in the UK.
There is no way in which such transactions could be recorded in the double-entry system that represents their books of records, which they are required to maintain by law.
Perhaps quite importantly, if a bank did try to lend the balance on one customer's account to another customer, it is very likely that the theft of the property of the customer whose balance was loaned would be involved.
The consequence is that the loanable‑funds myth of banking is just that: it is a myth, and that needs to be consigned to the bin.
Footnote: a note to bankers
Finally, let me add one last point to all the bankers who are going to read this, who say they think they do loan customers' funds.
You don't.
You are required to have deposits as part of your capital requirements as laid down by the Bank of England. I acknowledge this, but this does not mean you lend those funds.
It means these deposits must exist to provide security to ensure your bank's solvency before you are allowed to lend.
In fact, you are being told to keep customer deposits as part of your capital (as I have long contended), whether you are aware of it or not.
But you are not loaning those funds to customers because that is a technical impossibility for the reasons that I noted above.
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once again to remind these people
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/quarterly-bulletin-2014-q1.pdf
The Bank of England says what Richard is saying
and not just the BoE, of course
“It is much more realistic to say that the banks ‘create credit,’ that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them” Joseph Schumpeter “History of Economic Analysis,” Page 1114. Routledge, 2006. (written pre-1950)
or even
“since the ‘currency in common use’, being a currency provided by bankers, is all issued in the way of loans”
(The Collected Works of John Stuart Mill, Volume III – The Principles of Political Economy with Some of Their Applications to Social Philosophy, ch. 23, 4), (written 1800’s)
Schumpeter was an Austrian economist in almost every sense
shortly after the above quote he writes, “Nevertheless, it proved extraordinarily difficult for economists to recognize that bank loans and bank investments do create deposits”.
and in a footnote has
“the article of F.W. Crick, ‘The Genesis of Bank Deposits’ (Economica, 1927), which explains how bank loans create deposits and repayment to banks annihilates them—in a manner that should have been indeed, but evidently was not even then, ‘time-honored theory.’”
Thank you.
Galbraith was, of course, very good on this, but these older sources are very valuable.
Richard,
Firstly I dont doubt the truth of what you say and it doesnt help that I am reading it before starting work so I am not giving it the time it deserves.
BUT its sadly quite easy to see how the much simpler ‘bank loans deposits’ idea is to understand like the household analogy and how Politicians either dont or choose not to understand it.
Accepted
I clearly need to produce a short form of this, having done a long form
Any chance of numerical examples which I personally find easier to comprehend?
I might look at doing that, as well as producing a simpler version of this. I had to do the long version first of all, as a precursor to simplifying the thing.
Thank you for posting this explanation. It’s is very important and correct up until the very end where you suggest that deposits are part of banks’ capital requirements.
We have crossed swords on this issue before and I do not expect this post to be published.
However, it is worth noting that, just as the BoE is clear in supporting your explanation of money creation and rejection of the flawed concept of “loanable funds”, it is equally clear on the distinction between capital and other liabilities including deposits. The latter are not considered capital – not least because as the BoE states capital, unlike deposits, is perpetual and therefore had the ability to absorb losses, which deposits cannot do.
The BoE and other central banks publish definition on capital and capital requirement. Deposits do not appear of them.
Rephrase the final section, and this is a very important and useful primer.
The final section is right.
If a bank fails depositors lose their money.
That means their capital is lost.
You are relying on a bit of Bank of England sophistry to deny economic substance. I am discussing ecnomic substance.
Deposits are NOT bank capital. They are liabilities of the bank. This is a fact and the more you deny it, the more it calls into question your broader understanding of the banking framework and regulations.
Capital for a bank has a specific meaning.
You are taking the pedants, legalistic view.
I am looking at economic substance.
If you do not understand the difference, my definition you are the problem.
The confusion arises partly because there have been runs on banks, and how that might be a problem if the funds have not been lent.
The issue here is partly losses on bad debts – if someone doesn’t pay back money loaned then the bank knows it cannot use the theoretical asset of that debt, and those write-downs may mean it is unprofitable.
Within different timescales – daily, monthly, eventually – the bank needs to be able to settle requested payments from itself. 2008 was partly a matter of working out who was holding bad debt, but it was also about liquidity. Many banks used short term borrowing to be able to make payments against longer term debts, repeatedly rolling over that borrowing. When the system largely paused, banks found themselves unable to borrow the necessary sums, or only at rates which would leave them sitting on massive losses on their loan book. In a long term view many were fine, but in the short term they could not service their obligations.
In many cases banks issued loans, provided the asset, and then sold the loan book. You still owed money to the bank, legally, as the transactions are separate, but the bank is no longer the ultimate beneficiary of that debt. It took a profit immediately (which may look good for bank share price purposes). In that case it can be hard to see trace who incurs the loss if you default. They also packaged groups of loans, and issued CDOs based on those such that one of the CDOs lost if any loan in the group defaulted and at the other end the CDO only lost if all the group of loans defaulted.
This was thought a clever way of making something less risky from risky assets. In reality, macroeconomic factors meant the loans did not have independent risks of defaults, those ‘good’ CDOs were over-valued, and more people found themselves sitting on losses.
In all cases, though, each party deals only with the bank as the counterparty, and it the losses within one or another timeframe that broke banks.
How many runs on ban ks have there been in the UK since 1860?
Maybe one. And the government ended it.
Why are you basing your argument on soemthing that does not happen then?
Please clarify, as I’m struggling to understand. If deposits are deposits, loans are loans, and never the twain shall meet, as you say, how is it even possible to have a run on a bank?
If banks are always able to repay their depositors/creditors, this shouldn’t even be technically possible. But the fact that there was one (albeit stopped by the government) suggests otherwise. And just because it only happened once since 1860 doesn’t allay people’s fear that it could happen in the future.
Bank runs happen because deposits and loans are entirely unrelated to each other.
Deposits tend to be short-term and many can be recalled at an instant.
Loans tend to be long-term, sometimes 25 years or more, and cannot be recalled very easily.
If depositors lose faith in a bank they can demand their money back very quickly and because a bank might have overextended it’s loan book it does not then have sufficient cash, or rather lines of credit with other banks, to let it make the payments that people are demanding. That is because, other banks do not wish to suffer a loss on lending to the bank that is suffering the run. So, that bank suffers a run and can fail because of solvency issue, but let us be clear, with the sole exception of Northern Rock, where a run was prevented by the government offering a guarantee, there has not been a run in the UK since the 1860 failure of Gurney‘s bank and so I’m not sure that this is an issue that need worry us greatly.
We need to look at the bank’s money. Just as I have an account at Santander, so Santander has an account at the Central Bank for the bank’s money (reserves). Loans and Deposits are not connected, Loans and Reserves are. If the bank grants a loan, the recipient spends it almost immediately. The people that receive that, e.g. house being sold, may bank at a different bank. That double entry is going to look like Santander grants a £100,000 mortgage so credits Mr A with £100k and debits Mr A’s Loan Account £100k. Mr A pays the £100k to Mr B for the house and Mr B banks at Barclays. How does the £100k get to Mr B’s account at Barclays? Santander debits Mr A’s account £100k and credits its own internal nominal account that represents its balance at the Central Bank (i.e. Santander’s money) with £100k. Instead of owing Mr A £100k Santander owes the Central Bank £100k, or has reduced its Central Bank balance by £100k. Meanwhile the external transaction takes place at the Central Bank to debit Santander £100k and credit Barclays £100k. The credit of £100k to Barclays is ‘for onward credit to Mr B’. So Barclays notes it has received £100k into its CB account. Internally Barclays debits its internal nominal account (Barclays own funds) and credit the account of Mr B.
Santander’s balance sheet hasn’t changed – it still has an asset of £100k owed by Mr A, which is matched by the liability of £100k, except that liability is a reduction in its reserves and not a balance owed to Mr A. The position is similar at Barclays.
It is evident that the constraint on lending is how much funds the bank has (reserves) to meet possible transfers to other banks. A small new bank may have new loans leave the bank, so is limited in what it can lend. If you are a large bank then outflows of your loans to others will probably be almost matched with inflows from other banks lending coming to you. So the large bank is fairly unlimited in what it can lend. If there was only one commercial bank it would in effect be the same as the Central Bank as it could lend ad infinitum with no risk of an outflow of reserves.
Thanks. And agreed.
Would I be right in thinking that a banks commercial and business debt and liabilities massively dwarf the double book keeping of individuals for buying a house, car, etc?
If so, how useful is the BoE guarantee in reality if any extension of credit from the BoE is cancelled out by increased exposure to defaults by the bank seeing it as a safety net to allow even riskier lending?
Because you are using language that leaves me unsure as to what you are referring to (debts and liabilities need not be the same) I am not sure how to answer that.
Are there technical/legal differences on this matter between banks on the one hand, and traditional building societies or credit unions on the other?
If I was asked that question I wouldn’t know how to answer it.
I totally agree with what you say about banks.
No, banks cannot lend depositor funds either. Not without stealiing them first. But as I keep saying, they can treat them as capital, and they do. As a result they can make loans out of thin air, but that is something entirely different.
Typo?
“Banks cannot lend depositer funds either…” should read “Building Societies cannot….” ??
Where?
Here: ?
https://www.taxresearch.org.uk/Blog/2025/08/14/banks-cannot-lend-their-depositors-funds/comment-page-1/#comment-1037488
Correct
I’d always understood that banks lend out a lot more money than is deposited with them, and that there are regulations governing the ratio. Is that true? If so, that can only happen if your description is correct.
The idea there’s a simple ratio between deposits and amount of loans, when you think about it, is only a modification of the loanable funds idea; or is sometimes explained as ‘fractional reserve banking’; and is inherently wrong because it makes the same error that ‘deposits create (or permit) loans’.
Therefore I recommend not to use it as a description; and to give a counter narrative if someone brings it up.
There are, however, ‘capital requirements’ on banks to ensure they have enough assets, and assets that are liquid enough, to pay out possible unusual demands from depositors or lenders to the bank. Cases with low probability of occurrence, but believable enough that the rules say banks must have some procedures to deal with them. The rules are much more complex than just a ratio. (If you look up the Bank for International Settlements and ‘Basel III’… you can lose yourself in a mass of technical descriptions, ‘stress tests’ and other things. You have been warned!)
Richard and other commenters here will no doubt correct me if I write incorrectly due to ‘a little learning’
The simple ratio is not a good idea because the relationship, as Clive Parry eluded to, is complex.
Richard Werner proved this empirically a decade ago with the help of a bank
From the abstract of his paper;
“An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, “out of thin air”.
The full paper can be read here:
https://www.sciencedirect.com/science/article/pii/S1057521914001070
I have also been told the same thing by a friend who was a highly placed executive in a well known commercial bank. She also confirmed that repayment of the loan ‘destroys’ the money.
Thanks
And he was right
A rare really useful social science experiment.
It’s Werner’s banking software test paper that’s really the definitive proof of licenced banks being able to create loan money from nothing. This is because the extensive use of software in modern day banking allows relatively straightforward tracking of balance sheet operations:-
“The test of booking a bank loan in banking software yields the
finding that the credit creation theory of banking alone conforms to
the empirical facts, providing a separate and different corroboration of
the findings in Werner (2014b).”
https://eprints.soton.ac.uk/384540/1/IRFA%25202015%2520Werner%2520Lost%2520Century%2520in%2520Economics%2520-%2520Banking.pdf
No, double entry is that.
Money only exists in ldegers
“Of course banks lend their depositor’s funds; where else does the money come from to make loans?”
Paul Krugman asked that question many years ago in his NYT column before being scaled and filleted by an audience of savvy MMTers.
I’ve often wondered since if he ever got it sorted out.
“Krugman responded to the criticism by writing a blog which claimed that banks don’t really create money, by explaining that in the economics textbook version of banking banks don’t create money. [..] And then posted a second after almost all of the commenters pointed out how wrong he was. [..] And then a third.”
— Mainstream economist discovers that banks create money (Krugman vs. Keen continued) (2012)
https://positivemoney.org/uk/archive/mainstream-economist-discovers-that-banks-create-money-krugman-vs-keen-continued/
Correct. Steve Keen won this argument, hands down, as did Stephanie Kelton in later exchanges.
It seems obvious that what you say is correct and agreed to by banks national and independent. I am still confused. I have savings with the Ecology Building Society. Their seliing point is that my money enables them to support eco-buildings and building innovation in the UK. They say they are limited in this worthy aim by the amount of money deposited with them. So while they could in theory enter new loans of very large amounts on their computers, they believe they are limited in the amount of loans they can make. Are they limited by the Bank of England, and how is this enforced?
I am an Ecology Member as well.
OK, the EBS doesnt act as a bank, all its money is held in a clearing bank so it cant ‘create’ money in its own right – thats how all Building Societies used to work.
So it can only lend depositors money
But its an exception that proves the rule
But the bank holding its money can fail. You have not escaped the banking system.
Richard Werner got a bank to test out what you are saying is true in terms of bank transactions:-
https://eprints.soton.ac.uk/384540/1/IRFA%25202015%2520Werner%2520Lost%2520Century%2520in%2520Economics%2520-%2520Banking.pdf
He did
And he found the result we expected
This is an excellent post, thanks. The word ‘interest’ only appears twice which is fine because the post isn’t about it. Further to which, when you have the opportunity, please could you write similarly on interest and tax? It would explain why H.Pill & friends like to keep the rates high and would highlight the fundamental differences between banks and building societies.
Cheers.
Give me time
The interest a bank charges on a loan adds to the bank’s own funds. And in fact after the loan is repaid the interest is the only thing still left.
Agreed
Having been coming here for some time, this is not new to me, but one way I looked at it was surely the the amount of money in circulation has exceeded ‘loanable funds’ for some time; it was quite frankly impossible for that to be the case and the money could only be credit/fiat money/debt.
Along the same lines:
2022 UK spending = £1,200bn
1965 tax revenues = £10bn (worth £200bn in 2022)
Clearly, taxes do not pay for government spending.
Well, thank you Ian.
And this is where I think the misunderstanding of the function of tax comes into pay. Tax is essential in curbing inflation – especially with so much money in circulation (fiat credit money) that is not tied to the ‘depositors funds as loans ‘ bullshit.
People who lived as working people in the 1960’s/1970’s I find have no idea how much money is actually circulating out there these days – the volume and the velocity of it. They still think of tax as an evil and paying for stuff.
Well I thought banks just kept our money in shoeboxes. The BBC said so years ago.
https://www.youtube.com/watch?v=pbKUv0701vE
One thing that does strike me whilst you’re on this topic is why on earth the mainstream media including the BBC isn’t providing a guide to voters on economics and how the UK’s monetary system works which allows interaction from viewers including challenges to what’s being said. After all government and bank spending and global trade issues are important elements in helping decide how you cast your vote. These guides are conspicuous by their absence! It’s as though elites deliberately want to keep voters in the dark. If so this can only mean Class War is still a strong reality in the UK!
My concern is that if they do provide economic instruction it would be hard-core near liberal, and that might not help us very much. Of course, we could then appeal for balance, but would we get it? Balance can be a very selective concept.
From a book keeping viewpoint I can see why people think that bank deposits fund bank loans. A simplified bank balance sheet might show assets largely comprising loans and a bit of cash with the liabilities side showing deposits and a bit of capital. this simply arises through the process you have described. there is no specific transaction matching and the cash account simply acts as a clearing mechanism, but once again people generally accept the household analogy.
Agreed. Thanks.
I was teaching this to bankers and BTEC students about 40 years ago. Most of them were puzzled by the fact that banks actually created money by making entries in loan accounts up to certain limits. They also took deposits, which represented about 5 per cent of the value of the loans, as I understood it at that time. There was never any danger of a ‘run on the bank’ as the bank did not lend out those deposits, but invested them at interest in safe securities. They also had to keep a certain level of their assets with the Central Bank commensurate with the money(loans) they had created. The Cental Bank would act as ‘lender of last resort’. A bit simplistic, compared to your very detailed explanation. You’ve left me wondering if I was telling them anything that was completely wrong. I got my information from textbooks of that time.
Sounds like you were right, for the period.
Banks do require a deposit for each loan they make but the act of making that loan actually creates the deposit required. Simple – what’s the fuss?
Well, the practice is much more complicated; banks operate in a highly regulated environment.
First, the loan will require Equity Capital to be allocated against it and this limits the size of the loan book. How much capital and the potential profit versus risk of loss will determine if the loan can be considered.
Second, the deposit created by advancing the loan will be “at call” and liquidity regulations do not permit a loan book to be financed by overnight deposits. Banks have to raise longer term funding by issuing bonds or attracting term deposits and this requires them to pay higher rates. Bank Treasury departments will typically tell they lending departments what their “cost of funds” is (a blended rate of all the borrowing the bank does).
So, the expected profit on a loan is the rate charged to the borrower minus the cost of funds minus some expected credit loss. The loan will also require Equity Capital and if the expected profit exceeds some hurdle rate on the Equity capital then the loan will be made.
This is a complicated and dynamic process – but one thing for sure; at no stage does anyone ‘open the safe’ to see how much they have on deposit before deciding to make the loan. (if the safe is stuffed then they just park it at the Central Bank and earn interest…. but that is another story).
Thanks
And I like this:
“Banks do require a deposit for each loan they make but the act of making that loan actually creates the deposit required. Simple – what’s the fuss?”
This does not seem right. It is implying that the loans have to be financed, or funded or however you describe it. They don’t because they are new money created ex nihilo. A deposit is a debt of the bank. Increasing its debts is not something the bank would want to do unless strictly necessary. What the bank does need is reserves (which are either a credit in its CB reserve account or a gilt). Granting a loan does raise the reserve requirement. Attracting deposits will tend to add to reserves and / or reduce the loss of reserves caused by an outflow of deposits. I was talking to a UK bank Treasurer earlier this year who said at the moment most UK banks are overflowing with reserves (thanks to QE of course, since bank reserves are all base money). He said currently most of the banks have effective reserves around 30% of liabilities (compared to around 3% reserves before 2008). There is no regulatory type of restraint on lending as a result. The need for the BoE to offer overnight loans, for example, no longer exists. They are not lending (other than mortgages) because they don’t see any creditworthy risks they want to take on. I think we are in the silly position where nearly 75% of UK bank loans are for mortgages, so essentially nothing for any genuine investment. Prior to 1980 UK banks were not allowed to offer domestic mortgages, just to illustrate how things have changed.
Thanks. Noted.
Certainly, there are excess reserves in the system owing to QE but the loan making process is still as I suggest. Banks only have large CBRA balances because people/organisations choose to deposit their money with them (apart from retained earnings/equity every £1 at the BoE will have a £1 owed to a lender/depositor). The bank will pay interest on those bonds/loans/deposits at various rates (zero on current accounts, much more for larger term deposits and bond issuance) and that is the “cost of funds”.
The UK has no minimum reserve requirement – lending is constrained by equity capital and liquidity regulations along with (as you say) lack of demand at the rate banks are prepared to lend at.
In general, I think most people understand the Capital “bit” but underestimate the importance of liquidity regs. If I make a loan I can’t just sit there and say “the loan is mirrored by the deposit that is created” and do nothing; I need to borrow in longer maturities…. and that costs.
Liquidity regulations presumably rely for effectiveness on the LCR, which appears fairly basic; 100% liquidity for 30-days (my question here is the extensiveness of of the effectiveness of the stress testing; i.e., the asset quality testing – here I am thinking of the SVB crisis as illustrative of a bigger judgement problem). The same problem of quality testing seems to me to apply ‘a fortiori’ to the NSFR (both numsrator and denominator). The calculation may be secure, but is the judgement of the quality; and how thorough the day-in-day-out testing?
And where does the LDI crisis fit in to all this? It doesn’t is the likely answer here; and that is the problem on an even bigger scale. The problem may start with someone else’s liquidity problem; but in the end, if there is a flight of capital, it will end in a banking tsunami that blows everything away.
‘You are taking the pedants, legalistic view. I am looking at economic substance.
If you do not understand the difference, my definition you are the problem.”
I am taking the correct terminology and definition of capital as understood by banking professionals and knowledgeable amateurs.
There is a reason that such terminology exists and it is to avoid confusion and misunderstanding – if you use the terminology incorrectly then you shouldn’t be surprised if people point out your mistake.
If you mean something different than you actually say, why not be more precise with your language rather than pretend you were right all along (when you meant something entirely different)?
I was precise with my language. I explained exactly what deposits are even though you would like to pretend otherwise to keep up the pretence that an excess return is payable to some providers of capital, and a minimal one to those who place their deposit with the bank but who are also at risk as a consequence. That is another aspect of the economic substance of this which you are trying to defend. Why aren’t I surprised?
No you weren’t precise with your language. A bank’s balance sheet has assets and liabilities. Deposits are liabilities. Capital is the difference between assets and liabilities.
There’s no debate on this. I don’t have to ‘pretend’ anything. It’s just factual and standard banking terminology.
Your arrogance won’t admit you to being wrong or using terminology incorrectly. It’s that simple.
Ask Clive – he’s one of the few on here who appear to know what they are talking about. And he’s corrected you on this previously.
Deposits are credits.
Capital is a credit.
The only difference is the ordering of priority in a default.
The deposits act as capital.
They are money lent to a bank to provide it with liquidity. As a matter of fact they are lost in a bank failure. They act as capital. If you can’t see or understand that, that is your problem, not mine. My suggestion is, learn to think. It help when trying to understand. Rules designed to constrain thought in particular ways rarely do.
Tom, I have had this discussion with Richard…. that bankers use the term “Capital” as shorthand for for CET1 or Common Equity Tier 1 (or occasionally they may include some hybrid capital, too) and that to use it in its broader sense invites criticism/confusion when talking about this particular topic.
However, I do accept that “Capital” is a broader term that includes debt (and therefore deposits) – for example, the department that deals in new issue bonds is called “Debt Capital Markets” in many banks.
So, although it might grate a little I have “got over it”.
Thanks.
Regulation and economic reality are not the same thing.
And words can mean two things.
So – I hope this is reasonable – I’m coming round to the conclusion that, before Thatcherism. while Building Societies have also always issued loans out of thin air they could loan only on domestic property and, as mutuals, in order to play safe, that, generally, with their own regard as to whether you were a good ‘member’ (ie had a reasonably good record of saving with them) – or not.
This, (when the banks were also ‘directed’ by the BoE not to loan to housing) to some degree at least, effectively controlled the housing market.
Since Thatcherism we have had gung ho neolib bankers (with whom the building societies are now competing) driving up prices in housing, really because they want ‘safe’ housing loans and not ‘unsafe’ business loans…
The building society model was operated via banks, as I undertsand it. But what they never did was lend one depositor’s money to another person. As I note, that could never happen.
BRAVO, BRAVISSIMO!!!
Perhaps it would be useful to explain what the bank *does* do with the depositors funds. After all, you’ve established that they don’t lend them out. But if they don’t lend them out, then there can’t be even a theoretical risk of non-repayment, a-la the Northern Rock panic. Yes, the government stepped in, but why would they need to if the depositors funds had never gone anywhere? The bank must in some way make the depositors fund less liquid than is necessary to allow full repayment. If the deposits have not been given to the borrowers (fully accepted), what is the cause of the lack of availability of depositors funds to repay on demand?
You are making a couple of mistakes.
Depositors do not have funds. I said that time and again. Plese read it all again.
And why are there runs? Because banks borrow short and lend long and sometimes there is a mismatch. That is it. It really that simple.
This makes no sense because of what you have previously said:
Banks borrow short – this is referring to banks borrowing money from saver I.e. through deposits
Banks lend long – this is referring to banks making loans to their customers.
You keep telling us that the former isn’t related to the latter, so how is there still a possibility of bank runs?
Because if depositors want their money back the bank they ask has most of its assets in long term arrangements it cannot call on for repayment.
So it has to ask other banks (or the Bank of England) for loans instead.
Other banks probably won’t provide them. And so the bank would collapse and the depositors would lose their money, simply because they asked for it.
But that does not happen because the Bank of England steps in and bails the bank out. So, all banking is dependent on the state. Therefore there has been no bank run since 1660.
So, what are you worrying about?
But this just contradicts what you said above – banks borrow short from depositors and lend long (via loans). But you said deposits don’t fund loans.
You can’t have it both ways!
They don’t.
They never do.
But the imbalance creates insolvency risk and so depositors can lose ther capital, as I said.
Why not read what I said?
Thanks to you Richard, I have today rather belatedly (I am, somewhat unexpectedly, well into my ninth decade) come to a new understanding of my relationship with my bank. It is the bank, not I, that owns the money I have on deposit with it. But it owes me that money and, by making a withdrawal or authorising a credit transfer to someone else’s account, I can confidently (with the back-up of the Government guarantee) require it to repay some or all of what it owes me.
Yay! Great!
There are no depositors funds! There is just an IOU in the bank computer system which says the bank owes Mr Jones £1000. When Mr Jones asks for his £1000 back then this relies on the bank having £1000 of its own money (in its reserves) to be able to pay him. If it doesn’t and can’t borrow additional reserves from another bank or the central bank, then the bank is insolvent and goes bust. Typically reserves are 10-15% of liabilities (though currently more like 30% due to QE). So if more than that ask for their deposits back then the bank will fold.
Correct
The problem here seems to be that the public has real difficulty in understanding that even if a depositor deposits “cash” in the bank, the bank does not hold the depositors deposit in the form of cash; what the depositor becomes is the bank’s creditor; and therefore at risk the protection of that deposit in a bank run then relies on special guarantees (limited at £85,000) , given not by the bank, but the BoE, for the Treasury. There is a transformation in dealing with a bank, from money to commercial credit; just like that. The Banks received special guarantees and privileges no other company could dream of receiving. And they still fail, time after time.
With the rise of digital transactions by phone, the Government has lost its critical contact with the public; providing 100% secure money directly to the public, and not mere commercial bank credit. This is a revolution, and it not for the better – either for Government or the public; and gratuitously benefits only banks and bankers, who have proven to be wanting (or QE and the scale of reserves, and the lavish guarantees and TBTF privileges now existing ,would not be required).
The difficulty is in the duality of states in money and banking. It is quantum in its nature. It’s an idea I am exploring.
Nothing about money is singular. It’s particle and flow, debit and credit, measure and medium, all at the same time. No wonder it’s hard to comprehend. I should write about this.
Is it possible to have only banks that behave as people think?
Was this the case in older times?
What would be the effect of that and thus why/how is it justified the banks to operate the way they do and not differently?
No
That’s the only word you need to know.
No it is not possoble
But if you had read a word I had written you would also see why it is undesirable
I think you are wasting my time
“the moment a person pays cash into their current account, that cash ceases to be their property, and in exchange for giving up that asset to the bank, they get an alternative asset, which is the liability that the bank owes to them as shown on their bank statement”.
One small quibble. The “cash” never was the property of the depositor. The depositor deposits an open, transferable IOU. The “cash” belongs to the issuer of the IOU (transferred to and transferable by the depositor); in most cases the issuer is the BoE, which created it from nothing , with a printer. This is fiat money. There is nothing real about it; it is all in the mind, and now typically recorded digitally just so we remember what is happening. And in adversity, in a bankruptcy run, even that “money” may prove no to be money….
Incidentally, I am bowled over by Clive Parry’s: “Banks do require a deposit for each loan they make but the act of making that loan actually creates the deposit required. Simple – what’s the fuss?”. That is where to start when rebutting the loanable funds blunder. Beautiful idea, expressed with enviable, elegant simplicity.
The debate over the meaning of “capital” usefully explains the problem with the understanding of bankers; their thought is defined not by monetary ideas, but by banking regulations. This is paper shuffling.
Thanks.
The quibble is fair – but adds in a layer of complication that I felt not needed this time round.
“bankruptcy” was an imbecilic autocorrect. It refers, rather to a bank run.
Ive often wondered how many of those queueing outside Northern Rock had savings under the £85k compensation limit (£170k for couples) and had nothing to worry about anyway. (I went through the compensation process when a local credit union collapsed so I know how it works).
The limit was much lower then. It was raised because of Northern Rock.
A payer can pay a payee by means of an Owed-Wealth-Rotation Transaction
(e.g. a buyer can pay a seller through the banking system):
1. The payer administers a zero-sum pair of postings:
a. A credit to its current account with the payer’s bank.
b. A debit to its payables account for the payee
(typically thereby anticipating and/or reversing an Owed-Wealth position
established by the associated Trade/Employment Transactions).
2. The payee administers a zero-sum pair of postings:
a. A credit to its receivables account for the payer
(typically thereby anticipating and/or reversing an Owed-Wealth position
established by the associated Trade/Employment Transactions).
b. A debit to its current account with the payee’s bank.
3. The payee’s bank administers a zero-sum pair of postings:
a. A credit to its current account for the payee.
b. A debit to its current account for the clearing house.
4. The clearing house administers a zero-sum pair of postings:
a. A credit to its current account for the payee’s bank.
b. A debit to its current account for the payer’s bank.
5. The payer’s bank administers a zero-sum pair of postings:
a. A credit to its current account for the clearing house.
b. A debit to its current account for the payer.
6. And back to 1 again.
Note that:
1. In an Owed-Wealth-Rotation Transaction, it is meaningless to talk about Owed-Wealth ‘moving’ from one macro-economic agent to another. Thus, in the diagram above, there are no arrows indicating movement; just balancing pairs of ‘+’ and ‘-’ signs at opposite ends of each line.
2. Each Owed-Wealth-Rotation Transaction is an integral and indivisible whole. Indeed, there is a single zero-sum-‘ker-ching’ moment, in which the whole ‘zero-sum-closed-circle-of-zero-sum-double-entry-postings’ either happens in total, or doesn’t happen in total (i.e. is reversed in total).
I explained the double entry here.
https://www.taxresearch.org.uk/Blog/2022/06/21/the-double-entry-behind-the-money-creation-in-the-central-bank-reserve-accounts/
How can I send an expanded version of the above (e.g. an e-mail), with diagrams and bulleted lists)?
Copy and paste it? Or print it as a PDF?
Many years ago, before the Bank of England officially admitted in a quarterly bulletin in 2014 that banks create money via lending, I carried out a very unscientific experiment. I visited Foyles bookshop in London and headed for the banking section. I checked all the basic textbooks on banking on their shelves to see what percentage of them explained how banks create money via lending. The answer was one hundred percent.
Is it correct that building societies create credit in the same way as commercial banks? They are essentially mutually owned mortgage banks, aren’t they?
A very clear explanation, thanks.
These days, yes.
Of old, they essentially banked through banks themselves.
Thanks Richard.
This statement from a recent news article is therefore inaccurate.
‘However, building societies had argued that the money deposited by savers was vital to fund mortgages, and that slashing the limit would reduce the number of homebuyers they could help’.
From the Guardian, 11 July.
https://www.theguardian.com/money/2025/jul/11/cash-isas-rachel-reeves-pauses-plans-to-reduce-amount-savers-can-put-in
Not if regulation requires deposits.
Regulation and economic substance do not always coincide.
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