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BANKING 101 – Video Course

There’s a lot of confusion about how banks work, most university economics courses still teach a model of banking that hasn’t applied to the real world for decades. While banking may seem like a complicated subject, anyone can learn the basics.

Do you really want to understand how banks create money, and what limits their ability to do so? Then our new 6-part video course ‘Banking 101′ is for you! Now you can watch the first two parts of this course below (a total of about 15 minutes). The final four parts will be released over the next few weeks.

Misconceptions around Banking

Banking 101 (Part 1)

TRANSCRIPT

PART 1: PUBLIC MISCONCEPTIONS AROUND BANKING There’s a lot of confusion about how banks work and where money comes from. Very few members of the public really understand it. Economics graduates have a slightly better idea, but many university economics courses still teach a model of banking that hasn’t applied to the real world for decades. The worrying thing is that many policy makers and economist still work on this outdated model.

Over the next hour we’ll discover how banks really work, and how money is created. But first, to clear up any confusion, we need to see what’s wrong about the way that most people think banks work.

Public Perception of Banking Number 1: The ‘Safe Deposit Box’

Most of us had a piggy bank when we were kids. The idea is really simple: keep putting small amounts of money into your piggy bank, and when a rainy day comes along, the money will still be sat there waiting for you. For a lot of people, this idea of keeping your money safe sticks with them into adult life. A poll done by ICM on behalf the Cobden Centre found that a third of the UK public still believe that this is how banks work. When they were told that actually the bank doesn’t just keep your money safe waiting for you to return and collect it, they answered “This is wrong – I haven’t given them my permission to do so.” So this idea that the banks keep our money safe is a bit of an illusion. Your bank account isn’t a safe deposit box. The bank doesn’t take your money, carry it down to the vault and put it in a box with your name written on the front. And it doesn’t store it in any digital equivalent of a safe deposit box either. What actually happens is that, when you put money into a bank, that money becomes the property of the bank. That’s right. The money that you put into the bank isn’t even your money. When your salary gets paid into your account, that money actually becomes the legal property of the bank. Because it becomes their property, the bank can use it for effectively anything it likes. But what are those numbers that appear in your account? Is that not money? In a legal sense, no. Those numbers in your account are just a record that the bank needs to repay you some money at some point in the future. In the accounting of the bank, this is recorded as a liability of the bank to the customer. It’s a liability because the money has to be repaid at some point in the future. This concept of a liability is actually very simple – and very important if you want to understand banking. Just think of it like this: if you borrowed £50 from a friend, you might make a note in your diary to remind you to repay the £50 in the near future. In the language of accounting, this is a liability from you, to your friend. So the balance of your bank account doesn’t actually represent the money that the bank is holding on your behalf. It just shows that they have a legal obligation – or liability – to repay you the money at some point in the future. Whether they will actually have that money when you ask for it is a different issue, but we’ll talk about that later.

Public Perception of Banking Number 2: The Middle-Man

Now the other two thirds of the UK public have a slightly better understanding of how banks really work. These people think that banks take money from savers and lend it to borrowers. The Cobden Centre poll that we mentioned earlier asked people if they were worried about this process: around 61% of people said they didn’t mind so long as they get some interest and the bank isn’t too reckless. This idea of banks as middle-men between people with spare money and people who need to borrow money is very common. In this idea, banks borrow money from people who want to save it, such as pensioners and wealthy individuals, and they then use that money to lend it to people who need to borrow, such as young families that want to buy houses or small businesses that want to invest and grow. The banks in this model make their money by charging the borrowers slightly more than they pay to the savers. The difference between the interest rates makes up their profit. In this model, banks just provide a service by getting money from people who don’t need it at the time, to people who do. This implies that if there’s no-one who wants to save, then no-one will be able to borrow. After all, if nobody came to the bank with savings, then the bank wouldn’t be able to make any loans. It also implies that if the banks lend far too much far too quickly, then they’ll eventually run out of money to lend. If that was the case, then reckless lending would only last for a short time, and then the banks would have to stop once they ran out of people’s savings to invest. That means it’s good for the country if we save, because it will provide more money for businesses to grow, which will lead to more jobs and a healthier economy. This is the way that a lot of economists think as well. In fact, a lot of economics courses at universites still teach that the amount of investment in the economy depends on how much we have in savings. But this is completely wrong, as we’ll see shortly. Let me point out that, so far, we haven’t talked at all about where the money really comes from. Most people just assume that money comes from the government or the Bank of England – after all, that’s what’s written on every £5, £10 or £20 note.

If you’d like to translate these videos into other languages, please email us first. (Someone else might already be working on a translation.) We’ll send you the transcript with timecodes.   (Do not translate the transcript above!)   Email: mira[at]positivemoney.org

What’s wrong with the money multiplier?

Banking 101 (Part 2)

TRANSCRIPT

PART 2: WHAT’S WRONG WITH THE TEXTBOOK MULTIPLIER MODEL?

We’ve seen the two main ideas that the general public have about the way banks work. Both of them are wrong. That’s not too surprising, after all, unlike the Positive Money team most people don’t spend their time obsessing about how banks work. And banking is complex, which means that most people give up trying to understand it. But what about economics or finance students? Most of these students and graduates have a slightly better understanding of banking. They get taught about something called the ‘money multiplier’.

The money multiplier story says that banks actually create much of the money in the economy. Here’s how the story goes: A man walks into a bank and deposits his salary of £1000 in cash. Now the bank knows that, on average, the customer won’t need the whole of his £1000 returned all at once. He’s probably going to spend a little bit of his salary each day over the course of the month. So the bank assumes that much of the money deposited is ‘idle’ or spare and won’t be needed on any particular day. It keeps back a small ‘reserve’ of say 10% of the money deposited with it (in this case £100), and lends out the other £900 to somebody who needs a loan. So the borrower takes this £900 and spends it at a local car dealer. The car dealer doesn’t want to keep that much cash in its office, so it takes the money back to another bank. Now the bank again realises that it can use the bulk of the money to make another loan. It keeps back 10% – £90 – and lend out the other £810 to make another loan. Whoever borrows the £810 spends it, and it comes back to one of the banks again. Whichever bank receives it then keeps back 10% i.e. £81, and makes a new loan of £729. This process of relending continues, with the same money being lent over and over again, but with 10% of the money being put in the reserve every time. Note that every one of the customers who paid money into the bank still thinks that their money is there, in the bank. The numbers on their bank statement confirm that the money is still there. Even though there is still only £1000 in cash flowing around, the sum total of everyone’s bank account balances has been increasing, and so has the total amount of debt. Supposedly this process continues, until after around 200 cycles, almost all of the original money is now in reserves, and only a fraction of a penny is being relent. By now, the sum total of all bank accounts adds up to about £10,000.

So the multiplier model that is still taught in many universities implies that this repeated process of a bank taking money from a customer, putting a little bit into a reserve, and then lending out the rest can create money out of nothing, because the same money is double-counted every time is it relent. The model says that if the reserve ratio – that’s the percentage of customers’ money that the banks have to keep in a reserve – is 10%, then the total amount of money will grow to roughly 10 times the amount of cash in the economy. You can imagine this model as a pyramid. The cash is the base of the pyramid ,and then, depending on the reserve ratio, the banks multiply up the total amount of money by relending it over and over again.

The fact is that what we’ve just shown you is completely wrong. It’s an inaccurate and outdated way of describing how the banking system works. In fact, banks in the UK haven’t worked like this for years. But despite that, this model is still used most of the time whenever people talk about how money is created, whether in universities or on videos on the internet. Before we spent 5 months researching exactly how the system worked, we used to think it worked like this too.

The fact that this pyramid model is still used is a problem for three reasons:

Firstly, this model implies that banks have to wait until someone puts money into a bank before they can start making loans. This implies that banks just react passively to what customers do, and that they wait for people with savings to come along before they start lending. This is not how it really works, as we’ll see later.

Secondly, it implies that the central bank has ultimate control over the total amount of money in the economy. They can control the amount of money by changing either the reserve ratio – that’s the percentage of customers’ money that banks have to keep in reserve – or the amount of ‘base money’ – cash – at the bottom of the pyramid. For example, if the Bank of England sets a legal reserve ratio –– and this reserve ratio is 10%, then the total money supply can grow to 10 times the amount of cash in the economy. If the Bank of England then increases the reserve ratio to 20%, then the money supply can only grow to 5 times the amount of cash in the economy. If the reserve ratio was dropped to 5%, then the money supply would grow to 20 times the amount of cash in the economy. Alternatively, the Bank of England could change how much cash there was in the economy in the first place. If it printed another £1000 and put that into the economy, and the reserve ratio is still 10%, then the theory says that the money supply will increase by a total of £10,000, after the banks have gone through the process of repeatedly re-lending that money. This process is described as altering the amount of ‘base money’ in the economy.

But the most significant implication of this model is that the Bank of England, or the Federal Reserve or European Central Bank, has complete control over how much money there really is in the economy. If they change the size of the base – by pumping more ‘base money’ into the system – then the total amount of money should increase. If they change the reserve ratio, then the steepness of the sides of the pyramid will change. But eventually, the reserve ratio stops the money supply growing any further. At some point we reach the top of the pyramid and the money supply stops growing. So there’s absolutely no possibility that the money supply can get out of control. There’s just one small problem. Almost everything about this description of banking is wrong.

In fact, Professor Charles Goodhart, of the London School of Economics and an advisor to the Bank of England for over 30 years, described this model as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.”

It might be forgivable for textbooks to be out of date if the rules had changed in the last couple of years – after all, a lot of rules and regulations changed during the financial crisis. But Professor Goodhart actually said this in 1984. 27 years, later university students are still learning a description of banking that is completely inaccurate. This is a big problem. If these students then go on to become economists and advisors to the government, and they don’t even really understand how money works, then our economy could end up in a real mess. Oh wait…it already is!

Now, I have to point out that these videos do apply to the UK, and we haven’t had time to confirm exactly how things work in the USA and Europe. But for those of you in the US, a paper published in 1992 refers to a textbook still used in universities today – and states that “the multiplier model…is at best a misleading and incomplete model, and at worst a completely mis-specified model’.

[Lombra, http://www.jstor.org/pss/40325454 ]

Here’s the bottom line when it comes to the ‘money multiplier’:

1) There’s no reserve ratio in the UK anymore, and there hasn’t been for a long time.

2) The Bank of England doesn’t have any real control over the amount of cash, or even electronic ‘base money’ (which we’ll talk about later).

3) And the Bank of England certainly doesn’t have control over how much money there is in the economy in total.

It’s not just economics graduates who have the wrong information. Even people working in the Treasury still believe it works according to the textbook. We’ve had letters from the Treasury saying things like this: “In this system, the Bank of England alone has control over the monetary base, which consists of currency (banknote and coins) and reserves held by commercial banks at the Bank of England. Commercial banks keep only a fraction of their deposits in reserve, lending out the remainder, while maintaining the simultaneous obligation to redeem all deposits upon demand.” Allowing people with an incomplete understanding of how money works to manage our economy is very dangerous. It’s like allowing engineering students who don’t understand gravity to build skyscrapers. People will suffer.

 

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  • John Morrison

    Nice so far. Flows well and seems to be going somewhere.

  • E. Corrigan

    Excellent! The means that leads to a clear understanding of what is actually happening is exactly what we need right now. Thank you to all those who are helping to bring this about.

  • John Wilson

    Very pleased to hear that you are beginning to understand how the system EXACTLY works. Money creation by the banks, as you are beginning to realise is CAPITAL constrained and, most certainly is NOT Reserve constrained. Looking forward to part 3.

    • James Murphy

      Pompous twit. Yes, I’m being ad hominem. No, it doesn’t engage with your argument. You’re still a pompous twit.

      • http://www.3spoken.co.uk/ Neil Wilson

        Pompous or not, he is right. Banks are constrained by capital, although even then they can engage in behaviour that increases the capital they have by laundering their own liabilities.

        • SussexBySea

          one man’s capital is another man’s debt. If Bank A creates £10,000 out of thin air and lends it to Mr Smith who then deposits it in Ms White’s account at Bank B then Bank B’s capital has gone up by £10,000. So now they get to use that to create even more thin air money. The only true capital in the world are natural resources, the natural commons (clean water, clean air, ozone, rain forests ** etc) and intellectual capital (learning, scientific discoveries and the application of such into useful technologies).

          Money is only ever a token to wealth. Or put another way, a token to capital. Which is precisely why Usury and debt-at-interest are so fundamentally flawed and evil. Especially when left in the hands of morally suspect bankers who are only interested in increasing their short term profit. The credit/debt/money in the system explodes exponentially, the bankers convert their accounting entries into bonuses and then into tangible real wealth (with the protection of ancient property laws meaning real wealth accumulates into fewer and fewer hands) and leave the mess behind – without one single extra unit of real wealth being created. Just imagine if, rather than pump all the bogus credit into housing, the banks had invested it in research and development into something potentially useful like nuclear fusion? But, oh, then they would have to wait decades for any return rather than the annual bonus.

          The world has committed the cardinal sin of falling in love with money. This sin is not just about becoming greedy and wanting more. It is about falling under money’s spell and believing that in itself it is real wealth. It is not. Not now, not then and never.

          (** and even the rainforest have become subject to accountants assigning them a monetary value, rather than understanding their true value which is to act as the lungs of the planet, keeping the atmosphere habitable. But hey, when you look at a tree as lumber in a saw mill and the land under it full of cattle then why worry about tomorrow – let’s fill the bank account with more binary digits and consider ourselves wealthy. Idiot Humans.)

          • johnwilson

            When Mr White deposits his £10k in bank B it is treated as a liability of Bank B to Mr White and, therefore,is retained by bank B as a reserve in their account at the BoE. It cannot be treated as capital since it is a liability.

            Mr Smith, at the same time, has an asset (the £10k) and a liability to bank A and the security offered by Mr Smith to bank A to support this borrowing is treated as capital.

          • SussexBySea

            No. Completely wrong. It is NOT retained in BoE. This is a very popular misconception but it is plain wrong.

          • johnwilson

            I didn’t say it is retained in BoE. It is deposited into the account of bank B at the BoE as part of bank B’s reserves. Reserves are always needed in order to cover withdrawals; and that’s why it is a liability and not capital.

          • SussexBySea

            Again, this is incorrect and misleading. If it were true there would not be the need for the government to back-stop deposits as the deposit would always be there. The deposit becomes the legal property of the bank. It is then free to use it to do whatever it wants. In recent times this usually meant gambling in the casino via prop-trading. You are trying to make a distinction where none exists, outside of woefully outdated economics text books. This is the very heart of what is wrong – both in the general population’s understanding of banking and the system itself. There is no reserve requirement any more.

          • johnwilson

            I apologise if I have caused ambiguity – this was not intentional.

            You will see that I did make a “qualification” by use of the word *part* of the banks reserves. I fully accept that deposits become the legal property of banks and, of course, some of these deposits have hitherto, as they continue to be used now, have been diverted into gambling and casino operations, as well as for the purchase of government gilts. The point is that deposits are in fact a liability on the part of banks and do not form part of the capital requirements to which they are required to adhere to for lending purposes.

            When a bank makes a loan in creates its own money ex-nihilo (out of thin air) having regard to (a) a customers creditworthiness and (b) the amount of net capital it is holding in its balance sheet. Deposits DO NOT, as I have said before form part of this Capital since they are liabilities.

            You also mention reserve requirements – I understand that in Canada there are no reserve requirements but, over here, in the UK the banks are required to operate what is known as “reserve maintenance”. In other words they are required to hold sufficient liquidity (deposits) at all times in order to meet withdrawals and transfers between banks. Fractional reserve banking has not been around since 1971 when President Nixon abolished the gold window.

  • Kavy

    I’m reading a superb new book called, Economists and the Powerful: Convenient Theories, Distorted Facts, Ample Rewards, by Norbert Haring and Nial Douglas. It clearly explains what is wrong with moden banking and why neoliberalism doesn’t work. For instance, pension funds take 50% of what we have paid into our pension (in hidden charges) over the lifetime of our savings to pay for managing our funds, and yet, along with other sections of the bank insider dealing ensures that our shares are bought and sold at completely the wrong time so that the bankers make all the money instead.
    The authors of the above book say that our pensions under perform by about 20% because of this insider dealing. This is stealing on an enormous scale and our pension funds are at near collapse because of it. I recently had to increase my monthly contributions to my pension fund to save it and yet I will get nothing more out of it in the end.

    Economists and the Powerful: Convenient Theories, Distorted Facts, Ample Rewards, by Norbert Haring and Nial Douglas.

    http://www.amazon.co.uk/gp/product/B009K44OW2/ref=oh_d__o02_details_o02__i00

    • Dave

      Excellent videos! Keep up the good work.

  • Kavy

    I’m reading a superb new book called, Economists and the Powerful: Convenient Theories, Distorted Facts, Ample Rewards, by Norbert Haring and Nial Douglas. It clearly explains what is wrong with moden banking and why neoliberalism doesn’t work. For instance, pension funds take 50% of what we have paid into our pension (in hidden charges) over the lifetime of our savings to pay for managing our funds, and yet, along with other sections of the bank insider dealing ensures that our shares are bought and sold at completely the wrong time so that the bankers make all the money instead.
    The authors of the above book say that our pensions under perform by about 20% because of this insider dealing. This is stealing on an enormous scale and our pension funds are at near collapse because of it. I recently had to increase my monthly contributions to my pension fund to save it and yet I will get nothing more out of it in the end.

    Economists and the Powerful: Convenient Theories, Distorted Facts, Ample Rewards, by Norbert Haring and Nial Douglas.

    http://www.amazon.co.uk/gp/product/B009K44OW2/ref=oh_d__o02_details_o02__i00

  • Lara

    Thank you! Looking forward to part 3 very much. I think I’ve figured it out, and I am keen to check to see if I’ve got it right.

  • http://www.facebook.com/jiles.halling Jiles Halling

    Can’t wait for part 3

  • Dave

    Excellent videos! Keep up the good work.

  • Jonathan Spink

    Keep up the excellent work.

    Some feedback on part 2;
    1. the pace of the oral delivery seems quite fast especially for anyone who does not already have a grounding in the underlying concepts. Words like “reserves” may not be generally understood.
    2. the figure of total savings is stated as £4,095.10 – if it could be shown visually that this comes from £1000 + £900 + £810 + £729 + 656.10 then it would save mental effort on the part of the viewer
    3. the figure of total debt of £4,095.10 appears incorrect in the context of the model being described – I think the first £1,000 should be treated as base money (it being noted the salary deposit is in “cash”) – so the total debt created would be £3,095.10. Also it would be good if the debtors (as well as the savers) were shown visually along with their balances so it is obvious from where this figure comes.

  • Jonathan Spink

    Keep up the excellent work.

    Some feedback on part 2;
    1. the pace of the oral delivery seems quite fast especially for anyone who does not already have a grounding in the underlying concepts. Words like “reserves” may not be generally understood.
    2. the figure of total savings is stated as £4,095.10 – if it could be shown visually that this comes from £1000 + £900 + £810 + £729 + 656.10 then it would save mental effort on the part of the viewer
    3. the figure of total debt of £4,095.10 appears incorrect in the context of the model being described – I think the first £1,000 should be treated as base money (it being noted the salary deposit is in “cash”) – so the total debt created would be £3,095.10. Also it would be good if the debtors (as well as the savers) were shown visually along with their balances so it is obvious from where this figure comes.

  • SussexBySea

    Excellent work – but do you think you might put an apostrophe in “Jane’s” account in the first video? A real bug-bear of mine.

  • mike crees

    Well done ….it about time this situation was brought to the attention of all people who use and have bank accounts…

  • John
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  • http://www.facebook.com/profile.php?id=761194187 Paul Thomas

    When is Part 3 out?

    • Mira Tekelova (Positive Money)

      On 20th-21st December

  • http://www.realliberalchristianchurch.org Tom Usher

    I’m glad the video said you haven’t had time yet to look into the US. The US definitely requires 10% reserves. The problem right now (in the mainstream pro-interest/usury view) in the US is that excess reserves are still huge. They aren’t lending. They are making money by not lending. They claim to be afraid to lend. Bernanke is pulling his hair out. Well, maybe his beard. Contrary to the video (it showed Bernanke as one who doesn’t know how it works), Bernanke really does know how it works.

    Keep up the good work!

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