Tomorrow you walk into a bank and apply for a loan of £10,000. Being the upstanding citizen of society that you are, the bank immediately approves your request for a loan, and credits your current account with £10,000.
Where does this money come from?
Two popular answers are:
The £10,000 comes from other depositors’ money
The £10,000 is “multiplied up” from some initial amount of other depositors’ money
Both of these answers are incorrect.
The £10,000 credited into your account is £10,000 of new money, materialised from nothing.
You may be wondering what this creation of money does to a bank’s balance sheet, but fear not, the approval of the loan simultaneously creates an asset worth £10,000 (your obligation to repay the bank), and a liability worth £10,000 (your new deposit at the bank), and so the bank’s balance sheet remains… balanced (but larger).
You may intuitively wish to fight this fact, and say that the £10,000 loan is not “money”, but then, are any bank deposits “money”? How can you tell the difference between a bank deposit created by a loan, and a bank deposit created by you depositing £10,000 of cash over the counter? You can’t - there is no difference.
The key point here is: private commercial banks have the power to create (or colloquially “print”) money.
What does the Central Bank do?
If commercial banks can create money, then what’s the point of the Central Bank?
The Central Bank can also create money, referred to (not unreasonably) as “Central Bank Money”. This can take 2 forms: Cash (in the form of notes & coins) or Reserves (essentially non-withdrawable deposits at the Central Bank). Money in the form of Central Bank Reserves can only be held by those with a reserve account at the Central Bank, which is usually a right reserved for the commercial banks of the land.
Commercial banks can acquire reserves by selling government bonds (sovereign debt) to the Central Bank in exchange for newly created reserves (when the Central Bank chooses to do so), or by borrowing the reserves of other banks on the interbank lending market (where an interest rate close to LIBOR - the London Inter-Bank Offered Rate - is payable). Commercial banks can acquire cash by exchanging their reserves for an equivalent amount of cash (when the Central Bank chooses to do so). The Central Bank has discretion over when to create Cash, and when to create more Central Bank Reserves (although it should be noted that they’re generally obliged to perform this duty on request to avert complete financial collapse).
We have seen that there are therefore 3 types of money:
Cash - created by the Central Bank
Reserves - created by the Central Bank
Bank Deposits (also referred to as “Demand Deposits”) - created by commercial banks
The largest type of money by far is Commercial Bank Deposits. Commercial Banks create substantially more money than the Central Bank.
Cash & Reserves taken together are colloquially referred to as “narrow money” or “base money”. Cash, Reserves & Bank Deposits taken together are referred to as “broad money”.
The relevant Central Banks for each currency generally keep track of the quantity of each of these types of money. The data for Pound Sterling taken from the Bank of England is plotted on the graph below[1][2][3]:
Quantitative Easing
As part of a strategy known as Quantitative Easing, the Bank of England dramatically expanded the quantity of reserves in 2008 to combat the financial crisis, again in 2012 to combat the double-dip recession, again in 2016 in response to Brexit, and again in 2020 as a result of Coronavirus. Prior to 2008, Bank of England reserves grew at a much lower rate (in-line with general economic growth).
This strategy was executed by creating reserves and buying domestic sovereign debt with the newly created reserves. As part of this exchange, the newly created reserves were transferred into the ownership of the settling bank, and the sovereign debt was transferred into the ownership of the Bank of England.
The motivation for this substantial expansion of reserves was to combat the destruction of commercial bank money caused by loan repayments, bad loans, and commercial banks' hesitancy to extend new loans (the “credit crunch”). It should be noted that even though the quantity of reserves has increased substantially from March-2009 to Jan-2016, the overall quantity of money remained fairly flat (although more recent exercises in QE have had a more direct effect on increasing the overall money supply).
The story is similar across most Western central banks, whether it’s the US Federal Reserve, the European Central Bank, the Bank of England or the Bank of Canada.
What limits commercial bank money creation?
Commercial banks can only create money by lending it, but banks cannot just lend money freely, as the bank is still liable for the created money if the debtor fails to repay. If a loan goes bad, banks have to write down the value of the asset (the loan), to reflect the level of impairment. As a bank’s balance sheet still has to balance, it must cover this impairment with its own capital, creating a loss for the bank. If enough loans go bad at the same time (see 2008), the bank can end up with more liabilities than assets, and become insolvent. An individual bank becoming insolvent is perhaps manageable. All banks becoming insolvent simultaneously is catastrophic - this is essentially what happened in 2008 with the sub-prime mortgage crisis (huge quantities of widely held low quality mortgage debt became substantially impaired).
As there are a scarcity of profitable opportunities to lend, this acts as a natural brake on the rate at which new money is created.
The Bank of England Base Rate (the amount of interest the Central Bank pays on reserves held by commercial banks) also affects the number of profitable lending opportunities, and thus has some influence over the amount of money creation (a lower base rate should result in more lending, and thus money creation, all other things being equal).
Why do commercial banks need Central Bank reserves?
When you have a deposit at a bank, you can do 3 things with it:
Sit and admire it
Withdraw it as cash
Transfer it to another account (or “spend” it)
If you withdraw it as cash, the commercial bank needs to have the requisite amount of cash on hand. Commercial banks ensure they have a reasonable amount of “Cash holdings” to cover depositors withdrawal requests (typically around £1 for every £100 of deposits). These “cash holdings” are obtained by exchanging the bank's CB reserves for it.
If you transfer it to another account, one of two options will be true:
The account you’re transferring to is part of the same commercial bank
The account you’re transferring to is part of a different commercial bank
If the account is at the same bank, then the bank can simply debit one account and credit the other, and no communication with the outside world is required.
If the account is at another bank, your bank has to send money to that bank. This is done by your bank transferring the identical amount of their reserves from their reserve account to the destination bank’s reserve account, in a process known as multilateral net settlement.
You may think that this requires a bank to have reserves equal to all of the deposits, however, whilst you are transferring a deposit out of the bank, the likelihood is that somebody else is transferring a deposit into the bank. These two transfers “net out” (hence the ‘net’ in multilateral net settlement) and mean that the bank only has to transfer reserves equivalent to the net movement of money to other banks each day. This is typically a very small proportion of the overall value of transfers done in a day, and mean that a bank in practice doesn’t require anywhere near the amount of reserves you might think. Presently, banks hold around £7 in reserves for every £100 of deposits, up from £1.25 before the financial crisis[4].
As noted above, if a bank is caught short, and doesn’t have sufficient reserves to cover its net outflows, it can either borrow reserves from other banks on the LIBOR market, or it can borrow reserves directly from the Bank of England at a penal rate (currently 25 basis points above the base rate, and collateral must be provided).
Doesn’t this privatisation of money creation cause massive inflation?
There’s a few of things to bear in mind here.
First, the level of inflation doesn’t actually depend on the quantity of money, but its availability for use in transactions.
Second, Central Banks have levers they can pull to reduce the amount of money creation in response to inflation, whether it be changing the Base Rate, reducing Central Bank reserves by unwinding quantitative easing, or working with the government to introduce explicit credit controls (which is still very common in Asia).
Third, to some extent, yes, it does cause significant inflation. Banks have an incentive to lend money against secured debts (i.e. where collateral is put up in exchange for the money, e.g. mortgages) over and above unsecured debts (which are typically more productive, like a business loan to invest in a factory), as if the debtor stops repaying, the bank can sell the collateral and avoid taking the loss. For this reason, banks have a strong incentive to lend against housing and other financial instruments. This means a substantial proportion of money creation occurs in non-GDP financial transactions, rather than in productive ways, and can substantially inflate the value of those assets against which debts are frequently secured. This can be seen in the huge growth in house prices that’s occurred since the 1970s, which coincides with the removal of credit controls and liquidity reserve requirements.
Commonly used measures of inflation use a basket of consumer goods, rather than a basket of financial instruments to capture the level of inflation in the economy. However as the majority of new money is created for financial transactions and doesn’t immediately enter the “real economy”, these measures of inflation remain at very low levels even as the price of financial instruments soar. This uncontrolled credit creation creates systemic instability in the economy, and requires the Government and Central Banks to step in on regular occasions (roughly every 10 to 15 years) to sort out the mess.
Summary
There are 3 key types of money: cash (notes & coins), central bank reserves and bank deposits.
The largest type of money by far is Commercial Bank Deposits.
Commercial Banks create substantially more money than the Central Bank.
Commercial Banks need cash to satisfy depositors withdrawal demands.
Commercial Banks need Central Bank Reserves to be able to transfer money to other banks.
Increasing Central Bank Reserves (e.g. through quantitative easing) doesn’t necessarily increase the overall quantity of money.
Commercial Bank money creation is limited by the availability of profitable lending opportunities.
Commercial Bank money creation does cause inflation, and this is typically more visible in the financial sector than other sectors as banks prefer to lend against financial instruments as security.
References
Bank of England (2021). Monthly average amount outstanding of total sterling notes and coin in circulation, excluding backing assets for commercial banknote issue in Scotland and Northern Ireland total (in sterling millions) not seasonally adjusted.
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Bank of England (2021). Monthly average of amounts outstanding (on Wednesdays) of Bank of England Banking Department sterling reserves balance liabilities (in sterling millions) not seasonally adjusted.
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Bank of England (2021). Monthly amounts outstanding of M4 (monetary financial institutions' sterling M4 liabilities to private sector) (in sterling millions) not seasonally adjusted.
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Ryan-Collins, J., Greenham, T., Werner, R., & Jackson, A. (2012).
Where Does Money Come From?: A Guide to the UK Monetary and Banking System
. New Economics Foundation.