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Common Misconceptions about Banking

There is significant confusion about banks. Much of the public is unclear about what banks actually do with their money. Economics graduates are slightly better informed, yet many textbooks used in undergraduate economic courses teach a model of banking that has not applied in the UK for a few decades, and unfortunately many policy makers and economists still work on this outdated model.

Here is a brief overview of the common misconceptions about what banks do, and then gives an initial overview of what they actually do.

Popular Perceptions of Banking 1: The ‘Safe Deposit Box’

Most people will have had a ‘piggy bank’ at some point in their childhood. The idea is simple: keep putting small amounts of money into your piggy bank, and the money will just sit there safely until you need to spend it.

For many people, this idea of keeping money safe in some kind of box ready for a ‘rainy day’ persists into adult life. A poll conducted by ICM on behalf of the Cobden Centre[1]found that 33% of people were under the impression that a bank does not make use of the money in customers’ current accounts.

When told the reality – that banks use at least some of the money deposited within current accounts to fund loans – this group of people answered “This is wrong – I have not given them my permission to do so”.

You do not own the money you have put in the bank. 

The ‘custodial’ role that banks are assumed to play by a third of the public is something of an illusion. Similar confusion is found over the ownership of the money that we put into our bank accounts. The ICB/Cobden Centre poll found that 77% of people believed that the money they deposited in banks legally belonged to them.[1]  In fact, the money that you deposited legally belongs to the bank.

When a member of the public makes a deposit of £1000 into the bank, the bank does not hold that money in a safe box with the customer’s name on it (or any digital equivalent).   Whilst banks do have cash vaults, the cash they keep there is not customers’ money.

Instead, the bank takes legal ownership of the cash deposited and records that they owe the customer £1000. In the accounting of the bank, this is recorded as a liability of the bank to the customer. It is liability because at some point in the future it may have to be repaid.

The concept of a ‘liability’ is essential to understanding modern banking, and is actually very simple. If you were to borrow £50 from a friend, you might make a note in your diary to remind you to repay the £50 a couple of weeks later. In the language of accounting, this £50 is a liability of you to your friend.

The balance of your bank account, and indeed the bank account of all members of the public and all businesses, is the bank’s ‘IOU’, and shows that they have a legal obligation (i.e. liability) to pay the money at some point in the future.

Popular Perceptions of Banking 2: Taking Money from Savers and Lending it to Borrowers

The ICM/Cobden Centre poll found that around 61 per cent of the public share a slightly more accurate understanding of banking: the idea that banks take money from savers and lend it to borrowers. When asked if they were concerned about this process, this group answered ‘I don’t mind as long as the banks pay interest and aren’t too reckless.’

This view sees banks as financial intermediaries, recycling and allocating our savings into (we hope) profitable investments that provide us with a financial return in the form of interest. The interest we receive on savings accounts is an incentive to save and a form of compensation for not spending the money immediately. Banks give lower interest to savers than they charge to borrowers in order to make a profit and cover their losses in case of default. The difference
between the interest rate banks pay to savers and the interest they charge to borrowers is called the ‘interest rate spread’ or ‘margin’.

Banks intermediate money across space (savings in London may fund loans in Newcastle); and time (my savings are pooled with those of others and loaned over a longer-term period to enable a borrower to buy a house). Shifting money and capital around the economy, and transforming short-term savings into long-term loans (a process known as ‘maturity transformation’) is very important for the broader economy: it ensures that savings are actively being put to use by the rest of the economy rather than lying dormant under our mattresses. We can also invest our money directly with companies by purchasing shares or bonds issued by them.

Banks, according to this viewpoint, are important, but relatively neutral players in our financial system, almost like the lubricant that enables the cogs of consumption, saving, and production to turn smoothly. So it is perhaps understandable that orthodox economists do not put banks or money at the heart of their models of the economy. Maybe sometimes things go wrong – banks allocate too many savings to a particular industry sector for example that is prone to default – but in the long run, so the theory states, it is not the banks themselves that are really determining economic outcomes.

This theory is incorrect. It also leads to assumptions about the economy that do not hold true in reality, such as the idea that high levels of savings by the public will lead to high investment in productive businesses (and conversely that a lack of savings by the public will choke off investment in productive businesses).

Most importantly, this understanding of banking completely overlooks the question: Where does money come from? Money is implicitly assumed to come from the Bank of England (after all, that’s what it says on every £5 or £10 note), the Royal Mint, or some other part of the state. The reality is quite different…

This was en extract from the book Where Does Money Come From?, which explains exactly how money is created in the UK. Here you can read the Foreword by Prof Charles Goodhart, one of the leading authorities in banking.

The confusion (around banking) comes because the reality of modern banking is complex and partially hidden. In researching for this guide, the authors had to piece together information that was spread across more than 500 documents, guides, manuals and papers from central banks, regulators and other authorities. Few economists have time to do this research first-hand and most individuals in the financial sector only have expertise in a small area of the system, meaning that there is a shortage of people who have a truly accurate and comprehensive understanding of the modern banking and monetary system as a whole.


[1]ESCP Europe/Cobden Centre, ‘Public Attitudes to Banking’, June 2010, www.cobdencentre.org

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  • S Moore

    Why not nationalise the whole banking industry and lend money at a fixed rate of say 3%?
    We all get cheap loans hmg makes a small profit, everyone knows where they stand and the country’s financial system is protected from the spiv’s in the the city of London. The only flaw I can see to this is the Tory government/press right wing ideology.

    • DozyHole

      I suppose the positive money point of view may be that you don’t need to nationalise banking, just the money supply.

      Banking would still have a major role to play facilitating the needs of lenders and borrowers.

      The effect of the positive money proposals would probably achieve the same result as what you suggest.

  • S Moore

    I’m a great believer in nationalized industry, but that’s just me. I feel that when something is left to market forces then it just becomes the usual race towards the bottom and that businessmen will always put profit before people.
    However there is no “guarantee” that the state would do things any better, I guess it’s all down to the framework and the morality of the people running the show. What could be done is a change in the law that states that “all business’s should be run in the interests of the shareholder” to all business’s should be run in the interests of the nation and its people” It depends on what you think of as important.

    • DozyHole

      One of the good things about the positive money proposals is that it transcends the left v right debate.

      They have some support from all sides of the political spectrum.

      I am conflicted in the whole left/right debate, seems like whoever has control has the power to abuse that control whether that be government or big business.

      The government and the banks turned a blind eye leading up to the crisis as it suited both to do so.

      Positive money propose that an independent body of neither political persuasion should oversee money creation, and work for the benefit of society, not for profit(banks) or to buy political favour(politicians).

  • S Moore

    Can’t disagree with that, so why not bring back building society’s with the additional clause that they can’t be transformed into banks

  • Mary-Ellen Large
  • http://www.nordicenterprisetrust.wordpress.com Chris Cook

    If I deposit cash (ie notes and coin), then the bank credits my account with….something….and that ‘thing’ is actually a virtual promissory note which is a ‘look-alike’ of an undated treasury bill. ie the public credit or ‘stock’ which was privatised by banks from 1694 onwards.

    I now have title to this virtual promissory note (cash) – ie electronic money knows who owns it – because the bank’s accounting record in respect of demand deposits is to all intents and purposes a title repository to cash.

    The undated ‘liability’ of a demand deposit is NOT the same thing in accounting terms as a dated liability – a debt or term deposit – any more than the ‘equity’ claim of an owner over a productive asset is the same thing as the claim of a secured creditor over the same asset.

    Current accounts and loan accounts are distinct because the legal relationships are distinct.

    Both you and the book have the ‘polarity’ of private bank money reversed. The bank is asserting an undated ownership claim – not a debt claim – over the worthless promissory notes (cash – look-alikes of central bank money) it creates when lending or spending money into existence.

    An undated credit liability and a dated debt liability are completely different and to conflate them is a serious error.

    The leading economic theory I have seen which correctly identifies bank money as a credit instrument, not a debt instrument, is Modern Monetary Theory.

    • Robert

      You may (or may not, I honestly can’t tell) be making a serious point and a valid criticism.

      I wonder: Do you actually *wish* to be understood? If so, you’re not succeeding – not at least where the average (intelligent) reader is concerned. Not so long as you insist upon expressing your arguments in terms totally incomprehensible to any such person.

      For instance, what for God’s sake does this mean, in English:-
      “Both you and the book have the ‘polarity’ of private bank money reversed. The bank is asserting an undated ownership claim – not a debt claim – over the worthless promissory notes (cash – look-alikes of central bank money) it creates when lending or spending money into existence.”?

      • http://www.nordicenterprisetrust.wordpress.com Chris Cook

        Let’s try again.

        Bank money is in fact a positive – not a negative.

        +1 not -1

        A credit instrument – not a debt instrument.

        And there is a big difference between the ownership of a thing, and the ownership of a claim over a thing owned by someone else.

        • Robert

          Go on.

          So…?

          • http://www.nordicenterprisetrust.wordpress.com Chris Cook

            “When told the reality – that banks use at least some of the money deposited within current accounts to fund loans – this group of people answered “This is wrong – I have not given them my permission to do so”.”

            So this is false.

            Current accounts fund nothing: a dated loan must be balanced/funded by a dated deposit.

            The Positive Money analysis is fundamentally wrong.

          • Robert

            So, are you also claiming that it follows from your critique that the assertion (which of course is the cornerstone of the PM position) that the private banks create most of our money, ex nihilo, is also “false”? (As you’re doubtless aware, even MMT doesn’t say this: it just questions its importance).

            It’s still not clear to me whether this is your position or not, nor (if so) how you believe it necessarily follows from your argument.

    • Robert

      -or this:-
      “I now have title to this virtual promissory note (cash) – ie electronic money knows who owns it – because the bank’s accounting record in respect of demand deposits is to all intents and purposes a title repository to cash”?

      • http://www.nordicenterprisetrust.wordpress.com Chris Cook

        “So, are you also claiming that it follows from your critique that the assertion (which of course is the cornerstone of the PM position) that the private banks create most of our money, ex nihilo, is also “false”?”

        No.

        Banks do create such money.

        But Positive Money’s analysis as to the mechanism by which banks do so is IMHO fundamentally wrong and this means that the remedies they suggest are fundamentally wrong as well.

        MMT correctly regards money as a credit instrument, but IMHO incorrectly sees the State as necessary in its creation.

        MMT also incorrectly believes that bank-created money is destroyed when loans are repaid or written off, when the fact is that the only way in which modern bank (public or private bank credit) money may be ‘destroyed ‘ is through payment of taxes.

        Positive Money – in contrast with its name – is analysing modern money as a (negative) debt instrument.

        • Robert

          “But Positive Money’s analysis as to the mechanism by which banks do so is IMHO fundamentally wrong and this means that the remedies they suggest are fundamentally wrong as well”.

          Not necessarily – they could be right for the “wrong” (in your opinion) reasons.

          But to me this argument is sterile anyway for the reasons given below. But I wouldn’t expect you to agree with that.

        • S Moore

          you state “MMT also incorrectly believes that bank-created money is destroyed when loans are repaid or written off, when the fact is that the only way in which modern bank (public or private bank credit) money may be ‘destroyed ‘ is through payment of taxes.”
          What utter bollocks! Most money as we now know only exists on a computer screen, the debt gets cancelled when the loan is repaid plus the large amount of interest the banks charge us for creating electronic money out of thin air.
          I’m not an economist but even I can see your argument is flawed which probably makes you a Tory voter

          • http://www.nordicenterprisetrust.wordpress.com Chris Cook

            The debt gets cancelled.

            The money that was created at the outset does not.

            I am not an economist either but I have made it my business to understand the system building upon 25 years’ experience in market regulation and development, much of it at high level.

            What is the basis of your assertions?

            Quite why you think saying this makes me a Tory voter – which those who know me would find hilarious – is beyond me.

  • Robert

    To me it seems that you’re substituting accounting technicalities for real life. You appear to believe that man is made to satisfy the demands of accountancy rather than vice versa. Personally I don’t give a fig for the niceties of double-entry bookkeeping so far as the determination of societal issues (including ones which connect with war (eg Weimar Germany), revolution (eg the American colonies)and the survival of our planet (now)) are concerned. Accountancy is just a useful technique, not the basis of life on earth. It should only occupy a place in the argument proportionate to that (limited) usefulness.

    • http://www.nordicenterprisetrust.wordpress.com Chris Cook

      I couldn’t agree more.

      But it is Positive Money, not me, who decided – quite rightly (and kudos to them) – to analyse and de-construct the national banking/accounting system, which is a necessary pre-condition for constructive proposals achievable in the real world.

      I don’t think their assumptions are correct, and in a fundamental respect.

      Unfortunately accountancy rules our lives, and as you appear to do, I wish it to be the servant, not the master.

      • Robert

        “I don’t think their assumptions are correct, and in a fundamental respect”.

        This, I concede, would indeed be worrying if well-founded.

        I’ll have to chew it over at greater leisure. Trouble is that I’m such a dunce when it comes to understanding the technicalities!

        But at least I no longer feel impelled to question your intentions.

        Cheers!

  • Robert

    “…when the fact is that the only way in which modern bank (public or private bank credit) money may be ‘destroyed ‘ is through payment of taxes.”

    You may be right about that – I’m not well-versed enough in MMT to know definitively. Nevertheless, it’s not what I had understood. Mosler for instance vividly describes the (hypothetised) throwing into the shredder by the clerk at the tax-collection window of tax payments made in cash, the point being that taxation only has as its purpose the withdrawal of purchasing-power from the non-government sector – not the funding of government expenditure.

    This seems to be exactly in accord with what you are arguing.

    • http://www.nordicenterprisetrust.wordpress.com Chris Cook

      Mosler is exactly right re cash. But I don’t think he has electronic cash right.

      By way of a ‘thought experiment’, imagine a bank is winding down its operations (not an unlikely scenario) and has completely wound down its loan book apart from one last outstanding loan of £100.

      The bank’s balance sheet will have an asset of the (dated) loan £100 and liabilities of (dated) deposits of £100.

      The last borrower walks in the door and pays off the loan with £100 in cash or cheque. (it doesn’t matter which).

      The bank uses then repays its outstanding £100 term deposits.

      But the £100 does not evaporate, as the MMT’ers appear to think.

      It is now sitting as a (undated) demand deposit of £100 in a current account at another bank in the name of whoever it was who lent the expiring bank £100 as a term deposit.

  • Robert

    “But the £100 does not evaporate, as the MMT’ers appear to think.”

    So you not only have a disagreement on fundamentals with PM but also with MMT! I must say I admire your temerity!

    I in my ignorance have taken it as axiomatic that however wrongheaded som of MMT may be (and I think it is) on their own ground (“functional finance” as it used to be called) having a complete understanding of how the financial system actually operates as distivnct from the almost-completely wrong account given in economics textbooks – they were unchallangeable.

    Which of the two protagonists am I to believe, and why?

    • http://www.nordicenterprisetrust.wordpress.com Chris Cook

      Well, I don’t think it’s a question of EITHER Positive Money OR MMT.

      MMT gets the ‘polarity’ of money right – seeing it as a credit instrument, not a debt instrument.

      Whereas, Positive Money – despite the name – IMHO gets that wrong by advocating what would in fact be Negative Money.

      But I think both share the mistaken view that private bank created money is created as debt (rather than as the object of debt), and that when debt is repaid or cancelled the money disappears.

      Once upon a time – in the days of ‘free banking’ beloved of some Austrian economists before central banks came along – that was in fact the case.

      But these days these bank IOUs/credit instruments are – by a feat of accounting legerdemain – not the loan, but the OBJECT of the loan or the thing which is loaned.

      ie the virtual money/cash of which borrowers have the use over time, and for which use they pay interest.

      • Robert

        “Well, I don’t think it’s a question of EITHER Positive Money OR MMT.”

        Actually, the protagonists I had in mind were you and MMT!

        “MMT gets the ‘polarity’ of money right – seeing it as a credit instrument, not a debt instrument”.

        It’s clear that to you this distinction is a crucial one. But is not one man’s credit instrument another one’s debt instrument? In other words doesn’t the difference lie only in which end of a single transaction each party to it is on? Which seems to me not to be a difference at all.

        Can you elucidate further?

        • http://www.nordicenterprisetrust.wordpress.com Chris Cook

          If I issue an IOU it’s a credit instrument, backed by my capacity to provide goods and services.

          This is a Bill of Credit – also known as a Real Bill – and banks used to issue these once upon a time.

          These Bills would be assigned and discounted/accepted by third parties in exchange for value, until eventually someone would eventually present it to the issuing bank, and would – if the bank had it – receive gold or other acceptable value.

          But what now happens is that a private bank is issuing a credit instrument which is not based upon value provided by the bank, but rather is based upon no value created by the bank but rather – in aggregate – upon IOUs/Real Bills provided by borrowers to the bank, and often backed by collateral such as land.

          So it is not a claim over value provided by the issuer – a credit instrument – but rather a claim over value provided by someone else, which is a debt instrument.

          What of it, you may ask?

          Well, this mistaken assumption affects Economics in the same way that Physics would be affected if anti-matter were assumed to be matter.

          This would completely invalidate all predictions based upon it, and as we see, that is precisely the case with conventional economics as a forecasting tool.

          Garbage In = Garbage Out.

          • Robert

            “Well, this mistaken assumption affects Economics in the same way that Physics would be affected if anti-matter were assumed to be matter.

            This would completely invalidate all predictions based upon it, and as we see, that is precisely the case with conventional economics as a forecasting tool.

            Garbage In = Garbage Out”.

            I like your analogy!

            Very thought-provoking.

  • Robert

    OK, sorry – you already did:-
    “MMT correctly regards money as a credit instrument, but IMHO incorrectly sees the State as necessary in its creation”.

    I infer that the argument is that when money is created by private agencies it can *only* take the form of credit. When banks borrow, on the other hand, they are not creating money.

    You are saying that PM – by holding to the position that money-creation must be exclusively in the hands of government (which incidentally is a position I subscribe to) is by the same token asserting that money-creation by its very nature necessarily involves government, and that that assertion is false.

    Have I understood you correctly?

    If I have, I must say that I can’t see why your conclusion necessarily follows.

    • Robert

      You were too quick for me!

      It seems I was on the wrong track.

  • Robert

    OK, so where does this take us?

    You take it as axiomatic that what you see as a fundamental taxonomic error in PM’s analysis automatically renders their prescription for remedial action invalid in its entirety.

    Even assuming for the sake of argument that your criticism is well-founded, I don’t see that the conclusion you draw from it necessarily follows.

    In fact, does it really matter at all, except to purists?

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