The Clerk
Why this chapter
To understand where money in an economy comes from at all, and why a bank account is not a safe holding your banknotes.
An analogy
Picture the coat check at a theater. You hand over your coat and get a tag. The coat hangs with the attendant, and you hold a slip of paper that will get it back. A bank is built almost the same way, with one important difference: the attendant has no right to wear your coat, and a bank does. It takes what you brought in, puts it to work, and leaves you the tag. Then things get strange. This attendant can write out new tags without receiving a single new coat — and people around town buy apartments with those tags. The whole first chapter is about how that works and why it is not a fraud.
How it works
A bank's balance sheet is two columns. Assets are what is owed to the bank (loans, reserves — the bank's money in its account at the central bank, bonds). Liabilities are what the bank owes (your deposits are its debt to you!) plus the shareholders' equity.
Every operation is at least two entries, and after it assets equal liabilities again. Four kinds of movement: A+L+ (the balance sheet grows: you made a loan), A−L− (it shrinks: the loan was repaid), A+A− (asset traded for asset: you bought a bond with reserves — bonds ↑, reserves ↓), L+L− (liability for liability: a transfer between customer accounts). Careful, here is the trap: “the customer withdrew cash” looks like a swap of assets, but it is A−L− — vault cash ↓ and the customer's deposit ↓, the balance sheet has shrunk.
Money creation: when a bank raises the asset “loan” and the liability “deposit” at the same time, the money supply grows. Repayment is the reverse — money dies.
The words of this chapter
Assets and liabilities
An asset is everything the institution owns or is owed: the loans it has made, its buildings, the money in its own account. A liability is everything the institution itself owes: customers' money in their accounts, plus the owners' own share, which is called equity.
The two columns were invented so that at any moment you can see not only what the bank owns but whose money paid for it. Ownership with no answer to the second question says nothing about soundness.
Double-entry bookkeeping
A rule of accounting: one operation always changes at least two lines, and after it the columns add up again. A loan is made — both sides grow. The customer repays — both shrink.
This is not an accounting formality but a way of not lying to yourself: with one entry you can draw any wealth you like. The second entry always asks — at whose expense.
A deposit
Money in a customer's account. From the bank's point of view this is not storage but a loan with an open repayment date: the institution buys the right to use someone else's money in exchange for a promise to return it on demand.
It was invented for the convenience of both sides: the customer does not have to guard cash, and the bank needs money to work with. The price of that convenience is that you became the bank's lender, usually without giving it a thought.
Reserves
Banks' money in accounts at the central bank — what banks pay each other with. This is a separate kind of money: people and companies cannot hold it.
It is needed because there are many banks, and a payment between customers of different banks has to be closed with something. Banks are not satisfied with each other's entries — they need a shared asset that belongs to nobody.
The money supply
All the money people and companies use: cash in hand plus balances in accounts. Banks' reserves are not part of it — that is money on another floor.
The concept is needed to tell money being moved apart from money appearing. A transfer to your neighbor creates nothing, while making a loan does.
Netting
The offsetting of opposing payments. Over a day banks send money to each other in both directions, and at the end of the day only the difference is settled, rather than every payment separately.
It was invented out of thrift: holding money against every payment of the day is too expensive. Opposing flows cancel almost everything themselves, and the real money needed is many times less than the turnover.
What happens to the balance sheet
Take the main event of the chapter — making a loan. On the left, among the bank's property, a claim on the borrower appears. On the right, among its debts, an account for that same borrower appears. No third person took part in the deal: not one depositor became poorer. The bank did not hand over anyone else's money — it created a debt to the customer and a claim on that same customer at the same moment. The reverse operation is a mirror image: when the loan is repaid, both lines shrink and the money disappears.
Where the money comes from here
In this chapter the bank earns on the difference between two flows that belong to other people: it pays less for the money entrusted to it than it charges for the money it has lent out. In not one operation of the chapter does it sell anything of its own. The one who pays for this is the borrower — with interest, taken out of that same borrower's balance. The depositor receives less than the bank earns on their money, and that is the price of being able to take the money back at any moment. The one who loses is whoever borrowed against a cash flow that never happened: the debt does not go anywhere, while the money created against it stays out walking around the economy. Here is why this matters to you: when you take out a business loan, you are not bargaining over “other people's savings” but over the institution's readiness to take on your risk.
What people usually get wrong
The common belief. A bank lends out depositors' money: collect more deposits and you can make more loans.
What is actually true. A loan is created by an entry. The Bank of England put it plainly in 2014: in making a loan, a bank creates a deposit and with it creates new money. About 90% of all the money on the planet is born this way, and in the United Kingdom up to 97%.
The common belief. The money in my account is my money, lying in the bank and waiting for me.
What is actually true. What lies in the account is the bank's debt to you. The cash you brought in became the bank's property that same second, and in exchange you received a claim.
The common belief. When a borrower repays a loan, the money comes back to the bank and waits for the next borrower.
What is actually true. Repayment destroys money: both the bank's claim and the balance in the account vanish. Nothing comes back — the two lines are simply erased.
After this chapter you will be able to
- read a deposit as an exchange of a thing for a claim on the institution, and see whose asset the money you brought in has become
- tell a payment inside one ledger from a settlement between institutions by whether the settlement asset moves
- put together a loan as the creation of a claim and a means of payment at the same moment, without hunting for a source of the money
- predict how much of the settlement asset will leave the institution behind a customer balance that is leaving
- put together a repayment as the destruction of money, and explain why mass repayment shrinks an economy
Check yourself
A customer withdrew cash from an ATM. Is there more money in the economy, less, or the same amount?
The same amount.
Only the form changed: the balance in the account fell by exactly as much as the notes in hand grew. The bank's balance sheet shrank on both sides, but the amount of money people hold did not change.
The bank made a mortgage loan. Which depositor now has less money?
Nobody.
Not one other balance was touched. Two new lines appeared: a claim on the borrower and that same borrower's new balance. That is exactly why the question “where did the bank get this money” has no answer — it was not taken, it was created.
Why does a bank need money in an account at the central bank at all, if it creates loans with an entry?
To handle money leaving for other banks.
While the money that was created moves between customers of one bank, nothing moves. As soon as a customer pays into another bank, the shared settlement asset goes out behind the payment. The loan is made first, and backing it up comes afterwards.
In short
The money in your account is not banknotes in the bank's basement but the bank's debt to you. When a bank makes a loan, it does not take money from depositors: it makes two entries at once — it owes the customer, and the customer owes it. At that moment there is more money in the country. When the loan is repaid, both entries are erased and there is less money. The bank lives on the difference: it pays less for other people's money than it charges for its own.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.