The Surprising Reality of How Money is Created in the UK

A sketch of how money used to work.
  1. The bank creates a new digital bank balance of +£1,000 in my account. It doesn’t need to draw from customer savings to create this balance. It just makes a digital entry.
  2. The bank recognises a new ‘asset’ in its accounts because it now expects a future repayment from me that’s worth £1,000.
  3. The bank also recognises a new matching obligation (or liability) of £1,000. This is because it has made me a promise—an I owe you (“IOU”)—that I can go to a cash machine and withdraw £1,000 in hard cash if I wanted. I can also send some or all of this digital IOU to others as payment for goods or services. This would transfer the IOU made by the bank to me, to an IOU the bank makes to another individual or business.
  4. When I repay the loan, the new money that was created by the bank is cancelled out and destroyed. Any extra bits I repay as interest are kept by the bank as profit. Such earnings are usually held by the bank as ‘capital’—amounts which ultimately benefit the shareholders and other funders of the bank.
  • Do banks create money from thin air?
  • Is your personal income in the bank ‘real money’?
  • What stops high street banks from creating too much money if issuing loans isn’t restricted by lending from customer deposits?
  • Where does the Bank of England fit in? Does it also create money from nothing given it doesn’t hold gold reserves for every pound sterling?
  • How do banks fail?

Key Definitions

FAQ on How Money Works in the UK

  1. Regulation (by the Prudential Regulation Authority) — Commercial banks are highly regulated and there are rules on how financially sound they need to be. More specifically, if a bank lends too much money, it exposes itself to more risk of losses from loans that go bad. Such a bank would therefore need larger buffers of its own funding (i.e. ‘capital’) that could absorb potential losses. If the bank failed to secure enough of a buffer—as is required by regulators—it could lose its permission to operate. Here’s a recent example where regulators asked Monzo to increase its ‘capital’ to guard against potential losses.
  2. Market forces (from other banks, businesses, and households) — A bank can only lend money if it has borrowers to lend to. And not just that, but the pool of credit-worthy borrowers is limited. So even if a bank finds enough good borrowers, it has to compete for them against other banks. One way it can do this is to offer loans at low interest rates. Yet, if the rates are too low the bank would risk making losses that could put it out of business. Lending (and money creation) is therefore limited by the opportunities a bank can find to lend money at a profit.
  3. Interest rates (set by the Bank of England) — Another factor that influences the amount of money creation is the interest rate the Bank of England pays on central reserves held by commercial banks (i.e. the “Bank Rate”). You can read more about this here but the basic principle of this factor is this: If there’s too much money and lending in the economy, the Bank of England can raise the Bank Rate. This change usually flows through to the wider economy such that banks now have to pay more interest on savings and in turn, they have to charge a higher interest rate on loans. If loans are more expensive, less people will borrow money and that ultimately limits the creation of new bank deposits.
Chart data from Bank of England (LPQAUYN, LPQBC44, LPQBC56, LPQBC57)
  • High value transactions (on average £1m+ or for things like buying a house) don’t happen with the offsetting system I described earlier. Instead, they go directly through a Bank of England accounting system called ‘real-time gross settlement’. These payments are dealt with one-by-one but through a ‘clearing house automated payment system’ called CHAPS, which draws from central bank reserves.
  • In 2019 CHAPS payments were just 0.5% of the volume of payments in the UK (around 192,000 transactions a day) but they represented 92% of all the sterling value (£83 trillion for the year or £330bn every working day.)
  • You might have heard of payment technologies like Faster Payments or Bacs. These systems are not operated by the Bank of England and deal with smaller value transactions. They allow banks to offset amounts with each other first, and then the final net obligation is sent to the Bank of England for settlement with central bank reserves through its real-time gross settlement system.
Note: The Bank creates new central bank reserves when it lends money to commercial banks.
  1. The bank would have more liabilities than assets.
  2. It would be considered ‘insolvent’.
  3. Investors who originally funded the bank (by buying its shares or lending it money) could force it to shut down and sell everything it owns so that they could recover their capital.
  • How does one interview for the job of Governor of the Bank England? Here are the answers Mark Carney had to give to a selection panel when he applied for and the job.
  • What’s the most common banknote in the UK? The £20 note accounts for almost half of all banknotes in circulation in the UK economy both by volume and value.
  • Will the Bank of England ever make central reserves available to the public and non-bank private sector? Possibly. Here’s a discussion paper from the Bank that considers the opportunities and challenges of a widely used central bank digital currency.



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