If Banks can Create Money, then why did Northern Rock run out of Money?

    By Alistair McConnachie

    Some people who are opposed to our reform will claim that we must be wrong when we say that “banks create money” because, “If banks can create money, then they should never go bust.” This article was written with credit due (or a debt owed!) to Ben Dyson and the Positive Money website. (1)

    There are Three Types of Money

    1) Notes and coins (created by the Bank of England and the Royal Mint).

    2) The numbers in your account, called “bank deposits”. This is the most common sort of money and it is the money to which we refer when we speak about “banks creating money”. It represents around 97% of money in existence. Banks create this money by creating a new deposit in a customer’s account when the customer receives a loan.

    3) Central bank reserves, held at the BoE and accessible only by banks. Banks cannot “create” this kind of money.

    What are Central Bank Reserves?

    Every commercial “High Street” bank must have an account with the Bank of England. Its central bank reserve is the money which a bank has in its account with the Bank of England. It is the money that it uses to settle its debts with the other banks at the end of each working day.

    Importantly, it must ensure its reserve balance is even at the end of each day and if there is a shortfall, then it must borrow money from a bank which has a surplus that evening.

    Reserve money is exclusive to the banks. The only way you can get your hands on these reserves is to become a bank and open an account at the Bank of England.

    During the course of a working day, the customers of banks are taking out cash money from machines, writing cheques, and using debit cards to make payments.

    All day, there is money leaving the bank, and money coming in to the bank, as payments are made, and as loans are repaid and as new deposits are created.

    At the end of every day, all those payments between customers of different banks are “netted out” in the various payment systems such as BACS, Visa etc.

    Only the net amount – that which is left – is transferred between the various banks. That is, since most of the payments between banks will cancel each other out, then the total amount transferred at the end of the day will only be a fraction of the total amount spent by customers.

    Crucially, it is the bank’s central bank reserve money which is transferred. It is this central bank reserve money that a bank can “run out of”.             

    Usually some banks will have taken in more money than has left the bank that day, while other banks will be a bit short and more money will have left the bank than it received.

    Those banks which have a deficit that evening must borrow from the banks which have a surplus, in order to ensure that their balance in their reserve account is even at the end of the day.

    For example, trade back and forth between say, the Royal Bank of Scotland, and HBOS may amount to millions or billions each day, but the net amount after the transactions are settled in the evening, may only be a few million pounds.

    RBS may find it is a few million “up”, in which case it has some extra central bank reserve money which it can lend to another bank, or it may find it is a few million “down” so it will have to borrow that money from a bank which is “up” that day.

    As Ben Dyson has pointed out (2):

    In normal times, the payments between customers of different banks (using bank-created bank credit) tend to cancel each other out, and only a small amount of central bank money would be needed to settle the difference between banks at the end of each day. As a prime example of this, before Quantitative Easing, the total amount of central bank reserves that were used by the banks to settle between themselves was around the £20bn mark (Bank of England figures for Central Bank sterling reserve balances (3). This was enough to settle over £704bn of daily transactions (See the 2007 Payments Systems Oversight Report for figures on average payment flows (4).

    That means that, while the total bank-created money supply (as measured by M4) was £1,600bn just prior to the crisis, the entire bank settlement system was able to run on just £20bn of central bank reserve money. 

    Why Northern Rock Failed

    Northern Rock was lending out money so fast that it exceeded the payments which were coming back in the other direction.

    At the end of each day it was massively out of balance in its reserve account at the Bank of England.

    It needed to borrow central bank reserves from the other banks but the other banks wouldn’t lend it any of their reserves. It went to the Bank of England – the lender of last resort – which loaned it some money. However, that demonstrated to the other banks that Northern Rock was on rocky financial ground.

    This made the other banks even more reluctant to lend to it, and consequently the central bank reserve money it was borrowing from other banks on the “inter-bank lending market” dried up.

    Ben again:

    But Northern Rock went on a lending binge…Because Northern Rock was expanding its lending faster than other banks, at the end of each day it would find that it ended up with a net outflow of central bank reserves. That is why it would borrow money (in the form of central bank reserves) from other banks, and indirectly from pension funds and other large investors. The borrowing was a way of bringing in central bank reserves to settle the huge outflows that lending at such a rate would have caused.

    Northern Rock eventually went bust when, for a variety of reasons, no-one would lend central bank reserves back to it, and it was unable to make its outward payments through the settlement system… Had Northern Rock instead expanded its lending – and created the type of money used by the public – at the same rate as other banks, it would have found that its daily inflows of central bank reserves roughly matched its outflows (since the payments from its customers to other banks would be cancelled out by payments from other banks to customers of Northern Rock). It is unlikely that it would have become so dependent on interbank lending to be able to make its payments. The very reason why Northern Rock went bust was the sheer speed at which it was creating money through issuing loans, which created a massive outflow of deposits which had to be settled by securing the reserves from somewhere. (5)

    Today, most banks remain reluctant to lend to each other because they all believe rightly, that each has huge “toxic debts” hidden within them. Full disclosure of accounts is a necessary policy.

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    1. Ben Dyson, “If banks can create money, how come Northern Rock went bust?” 16 July 2012, www.positivemoney.org.uk/2012/07/if-banks-can-create-money-how-come-northern-rock-went-bust

    2. Ibid.

    3. Bank of England Statistical Interactive Database www.bankofengland.co.uk/boeapps/iadb/newintermed.asp

    4. www.bankofengland.co.uk/publications/Documents/psor/psor2007.pdf

    5. Dyson, op cit.