Do Banks Create Money?
The tables shown below illustrate how banks create money. The tables show two hypothetical high street banks and a central bank. In this scenario, I bank with My Bank and you bank with Your Bank. The scenario shows what happens when My Bank grants me a loan which I then use to pay you for services rendered.
Row # 1
Both banks start identically with capital of £1,000 which they have deposited at the central bank (Bank of England). The central bank acts as the banker to the high street banks, so the two high street banks effectively each have a current account with the central bank. These current account balances are shown in the Central Bank table.
Row # 2
I apply for and am granted a loan for £100 from My Bank. My bank creates a current account in my name and gives me credit for £100. I am thus authorised to issue a cheque of up to £100 from this account. Note the absence of cash – the money credited to my account is purely electronic. At the same time, My Bank creates a My Loan account which shows I must repay My Bank £100. Money has been created immediately these two entries are posted to My Bank’s books.
Row # 3
I write a cheque in your favour for £100 drawn on My Bank to pay you for services rendered. You deposit this cheque with Your Bank which credits your current account and debits an account called My Bank with £100. This debit to the My Bank account signifies how much My Bank owes Your Bank.
Row # 4
Your Bank then submits the cheque for clearing. When the cheque is cleared My Bank will reduce my current account by £100 and reduce its Central Bank current account balance by the same amount. At the same time, Your Bank will increase its Central Bank current account by £100 and reduce its My Bank account by the same amount. This is to show that My Bank has settled is debt to Your Bank through the current accounts held at Central Bank. The Central Bank transfers £100 from the My Bank current account to the Your Bank current account to reflect this settlement.
Row # 5
The closing balances show the balances held by the banks once clearing has completed.
Row # 6
This row shows the difference between the closing and opening balances. It shows that I owe My Bank £100 and that My Bank’s current account held at the Central Bank has reduced by £100. My Bank will expect to earn interest on the loan and to restore its current account balance when I repay the loan. You now have a current account at Your Bank with a balance of £100. This is money you can spend – it is yours, This money did not exist until My Bank made the loan to me. It hasn’t come from the current accounts at the Central Bank because the total held at the Central Bank has not changed. So where has the £100 come from? The answer is it has been created out of nothing by My Bank when it approved my loan.