What is money?

Chances are when you think of money, you think of dollar bills, coins, a £20 note or even a credit card.

Money allows us to buy goods, such as an iPhone. It also lets us be paid something for what we do – such as stocking the shelves at a supermarket, or if you’re a train driver in London, watching videos while knitting all day.

Basically money facilitates the exchange of goods and services.

Great! You probably knew that, But have you ever asked yourself where that money comes from?

The answer is you!

Ok maybe not just you, but pretty much most of us.

Now if you’ve watched many of the finance channels on YouTube, you’d think it was the government that ‘prints money’.

No. Governments don’t print money, central banks (so banks like the Bank of England and Federal Reserve) print money and lend that to the government.

But this is what most people miss out: Central banks only create a fraction of the money in the economy.

Most money is created by commercial banks – these are the banks that you and I bank with: Think Chase Bank, NatWest, Barclays or HSBC.

Have you ever taken a loan, used a credit card or taken out a mortgage?

This is what the banks do when you take out any kind of credit:

1. Your bank will approve your loan and credit your account with the money, lets say £10,000. This money has been created digitally. A few numbers generated on a computer. It never existed before.
2. When you take out a loan, you’d expect that to be available to you to use, right? £10,000 is in your account – that’s the bank saying that ‘we will let you use this £10,000 whenever you need,’. So what the bank will do is record your loan on a sheet as a -£10,000 liability – because this money is owed to you when you use it in the future.
3. The bank will then also record your loan on a sheet as a +£10,000 asset as this is something that you owe to it. This is because you’re expected to pay back the £10,000 (plus interest) you borrowed.

Once you pay back your loan, the banks reverse the process:

1. You give the bank the £10,000 you owe (along with any interest).
2. The bank will then take that £10,000 look at the record and say: ‘I’ve already let this person take my £10,000 I gave them and I’ve also had the £10,000 paid back to me‘.
3. The bank will simply use that £10,000 to cancel out the £-10,000 liability on its sheet. The money is erased from the system, like it was never there.

Great, so banks create money to just destroy it. What’s the point of all of that?

Well the bank in our example didn’t just lend you £10,000 for fun, it charged you interest, just like every other loan out there, this is basically a fee the bank charges you for borrowing their money.

When you paid the bank back, you didn’t just pay the £10,000, you also paid interest on it.

The bank keeps this money as profit and either pays it out to its owners or it keeps it as ‘retained capital’ – we’ll touch base on this term later.

So now you’re wondering, are banks just making money out of nothing? Does that mean banks can lend infinitely to make themselves more money?

Yes to the first one and no to the second one.

As seen in the first example, banks DO make money out of thin air, but they can’t just lend as much as they want!

It’s too risky! There’s always a chance that some borrowers won’t be able pay back what they borrowed.

That’s why banks are regulated by authorities that set rules for how much banks can borrow (examples are the Prudential Regulation Authority in the UK, the Federal Reserve Board in the US, FINMA in Switzerland, and more). Rules vary across the different financial systems, however all prudential regulators set what are called minimum capital requirements. This means that banks must have a certain amount of their own money to be allowed to lend money.

Now remember that extra money that the bank made from that £10,000 loan? The bank can choose to keep that as ‘retained capital’, which is how banks increase their capital reserves. The bigger a bank’s capital reserves, the more it’s allowed to lend. The more it lends, the more capital reserves it will build up, it’s a never-ending cycle.

This allows banks to keep lending out more than they ever get back from loan payments, just not infinitely. This results in more and more money being out there for people and businesses to use.

Most money these days has been ‘printed’ or to put it in a better way, borrowed into existence.

So next time you see your monthly pay check land into your bank account, just know that it was money that was made up in a bank somewhere. 😉