The Surprising Reality of How Money is Created in the UK

Most people believe that only the Bank of England can create money. Many people also believe that high street banks can only lend money if they have enough savers’ deposits to lend from. But as I’ll explain shortly, both views are mistaken.

It’s true that once upon a time that’s how things worked. A central bank like the Bank of England had a monopoly on money creation and prior to 1931, this money was pegged to gold reserves.

Meanwhile, high street banks could only hold bank deposits in the form of savings from customers. And since savers rarely need all their money at once, banks would profit by lending out a portion (or multiple) of customer deposits at a higher interest rate than that offered to savers.

This isn’t how money works in the UK economy today. The reality is stranger than intuition would suggest. I certainly wouldn’t have believed the mechanics either had I not read a full account of the process in a 2014 bulletin published by the Bank of England itself.

It turns out, the Bank of England hasn’t got a monopoly on money creation. Commercial banks such as HSBC, Barclays, and Lloyds all create new money every time they issue a loan. They create this money as a digital entry that represents a new bank deposit for the borrower. So if I take out a loan of £1,000 from a bank, here’s what roughly happens:

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.

When I learnt about this process I expected these digital bank deposits to be a small fraction of money in the UK. But this expectation is wrong. Digital bank deposits make up the majority of money in the economy.

According to the Bank of England, around 80% of all money in circulation is created digitally by commercial banks. The remainder takes the form of currency (banknotes and coins) and central bank reserves (electronic money that commercial banks hold with the Bank of England). These make up around 3% and 18% of money in the UK economy respectively and only the Bank of England can create them.

If we focus on just the money that people and businesses use (so if we exclude central bank reserves), digital bank deposits make up 96% of money while just 4% is physical currency.

The curious among you will now have more questions about how all this works.

• 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?

These are all good questions. I got sucked into a rabbit hole of inquiry trying to answer them and the next 3,000 words reveal what I found.

The following section will condense a lot of complexity but if you can get through it, you’ll know more about how money works than 85% of politicians in the UK and probably over 90% of the general public.

We start with some key definitions before moving onto the questions of how money works in practice.

Key Definitions

Money

Money is just an “I owe you” (IOU) that’s easy to move around. It’s a recorded promise to deliver value in the future but critically, if everyone trusts the issuer of that promise, you can exchange that IOU directly with other people for other goods and services.

Early versions of this system can be traced back to English goldsmiths in the 1600s. You could store gold or silver with them and they would issue a “promissory note”. This piece of paper promised that you could withdraw your precious metals from a secure vault at some point in the future. Since other people also trusted goldsmiths, you could trade your promissory note with other people directly for other goods, rather than go back to the goldsmith to fetch your gold or silver for trade. Promissory notes were IOUs that were easy to move around, just like today’s money.

The best IOU object—whether it’s digital or in paper form—does three things well. First, it reliably stores value over the long term. Second, it’s accepted by everyone as medium of exchange. And finally, it’s used everywhere as a unit to measure the value of goods and services.

Modern money achieves all these functions wonderfully. It’s a trusted store of value (so I trust that the Bank of England will protect it from losing its worth); it’s accepted as a medium of exchange by everyone (and more importantly, it will always be accepted by the UK government when I pay my taxes); and finally, everything I buy or sell is valued and denominated in pound sterling, not some other unit of account.

Bank Deposits

A bank deposit is a digital form of money. It’s an electronic IOU that you hold in your bank account. It’s created by high street banks every time they issue a loan and it’s distinct from currency (which we’ll cover shortly.) As I shared earlier, bank deposits make up over 90% of all the money that people and companies hold in the UK.

‘But if this money is created when banks issue a loan, what are my savings then?’ you might ask. We’ll answer that in the questions section later. For now, just know that bank deposits are digital IOUs created by the likes of HSBC, Barclays, and other banks.

When you take out a loan, a bank just makes a digital entry that represents an IOU to you. It’s a promise of value from a bank that you can cash in (literally) when you decide to withdraw that loan as physical money.

These digital IOUs are easier to move around than physical money. So instead of withdrawing cash and paying for goods, you can just wire a portion of your digital IOU to someone else’s bank account. In that instance, what the bank owed you becomes something the bank owes to the recipient of your payment. And since everyone trusts that these digital IOUs can be converted to cash, they are widely accepted as money. The Bank of England also provides further security: If a bank fails, up to £85,000 of your bank deposits are guaranteed by the government.  

Currency

This is basically cash. It’s a physical record of an IOU from a central bank. It comes in the form of banknotes and coins that are manufactured and backed by the Bank of England. Only central banks can create this type of money and it represents just 4% of all the money that households and businesses have.

High street banks always have some currency to meet daily customer cash withdrawals. They buy it from the Bank of England using central reserves, which I’ll define next.

However, banks don’t need large holdings of currency because it’s unlikely that all customers would ever want to withdraw their full bank deposits at the same time. In addition, most people and businesses prefer the convenience of digital bank deposits. Currency is falling out of favour as you can see from the BBC chart below.

Central bank reserves

This is digital money created by the Bank of England for use by commercial banks only. Since a Barclays can’t create money to pay a Halifax or vice versa, central bank reserves are used as the ultimate settlement medium between banks. These reserves can also be exchanged for currency so that banks can meet customer cash demand.

How is central bank money created? Here’s a quote from a Bank of England handbook that explains the process:

“Unlike banknotes there is no physical cost to producing reserves, the central bank can create reserves simply by pressing a key on a keyboard to credit a commercial bank account.”

In other words, central bank reserves are created digitally, just like the money you have in your bank account. The main difference is that only banks can use this money. We’ll look at an example of this use later on.

Central bank

Each country has a “central” bank that manages its currency. In the UK we have the Bank of England (sometimes known as “the Bank”—with a capital “B”).

One of the Bank’s primary objectives is to help keep the value of money stable and to make sure there isn’t too much or too little of it. Without this stability, few people in the UK would adopt the pound as a medium of exchange or as a store of value.

The Bank can influence the stability of money by adjusting interest rates or creating more money (some people refer to this as “printing money” but the Bank does it digitally). You can read about how interest rates impact the economy here and how creating more money can stimulate spending in the economy here.

Although the Bank of England is owned by the UK government—and it returns most of its profits (around £400m per year) to HM Treasury—it’s independent from it. What does that mean in practice? Here’s a quote from the Bank’s website:

“Independence means that we can promote the good of the people of the UK by maintaining monetary and financial stability, free from political influence.”

Commercial (or high street) banks

This is all the banks you know, such as Monzo, RBS, Lloyds, Barclays and others. They are formally designated as ‘credit institutions’ and have permission from regulators to take deposits, make loans, and create new money.

~

Now that we know the different types of money and the distinction between central banks and high street banks, we can look more closely at how money works in practice. We’ll do that by addressing six key questions on the process.

FAQ on How Money Works in the UK

Do banks really create money from thin air?

No. This is because money is always linked to an IOU—a promise to deliver value at some point in the future. A brief historical detour on money makes this point clear.

Hunter gatherers didn’t need money (or IOUs) because they provided everything for themselves. But as life got more sophisticated, barter trade emerged. People would now trade various commodities for items they couldn’t get themselves, such as salt in exchange for clothes or spices for weapons.

This method of exchange only worked up to a certain point though. For example, if I needed to trade my ripe tomatoes today but I wasn’t sure what else I needed and when I needed it, my produce would go bad or I’d have to get spices or salt that I didn’t need.

This is where money as an IOU comes in. Rather than barter trade my tomatoes for a random commodity I didn’t need, I could go to a trusted party and get an IOU in exchange for my tomatoes. The issuer of the IOU would then promise to deliver some equivalent value to me in the future. Meanwhile, I could hold onto the IOU or trade it for other goods as long as other people trusted the IOU issuer as well.

This is what modern money enables. It transforms value into an easily exchangeable object that can move across time and space.

So when a bank issues a loan and creates a bank deposit, it isn’t really creating money from thin air. Instead, it’s transforming a borrower’s future ability to repay into an object that can be used today. Repayment is crucial and it’s why banks run credit checks to make sure borrowers can pay back their loans. Banks also charge a high enough interest on loans so that profits from lending can cover losses on the few debts that go bad.

Put in simpler terms, money used to be created by linking it to gold or some other precious object. Today, it can also be linked to someone’s ability to generate value in the future. Therefore money isn’t made from nothing. It’s always linked to value somewhere.

What stops banks from creating as much money as they want?

Commercial banks can’t issue loans and make new money without limit because doing so would put them out of business. There’s a variety of ways this can happen but let’s look at three factors that protect against this.

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. 

Are the savings and wages in my bank account real money?

Yes. They are real money to the extent that whatever deposit you have in your bank account, other people and businesses can accept it as payment.

You might now wonder: “My employer pays a salary into my bank account without taking out a loan. They have accumulated their own deposits by selling products or services. So if my salary isn’t linked to a loan, where do the bank deposits from my employer come from?”

I couldn’t find a definitive answer to this in my research but here’s what I believe is happening. If it were possible to go back in time and fully trace the family tree of where a bank deposit in your account came from, you’d probably find that a loan sparked its creation.

Consider the following facts. At the time of writing this blog, the private sector (excluding banks) in the UK held around £3 trillion of money. Guess how much debt the private sector has? Put another way, how much money do people and businesses owe to banks? When I wrote this it was around £3 trillion also. The chart below shows what these figures looked like historically.

Remember, money is an IOU and the majority of bank deposits in the UK are naturally linked to debt. That debt is then transformed into digital deposits that spread throughout the economy. This includes the money sitting in your account today.

How do payments between banks work?

Since each bank creates money when it issues loans, there has to be a way to use the sums created at one bank as payment to another bank account. This happens in two ways.

First, banks can offset payments against each other. For example if I send £100 from my Monzo account to a Barclays customer, there will also be payments flowing in the other direction that can offset what’s owed.

In our example, let’s assume a different Barclays customer has sent £150 from their account to another Monzo user. We now have a situation where the IOU Monzo had with me (it owed me my £100 of savings) has been transferred to an IOU it has with Barclays.

Conversely, the IOU Barclays had to its customer of £150 has now been transferred to an IOU Barclays has to Monzo. Still with me? Here’s a visual representation of this.

Given these exchanges, the two banks can just net off the two amounts to arrive at a net obligation. In this case, Barclays has a net IOU of £50 to Monzo (and in turn, Monzo has that IOU to the customer who was sent the £150).

Notice that Barclays can’t just create new money to settle the obligation it has to Monzo. It has to use another resource. This is where the second settlement method between banks comes in.

All commercial banks have an account with the Bank of England that holds their respective central bank reserves. Remember we defined central bank reserves as money that the Bank of England creates specifically for other banks to pay each other. We’ll come to how this money is created shortly, but for now, just know that all commercial banks have a portion of their ‘worth and savings’ (in other words assets) in the form of central bank reserves. They can draw from this balance to settle obligations with other banks when the offsetting method isn’t sufficient.

In our example, all Barclays would now have to do is ask the Bank of England to send £50 worth of central reserves from its account to Monzo in order to settle its obligation.

I wanted to write more about this process because there’s more to it. But given the 4,000 word limit I set myself we’ll have to stop here. For those who are super curious though, here are some quick facts about bank settlement systems in the UK and the relevant links where you can learn more.

• 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.

How do commercial banks get central bank reserves?

High street banks accumulate central bank reserves in three ways.

First, they can receive payment from other banks in the form of reserves—we covered this in the previous section.

Second, and more commonly, banks can borrow reserves from the Bank of England for a six-month period. This lending doesn’t come for free though. Commercial banks must offer the Bank of England a high-quality asset that it will hold until the loan is fully repaid. This ‘collateral’ is typically a high quality financial asset such as a gilt (i.e. a government bond – this is an IOU of future payments from a government to the bond holder). The diagram below from the Bank of England visualises this process.

Finally, commercial banks can get more central bank reserves by selling high quality financial assets to the Bank of England. Again, these are usually government bonds or other low-risk assets.

How do banks fail?

There are two main ways a bank can fail.

First, if we all decide to go to a bank and withdraw all our deposits as cash today, the bank would face a ‘liquidity crisis’ and go under. This is because no bank actually keeps everything it owns in the form of central bank reserves or currency. The majority of bank assets are in a less liquid form (e.g. its loan book and other investments) but so long as people have confidence that the bank’s finances are sound, this liquidity crisis—or ‘a run on the bank’, as it’s better known—is unlikely to happen.

The second way a bank can fail is if it ends up in a situation where the value of everything it owns (its assets) falls below the value of everything it owes (its liabilities.) This can happen if a bank issues loans recklessly to lots of borrowers who fail to pay back what they owe. In that instance, the following would happen:

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.

~

That’s all for now on how money works in the UK. I left out a lot of detail to keep the blog readable but I look forward to discussing this with readers and friends.

Bonus question 1: Why isn’t currency linked to gold anymore?

The ‘the gold standard’ was abandoned because it was too rigid. Fiat currency—so currency that isn’t pegged to an underlying asset—gave governments more flexibility in managing their money supply and ultimately, their economies.

In fact some economists argue that the gold standard made the great depression in the 1930s worse. Meanwhile the UK fared better because it was able to control its money supply without being tied to how much gold was available.

All told, pegging currency to gold risks more economic volatility and many governments prefer to have more control of their money supply than what’s possible with a commodity-linked currency.

Bonus question 2: If currency isn’t linked to gold, how can it be worth anything?

It all comes down to trust. And currency and central bank reserves are currently the most trusted IOUs you can get. They are a promise of value from the central bank and ultimately the government.

Moreover if I have £10 today, I trust that the Bank of England will always honour that value in whatever type of money they create in the future. I also know that the government will do what it can to help maintain its value over time and that it will always accept currency as payment for tax.

This—along with wide public acceptance of its worth—is what makes fiat currency valuable, even if it isn’t linked to gold or some other commodity.

Ps. Other interesting things I discovered during my research.

• 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.