Banks newly create 100% of the money they lend, says Bank of England

Contrary to textbook teachings, banks do not lend out depositors' savings

This post provides a high-level summary of an important bulletin titled Money Creation in the Modern Economy, which was published in 2014 by the Bank of England (the central bank of the United Kingdom). The bulletin has been called “game-changing” and “unprecedented.” It is already cited in 2,000 books and academic articles. The bulletin inspired the global research study that I summarized in another post: Global Study on Monetary Literacy Finds Massive Illiteracy & Disapproval. It also inspired the creation of the New Banking Consensus database, which catalogue’s similar statements to the Bank of Englands’s from over 150 central banks, banks, banking law scholars, and economists who study banking. Skip to the end of the article for my “big take-aways” from the Bank of England’s bulletin. I’ve also made a video that tells this story.

Table of Contents

Here’s what you’ll find in this post:

1. A summary of the claims made in the bulletin

2. Videos and infographics from the bulletin

3. Quotes excerpted from the bulletin

4. Why you should care to understand the Bank of England’s 2014 bulletin

5. An important disclaimer regarding evidence

Friendly warning before you read our summary

Continuing to consume this type of information may change your life experience in the following ways…

Summary of the Bank of England’s 2014 bulletin

The Bank of England, the central bank of the United Kingdom and the regulator of British banks, published a bulletin in 2014 stating that many of the key ideas taught in economics textbooks about banking and money creation are mistaken. The purpose of the Bank of England’s 2014 bulletin was to set the record straight on a number of these “popular misconceptions” (their words) so that the public would have a correct understanding of how the Bank of England’s “Quantitative Easing” program stimulates the economy.

The bulletin explains the following things about the true relationship between commercial banking and money creation:

• Commercial banks do not loan out their customer’s deposits. Ever. It’s not something that is even possible given the way that bank accounting actually works. Deposits are a liability of the bank, not an asset they can loan out.
  

• Commercial banks do not make loans by “multiplying up” central bank reserves. Ever. Central bank reserves are created as a byproduct of commercial banks making loans, not the other way around.
  

• Instead, commercial banks create brand new money whenever they make loans. This new money is created via simple accounting entries that add new deposits and liabilities to the commercial bank’s books, simultaneously. These new deposits and liabilities represent brand new money because they are not taken from anywhere else, such as from deposits or reserves.
  

• 97% of the money in circulation in the UK in 2014 was created by commercial banks when making loans. Only 3% of the money in circulation was issued by the central bank itself – when it mints coins and bills. (As future blog posts will show, ratios like this are common in most industrialized countries. More than 90% of the money in circulation is created by commercial banks when making loans while less than 10% is created by the central bank when minting coins and bills.)
  

• When bank loans are repaid, the money paid towards the principal is destroyed. It is deleted by the reversal of the accounting operations that created new money when the loan was originated. The portion the borrower pays towards interest is kept by the bank “to cover its operating costs and make profits.”
  

• Thus, the overall amount of money in the economy at any time fluctuates depending on the level of debt that households, businesses, and governments are willing to take-on or maintain. When debts are being paid off faster than new loans are being originated, the nation’s money supply shrinks. When loans are being originated faster than they are being paid off, the money supply expands. (By extension, under our current bank-originated monetary system, if all loans were paid off, the amount of money in the economy would be reduced to the 3% that exists as coins and paper bills.)
  

• The Bank of England’s “Quantitative Easing” program increases the amount of money in the economy, but not the way that many people think. According to the Bank of England’s 2014 bulletin, the general public imagines that the central bank’s Quantitative Easing program gives commercial banks free central bank reserves which the commercial banks then “multiply up” into new loans. In actuality, according to the Bank of England’s 2014 bulletin, the Bank of England borrows the money it uses in its Quantitative Easing program from commercial banks who “finance” it by creating fresh new money, as they always do when lending.
  
  The Bank of England then uses that new bank-created money to purchase financial assets (primarily government bonds and real estate securities) from “institutional investors” (i.e., mutual funds, pension funds, insurance companies, hedge funds, trusts, and sovereign wealth funds). The result is that the economy has more money than it had before. However, as the Bank of England’s 2014 bulletin acknowledges, the new money primarily lands in the hands of institutional investors.
  
  (Editorial comment: “Institutional investors” should be understood as “high net worth households” because the wealthiest 10% of households are the ultimate owners of between 65% and 94% of all financial assets, including those held by mutual funds, pension funds, trusts, etc. Thus, by placing more money in the hands of institutional investors, Quantitative Easing makes the rich richer. It also drive inequality in two other ways. The asset managers for institutional investors are expected to invest all the money that come into their management, which means that they *must* find things to buy with all the money they receive from the Fed’s massive purchases of assets via Quantitative Easing. Because the Fed’s Quantitative Easing purchases vacuumed trillions of dollars worth of financial assets out of the market, there are now *fewer* financial assets available for the asset managers to purchase. Thus, they have no choice but to overpay for the remaining financial assets, such as stocks. This overpaying pushes up the prices of the stock market, which is 91% owned by the top 10% of households, making the wealthiest wealthier. They also overpay for real estate, which makes housing and retail space more expensive for ordinary people and small businesses. This inflation in housing prices and rent eats into ordinary people’s income and savings, leaving them less wealthy. A group in the UK, called Positive Money, wrote a great report explaining all of this, and presenting better alternatives.)
  

• Quantitative Easing creates new central bank reserves, but reserves are debts of the central bank, not money for banks to lend. Because the Bank of England now owes the commercial banks for the money it borrowed, it gives the commercial banks new central bank reserves which represent a promise made by the Bank of England to pay the commercial bank back in the future, plus interest. You can thus think of central bank reserves as an I.O.U. (“I owe you”) given to the commercial banks by the central bank. Thus, the excess reserves held by commercial banks today are a byproduct of the Quantitative Easing program having borrowed new commercial bank money in the past. In other words, the excess reserves are not a foundation from which commercial banks can “multiply up” new money today. They are merely the residue of an injection of new money into the economy that already happened. This makes sense if we remember, as explained above, that commercial banks don’t need central bank reserves to create new money, anyway.
  

• Commercial banks also create the money that they use to buy government bonds, corporate bonds, and shares of stocks for their own asset portfolios. This increases the amount of money in the economy, but often only temporarily because…
  

• When banks sell financial assets, the money the bank receives from the buyer is deleted. The money is deleted by the reversal of the same accounting procedures that create money when banks buy assets. Thus, the amount of money in existence decreases whenever banks sell “mortgage-backed securities” to investors in a process called “securitization”.
  

• The bulk of the paper focuses on addressing a few concerns that have “been the subject of debate among a number of economic commentators and bloggers”:

  • 1) Can commercial banks create an unlimited amount of money, thereby causing inflation? The Bank of England’s 2014 bulletin answers that the primary limit on how much money commercial banks can create is the amount of debt that households, businesses, and governments are willing to take on. Higher interest rates discourage households, businesses, and governments from taking out new commercial bank loans. Therefore, the Bank of England can raise interest rates to indirectly limit how much money commercial banks can create when lending. This is the primary way the Bank of England fights inflation when it believes there is too much money being created by the commercial banking sector’s lending activities.

  • 2) Is the Bank of England’s Quantitative Easing program a handout to banks? The Bank answers that the central bank reserves that it gives to banks in its Quantitative Easing program can never be lent out by banks or “multiplied up” into new loans, therefore the excess reserves created by Quantitative Easing do not represent “free money” for banks. As noted above, the reserves are actually a byproduct of the Bank’s borrowing.
    

• The Bank of England acknowledges that Quantitative Easing causes inflation in asset prices (real estate, bonds, and stocks): “QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies. Those companies will then wish to rebalance their portfolios of assets by buying higher-yielding assets, raising the price of those assets.” (emphasis added)

Videos & Graphics

Entertainingly, the Bank of England chose their gold vault as the place to record an interview about the paper with one of the authors of the paper, Ryland Thomas.

The Bank of England’s 2014 bulletin includes “highly stylized” balance sheet diagrams like the one below to represent the balance sheet accounting operations that create and uncreate money when a commercial bank makes a new loan. Unless you already know a good bit about how to read the balance sheets used by the accounting profession, please don’t be intimidated if such visuals don’t improve your understanding. They are not required for understanding what has been explained above.

Direct Quotes from the 2014 Bulletin

Money creation by commercial banks

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. (emphasis in original text)

The reality of how money is created today differs from the description found in some economics textbooks: Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits… Nor is central bank money ‘multiplied up’ into more loans and deposits. (emphasis added)

This [bulletin] article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates [brand new] deposits — the reverse of the sequence typically described in textbooks. (bracketed text and emphasis added)

Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans. (emphasis in original text)

The Role of Central Bank Reserves

Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money— the so-called ‘money multiplier’ approach. … While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. (emphasis in original text)

As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them… It is these lending decisions that determine how many bank deposits are created by the banking system. (emphasis added)

In contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of… money. (emphasis added)

Other Ways Commercial Banks Create & Uncreate Money

Deposit creation or destruction will also occur any time the banking sector (including the central bank) buys or sells existing assets from or to consumers, or, more often, from companies or the government.

Banks buying and selling government bonds is one particularly important way in which the purchase or sale of existing assets by banks creates and destroys money. When banks purchase government bonds from the non-bank private sector they credit the sellers with [brand new] bank deposits. (bracketed text added for clarity)

Money Uncreation

Just as taking out a new loan creates money, the repayment of bank loans destroys money.

Money can also be destroyed through the issuance of long-term debt and equity instruments by banks. When banks issue these longer-term debt and equity instruments to non-bank financial companies, those companies pay for them with bank deposits. That reduces the amount of deposit, or money, liabilities on the banking sector’s balance sheet.

Monetary Policy

This description of the relationship between monetary policy and money differs from the description in many introductory textbooks, where central banks determine the quantity of broad money via a ‘money multiplier’ by actively varying the quantity of reserves. In that view, central banks implement monetary policy by choosing the quantity of reserves. And, because there is assumed to be a stable ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank deposits as banks increase lending and deposits. Neither step in that story represents an accurate description of the relationship between money and monetary policy in the modern economy. (emphasis added)

Reserve requirements are not an important aspect of monetary policy frameworks in most advanced economies today.

The Bank of England aims to make sure the amount of money creation in the economy is consistent with low and stable inflation. In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves. This then influences a range of interest rates in the economy, including those on bank loans… By influencing the price of credit in this way, monetary policy affects the creation of… money.

Failed to render LaTeX expression — no expression found

Failed to render LaTeX expression — no expression found

Why you should care to understand the Bank of England’s 2014 bulletin

The bulletin’s claims that the general public and “many economics textbooks” are wrong about how money is created (and deleted). What it describes about how banking works is truly surprising and game-changing because…

• The Bank of England is an authoritative source on the topic of money creation and banking. It is the second oldest central bank in the world – the first central bank given responsibility for overseeing the issuance of its nations currency (in 1844) – and the prototype for most of the central banks that came after it. It is also the regulator of all the banks in the UK. So we can safely assume that the Bank of England knows a few more things about the accounting of money and banking than the average person and even the average economist. Therefore, it’s a big deal when the Bank of England comes out and puts its stamp of approval on ideas that have been disregarded and even disparaged by mainstream economists for decades (as we’ll see in a future post). It seems very unlikely that the Bank of England would make such extraordinary claims mistakenly. (They are not mistaken, as we’ll see in future posts.) I’m not the only one who thinks the Bank of England’s 2014 bulletin is game-changing. Already, 1,500+ academic papers cite it.
  

• The ideas being overturned in the Bank of England’s 2014 bulletin are taught in practically all the best-selling economics textbooks of the last 70 years: Paul Samuelson’s Economics (1948) was the “most successful economics book ever published” and “the standard-bearer of the field for 50 years”. It teaches the bogus fractional reserve and money multiplier ideas on pages 324-329. The 2021 edition of the best-selling macroeconomics textbook in the entire world over the past 30 years, Principles of Economics by Harvard professor Gregory Mankiw teaches that banks lend out depositor’s savings on page 533 and then teaches that banks create money through fractional reserve lending on page 598. Not surprisingly, the mistaken ideas found in these textbooks are what are taught in innumerable videos on Youtube, which is increasingly the schoolhouse of the world. The mistaken ideas are also found everywhere in the mainstream press, to this day. Evening newscasters, newspapers, the business press, and celebrity financiers like Ray Dalio regularly mansplain-to-the-people how the economy works using the very ideas that the Bank of England’s 2014 bulletin says are false.
  

• The ideas refuted in the Bank of England’s 2014 bulletin are central to the field of economics. Money is at the heart of every economic measure and theory. The Bank of England is saying that influential thinkers in the field of economics are wrong about important aspects of money:

  • Who creates most of the money we use.

  • How much money there is, what causes the quantity of money to go up and down, and how volatile the quantity of money can be.

  • Where banks get the money that they lend out.

  • Where the money goes when it is used to pay back a bank loan.

  • Where banks get the money that they use to buy assets.

  • What happens to the money when someone pays a bank for an asset.
    

• The revelations in the Bank of England’s 2014 bulletin warrant an urgent and well-resourced effort to re-examine existing economic models, theories, and policy prescriptions in light of how banking and money creation actually work. Many of the most famous and influential economic models, theories, and policy prescriptions emanating from the field of economics assume that banks are lending out depositor’s savings, or, are multiplying-up reserves. Many more influential economic models, theories, and policy prescriptions leave money creation and deletion out of consideration altogether under the assumption that the quantity of money in circulation is “neutral” in the long-run. Such an assumption ignores the fact that large portions of the money supply are actually blipping in and out of existence at all times and that when an imbalance between the amount of creation and deletion develops it can quickly spiral into a crash like the Great Depression or the 2008 North Atlantic Financial Crisis. It is reasonable to think that re-evaluating existing mainstream economic models in light of these revelations may explain why the last 50 years has seen a global upsurge in the number and severity of bank-driven economic crises despite many countries adopting the recommendations of mainstream economists during that period.
  

• Independent researchers have confirmed the Bank of England’s claim that the ideas that they are refuting represent widely-held views (“popular misconceptions” as they call them). Following the publication of the Bank of England’s 2014 bulletin, two nonprofits hired Glocalities, a global research firm, to find out how pervasive the misconceptions are. Glocalities specializes in surveying consumers and citizens to learn about their beliefs and behaviors. They conducted a survey of 23,000 people living in 20 of the largest national economies. The results confirmed that 80% of people are unaware that commercial banks create most of the money in their nation. Most people believe it is their government or central bank that controls the quantity of their nation’s money supply. Survey respondents working in the finance industry were just as misinformed, with only 26% being aware that commercial banks created the majority of their nation’s money supply. Read my summary of that research here.

An Important Disclaimer Regarding Evidence

“Extraordinary claims require extraordinary evidence.” - Carl Sagan

Surprisingly, the Bank of England’s 2014 bulletin provides little empirical evidence to support its claims. (Don’t worry, you’ll see in future posts that strong empirical evidence does exist to confirm exactly what the bulletin claims.) While the Bank of England’s claims in this paper are extraordinary, the Bank fails to supply evidence that confirms them beyond a doubt:

• No Direct Observations. The 2014 bulletin includes no real-world proof of its claims. For example, the Bank of England’s staff could have taken out a real loan from a real bank and deposited in another real bank while the accounting books of the two banks were watched to confirm that the new money was not drawn from anywhere else. If the accounts of the two real-world banks changed in the ways the 2014 bulletin claims, that would prove beyond a doubt the Bank of England’s claims about how commercial lending and money creation actually work. (A study exactly like that was performed by economist Richard Werner in 2014, confirming the Bank of England’s claims.)

• No Procedural Observations. The 2014 bulletin doesn’t include any evidence from the standard operating procedures of commercial banks. The Bank of England could easily have corroborated their claims by including in the 2014 bulletin a few pages photocopied from the accounting protocols that accountants follow when booking loans inside banks. Or, they could have shown that the standard accounting software used by banks is programmed to create money in the way that they claim. (A study of bank accounting software was performed by economist Richard Werner in 2015, confirming the Bank of England’s claims.)

• No Eye Witness Testimony. The 2014 bulletin does not even include a single testimonial from a commercial banker saying, “Yes, that’s how it works. I’ve seen it with my own eyes. I’ve done it with my own hands.” (Such testimonials can be found on Youtube, such as this video by former Barclay’s banker Michael Kumhof.)

• All Circumstantial Evidence. The 2014 bulletin’s footnotes contain references to papers that largely contain circumstantial evidence, such as a research study showing that the quantity of central bank reserves has historically followed the expansions and contractions in bank loans, not led them.

All-in-all, it seems that the reader is expected to accept the Bank of England’s earthquaking claims about the accounting of banks and money creation simply because it is the Bank of England speaking. That’s not a wise idea for us readers. As research Benjamin Braun has shown, central banks have told multiple incompatible stories about how money is created and who controls the money supply. Their tune appears to change when popular opinion is against them. True to the pattern, the Bank of England’s 2014 bulletin was issued to ameliorate popular concern about its Quantitative Easing program.

Subscribe to Get Notified of New Posts

Thanks for reading my newsletter! Subscribe for free to receive new posts and support my work.

Feedback

I welcome thoughtful feedback that can help me improve my research and writing.