Banks don’t lend money (2023)

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…

(Video) BANKS DON'T LEND MONEY

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.

(Video) Banks don't lend money, they create it: Demystifying monetary and banking terminology

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:

(Video) 5 Truths About Money That Banks Don’t Want You To Know

  • “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”.

(Video) How Banks Create Money

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.

Mick’s Blog: http://mickanomics.blogspot.co.uk/

FAQs

Why banks are not willing to lend money? ›

The banks might not be willing to lend certain borrowers due to the following reasons: (a) Banks require proper documents and collateral as security against loans. Some persons fail to meet these requirements. (b) The borrowers who have not repaid previous loans, the banks might not be willing to lend them further.

Why do banks want to lend money? ›

Earning interest income is the most fundamental incentive for banks to loan money to companies. Commercial banks lend as much money as they can at all times, charging different interest rates to different customers to balance the different risk profiles of each borrower.

Do banks have the money they lend? ›

Banks operate on a system called fractional reserve, which allows them to keep only a small fraction of the money they lend available on hand as withdrawable cash reserves. Also, the 1913 Federal Reserve Act requires banks to maintain the minimum cash reserves needed to clear outgoing checks.

Why can't a bank lend out all of its reserves? ›

The amount that banks are able to lend is determined by central bank regulation. The central bank might say that commercial banks must hold a certain amount of highly liquid capital (cash, shareholders' equity, or anything relatively easy to sell) relative to its loans.

How much can a bank lend? ›

A legal lending limit is the most a bank or thrift can lend to a single borrower. The legal limit for national banks is 15% of the bank's capital. If the loan is secured by readily marketable securities, the limit is raised by 10%, bringing the total to 25%.

Why do banks hesitate to lend money to small scale industries? ›

Banks give loan on collateral which ensures or it acts as a guarantee that their loan will be repaid. Small Scale Industries do not have such valuable asset which they can give as collateral so banks hesitate to give loans without collateral.

How do banks decide who to lend to? ›

A bank can consider your personal finances using character and your property/assets to secure the loan (collateral). If you have a poor personal credit history, the bank might think it's possible your business could have similar problems.

What do banks look for when lending money? ›

Lenders need to determine whether you can comfortably afford your payments. Your income and employment history are good indicators of your ability to repay outstanding debt. Income amount, stability, and type of income may all be considered.

Where do banks get the money to lend? ›

What are Banks' Funding Costs and Lending Rates? Banks collect savings from households and businesses (savers) and use these funds to make loans to those who want to borrow (borrowers). Banks must pay interest on the funds that they collect from savers, which is one of their main funding costs.

What happens if banks don't hold enough reserves? ›

Important. The reserve requirement is the basis for all the Fed's other tools. If the bank doesn't have enough on hand to meet its reserve, it borrows from other banks. It may also borrow from the Federal Reserve discount window.

What are the 4 ways banks make money? ›

How Do Banks Make Money?
  • Interest income.
  • Capital markets income.
  • Fee-based income.
7 May 2022

Where do banks make most of their money? ›

They make money from what they call the spread, or the difference between the interest rate they pay for deposits and the interest rate they receive on the loans they make. They earn interest on the securities they hold.

Can you think of a reason why people in general do not lend money to one another to buy a house or a car How would your answer explain the existence of banks? ›

Explanation

There are some human and personal reasons for not lending money to one another because sometimes the repayment of loans became a difficult task, borrower feels uncomfortable in being surrounded with lender. Whereas as bank act as a financial intermediator, it charges interest against the loan.

Why do banks have so many reserves? ›

However, a careful examination of the balance sheet effects of central bank actions shows that the high level of reserves is simply a by-product of the Fed's new lending facilities and asset purchase programs.

What stops banks from creating money? ›

The answer is that banks are not financial intermediaries, but creators of the money supply, whereby the act of creating money is contingent on banks maintaining customer deposit accounts, because the money is invented in the form of fictitious customer deposits that are actually re-classified 'accounts payable' ...

How do banks lend out more money than they have? ›

However, banks actually rely on a fractional reserve banking system whereby banks can lend more than the number of actual deposits on hand. This leads to a money multiplier effect. If, for example, the amount of reserves held by a bank is 10%, then loans can multiply money by up to 10x.

What is a bank limit? ›

The maximum amount for a transaction in selected currency.

What is the limit of a loan? ›

What's a limit? The limit is the total loan amount you've borrowed, and it will reduce over the remaining contract period. If you make extra repayments, it will be reflected on your balance.

Why do farmers prefer to take loans from the money lenders rather than the banks? ›

Farmers need to borrow money to buy inputs like seeds, fertilizers and pesticides. Sometimes, banks do not lend money to farmers because they fear that they cannot repay the principle amount in periodic interests since agriculture is a seasonal business and the income is not fixed.

Who lends money to the small farmers? ›

The government always tries to help small farmers as they give loans to farmers at a very low interest. Q. In India, about 80 per cent of farmers are small farmers, who need credit for cultivation. (a) Why might banks be unwilling to lend to small farmers?

What are 5 C's of credit? ›

One way to do this is by checking what's called the five C's of credit: character, capacity, capital, collateral and conditions.

Which credit score do banks use? ›

CIBIL is quite popular as it has been in the business for a long time. Non-Banking Financial Companies and banks use the credit score provided by CIBIL, Experian and Equifax to determine the potential risk of lending to a customer. The lenders make use of these scores fix the credit limit for all eligible customers.

How are lending decisions made? ›

In determining if a loan will be approved, banks typically look at: Three years of audited financial statements, plus the current year-to-date financial statement. The budget/forecast financial projections for the borrower. The unrestricted operating revenue, expenses and excess trend.

What will most likely cause a lender to approve credit? ›

Your payment history is the most important factor in determining your credit score. A good credit score will increase your odds of being approved for a credit card as lenders like to see that you can manage an additional line of credit and make monthly payments on what you charge.

What is the most important consideration of banks in approving a loan? ›

Character. Character is the most important and therefore the first consideration in making a loan decision. It is also the most difficult, as it is subjective. Determining one's character is to determine the borrower's willingness to repay the loan.

What are 3 ways to establish good credit? ›

3 things you should do if you have no credit history
  • Become an authorized user. One of the quickest and easiest ways to build credit is by becoming an authorized user on a family member or friend's credit card. ...
  • Apply for a secured credit card. ...
  • Get credit for paying monthly utility and cell phone bills on time.

Can banks create money out of nothing? ›

Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans”. This misconception may stem from the seemingly magical simultaneous appearance of entries on both the liability and the asset side of a bank's balance sheet when it creates a new loan.

What stops banks from creating money? ›

The answer is that banks are not financial intermediaries, but creators of the money supply, whereby the act of creating money is contingent on banks maintaining customer deposit accounts, because the money is invented in the form of fictitious customer deposits that are actually re-classified 'accounts payable' ...

Can you think of a reason why people in general do not lend money to one another to buy a house or a car How would your answer explain the existence of banks? ›

Explanation

There are some human and personal reasons for not lending money to one another because sometimes the repayment of loans became a difficult task, borrower feels uncomfortable in being surrounded with lender. Whereas as bank act as a financial intermediator, it charges interest against the loan.

Where do banks get money to lend to borrowers? ›

Banks collect savings from households and businesses (savers) and use these funds to make loans to those who want to borrow (borrowers). Banks must pay interest on the funds that they collect from savers, which is one of their main funding costs.

How do banks make money off of the credit they issue? ›

Banks make money off cardholders by charging them interest and fees. While interest is not always garnered, especially since it typically applies to your balance, they can still charge annual fees and other miscellaneous fees depending on your habits. Other fees include late fees, balance transfer fees and more.

Who controls money in the world? ›

The International Monetary Fund (IMF), the body responsible for monitoring the international monetary system, recognizes eight major reserve currencies: the Australian dollar, the British pound sterling, the Canadian dollar, the Chinese renminbi, the euro, the Japanese yen, the Swiss franc, and the U.S. dollar.

Can banks make money out of nothing? ›

Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans”. This misconception may stem from the seemingly magical simultaneous appearance of entries on both the liability and the asset side of a bank's balance sheet when it creates a new loan.

Who invented money? ›

It wasn't until about 5,000 years ago that the Mesopotamian people created the shekel, which is considered the first known form of currency. Gold and silver coins date back to around 650 to 600 B.C. when stamped coins were used to pay armies.

How do I refuse a lending money to a friend? ›

Be Firm and Concise

When you speak to your friend or relative, firmly explain that you're not able to provide him with a loan. For example, “I'd love to help, but I'm just not in a position to lend you the money right now.” This is short and to the point and does not give your friend or relative much room for argument.

Do you lend money to your friend give reasons? ›

Solution. A friend in need is a friend indeed. If the friend fails to repay the money, the friendship can go sour. My timely help will earn me his trust.

Is it a good idea to lend money to friends? ›

Personal finance advisors contacted by NBC News BETTER have this advice: If you're don't feel comfortable lending that person money, don't do it. If you agree to do it, consider it to be a gift that won't be repaid. So, don't lend more than you can afford to lose.

How do banks make profit? ›

Banks generally make money by borrowing money from depositors and compensating them with a certain interest rate. The banks will lend the money out to borrowers, charging the borrowers a higher interest rate and profiting off the interest rate spread.

What is the main source of income of a bank? ›

The difference between the amount charged from borrowers and the amount paid to depositors is the primary source of income for banks. This amount is known as interest.

Where do banks keep their money? ›

Banks have two choices for your money. They put most of the money in a local Federal Reserve Bank and keep the remaining cash in a vault. The vault helps banks provide customers with quick withdrawals while they earn interest on the money in a Federal Reserve bank.

Why do banks try to sell you credit cards? ›

Selling credit cards counts more towards sales goals than helping someone open up a checking account or savings account, thereby crafting skewed incentives based on the profitability of a product sold, not on how well it matched the needs of a customer.

Why do banks charge you for insufficient funds when you don't have enough money on your account to pay it? ›

Banks and credit unions charge nonsufficient funds, or NSF, fees when you don't have enough money in your account to process a transaction. NSF fees can add up quickly, so it's important to take steps to avoid them.

What do banks do with your money? ›

Banks use the money in deposit accounts to make loans to other people or businesses. In return, the bank receives interest payments on those loans from borrowers.

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