Saturday, 22 June 2013

Banks don’t lend money

Professor Hyman Minsky once wrote “Banking is not money lending; to lend, a money lender must have money. The fundamental banking activity is accepting, that is, guaranteeing that some party is creditworthy. A bank, by accepting a debt instrument, agrees to make specified payments if the debtor will not or cannot”.

“Banking is not money lending”? Surely some mistake! Why would an economist as famous as Professor  Minsky make such an outrageous sounding statement?... Well the answer is that its perfectly true. Crazy though it sounds, banks don’t lend money at all. To understand why this is the case we must understand some technicalities about money.

Most people imagine that money is simply a system of government-created tokens (physical or electronic) that get passed form person to person as trade is carried out. Money of this kind does indeed exist, so called “central bank money” is of this type. However the vast majority of the money we spend day today is a second type, technically known as “broad money” or “cheque book money” which can best be described as “spendable bank IOUs”. The concept of a spendable IOU may sound rather strange, and in order to explain it, we must first consider some characteristics of an ordinary IOU, the kind you or I might use…

Say that Mick wanted to borrow £10 from Jim. Jim could give Mick a £10 note in return for a piece of paper with “I.O.U. £10, signed.. Mick” written on it. The IOU would then have some value to Jim as a legal record of the loan. At some later time Mick would repay the loan. At this point Jim should no longer keep the IOU because Mick would no longer owe Jim any money. The IOU has now done its job and may be disposed of. To summarise, the lifecycle of an ordinary IOU is as follows:
  1. Creation (out of nothing. It did not exist previously)
  2. It now has value as a legal record of the loan.
  3. It expires (back out of existence) when the loan is repaid.
Note that even though the IOU has value during stage 2, it is not easily spendable. If Jim went into a grocery shop and said “I’d like to have £10 worth of food, here’s an IOU from Mick, he’ll pay you back later”, the shopkeeper would almost certainly  refuse. This is because the shopkeeper has no idea if Mick is creditworthy, the shopkeeper would be worried he may never receive £10 from Mick. Now imagine for a moment that it could somehow be arranged to have a guarantee from a famous high street bank, that Mick would indeed pay £10 to the holder of the IOU. Then the shopkeepers fears would be allayed and he would have no reason not to accept Mick’s IOU as payment for food. To summarise, a bank guarantee could convert a non-spendable IOU into a spendable IOU.

So far this has all been hypothetical, but to see a non-spendable IOU get converted into a spendable one in the real world, look no further than the process of getting a “bank loan”. The term “bank loan” is in fact highly misleading. What is actually going on is not lending at all, it is in fact an IOU swapping arrangement. If Mick went to borrow £1000 from a bank, the first thing that would happen is that the bank would asses Mick’s creditworthiness. Assuming it was good enough, then the bank would ask Mick to sign a “loan agreement” which is essentially an IOU from Mick to the bank. What the bank would give Mick would generally not be “central bank money”, but instead its own IOUs (i.e. cheque book money). And just like ordinary IOUs, bank IOUs do not have to be obtained from anybody else. They are just created on the spot. No “lending” is going on. In order to “lend”, the bank would have had to have been in possession of the money beforehand, and they were not.

So there you have the layman’s explanation. But some people are still not convinced. Many people have heard a different explanation of the money creation process at university or from textbooks and so assume that this explanation is somehow wrong. But let me assure you that it is the textbook explanation that is wrong. I do realise that “extraordinary claims require extraordinary evidence”. So here goes…

The first thing to say is that the explanation given here is indeed a simplification of the money creation process as it occurs in the real world. The full details of which are so complex and so frequently changing that they are not taught to undergraduate students as part of economics degrees. What students are often taught instead is a toy model of reality. A not-actually-true teaching aid. The idea of using a not-actually-true teaching aid is not unique to economics, in the field of chemistry a similar thing occurs with regard the behaviour of electrons around atomic nuclei. The real world behaviour is too complex for undergraduate students, so they are taught a not-actually-true story of “electron shells”. Its in virtually all the textbooks.

The standard not-actually-true method for teaching students about the workings of our monetary system is an explanation called the “money multiplier model” in which banks appear to lend out money that has been deposited with them. When some economists finish their degrees and subsequently go on to specialise in the monetary system and finally learn the full details of the process, they occasionally have some choice words to say about the undergraduate textbook model:
  • “The way monetary economics and banking is taught in many, maybe most, universities is very misleading”. Professor David Miles, Monetary Policy Committee, Bank of England.
  • “The old pedagogical analytical approach that centred around the money multiplier was misleading, atheoretical and has recently been shown to be without predictive value. It should be discarded immediately.”. Professor Charles Goodhart CBE, FBA, ex Monetary Policy Committee, Bank of England.
  • "The textbook treatment of money in the transmission mechanism can be rejected". Michael Kumhof, Deputy Division Chief, Modelling Unit, Research Department, International Monetary Fund.
  • "Textbooks assume that money is exogenous." ... "In the United Kingdom, money is endogenous" Mervyn King, Governor of the Bank of England.
Notice the extremely high calibre of the economists being quoted. These are all economists that specialise in the workings of our monetary system.

Is this issue controversial? Well yes and no (but mainly no)... let me explain. the issue is only controversial in as much as non-experts (that have just learned the textbook story) may say things that contradict the experts that have a detailed knowledge of the system in reality. But amongst the experts, it is not controversial at all.

I shall finish with a quote form Professor  Victoria Chick, Emeritus Professor of Economics, University College London:  “Banks do not lend money. It may feel like it when you get a 'loan', but that’s not what they are doing. They don’t have a pot of money which they are passing on. What they are doing is accepting your IOU… they simply write up your account”.

So there you have it, banks do not lend money. And if you want to argue against this on academic grounds, please only quote economists that specialise in the monetary system. 


  1. I don't know about an economic standpoint, but from a legal standpoint, at least in my jurisdiction of Queensland, Australia, I can legally lend or sell you something that I don't own provided I have your consent.

    The banks may even have implied consent if you never signed up to terms and conditions about the relationship that you and the bank have with your money.

    Regardless, when you accept a loan, which used in it's ordinary meaning "to borrow" (or something along those lines) and you agree to terms and conditions, you can't fall back on legal doctrine (that I am aware of) that would mean that you didn't have to pay back the loan.

    Facing the reality of it, if it could be done, it would have been done, and there are a lot of cases where the courts have required payment of loans.

    So quote as many economists as you want and can but it doesn't change the legality of it... and it almost always comes down to the law. Find some Judges, then let's talk.

  2. Nice writeup, Mick, many thanks. A question for you? The parallel between the everyday IOU and the bank "loan" doesn't seem to me to work. After all, when I give my buddy my IOU, he gives me actual money that he actually has in exchange. That's not what banks do -- I give a bank my IOU and in exchange they just make money up. They didn't have it before -- they're just waving a magic wand.

    Am I missing something? And if not, shouldn't this have some implications?

    1. Actually the 'borrower' creates the money since the loan agreement (the IOU) becomes 'money' (a liquid document or cash equivalent) when the 'borrower' signs it! What the banks then do is create an electronic account for the 'borrower' and convert the liquid document into digital currency by typing numbers into the account! In the case of an asset purchase (such as a house for example) the seller is then paid with this currency. The transaction is thus complete. So no lending takes place and consequently no money (currency) is owed to the bank! The only reason why people work years to pay back the so-called loan with interest is that they believe that the bank actually lent them real money! They are obviously deceived.

  3. I analysed an ordinary IOU just to show some features like creation out of nothing and the fact that it expires. But I am not saying that getting a bank "loan" is like exchanging an IOU for tokens. Instead it is exchanging an IOU for another IOU.

  4. The "out of thin air" idea is misleading (even if strictly true!).
    It leads many to think it is like a forger printing notes.

    In simple terms, if I need to pay Fred £50 and I have no money, I get my bank to allow me to overdraw and I give Fred a cheque. If Fred the deposits the cheque in the same bank, it means I owe the bank £50 and the bank owes Fred £50....he has £50 in his account. He can spend it, so we call it money. It isn't like a forger, who creates notes not backed by anything since Fred's money is backed by my obligation to pay the bank the £50 (though if I do a runner, the bank still owes Fred £50).

    Of course, if Fred uses a different bank, it is a bit more complicated, but if we think of the banking system as one big bank, we can ignore the details without being far from the truth, at a rough and ready level.

    Rob Slack

  5. Very good piece Mick, you are very clear and don't get too controversial with it, this stuff is so current, and people largely unaware, like that surveys in Switzerland where a majority didn't know that banks create our money. Power to your elbow :)