At school or university, we’re told that money is created by the central bank. But that is not actually the case: the commercial banks are the ones creating money. The same banks that love to take risks and helped cause a global financial crisis a few years ago. Could fintech companies save us from the instability they create?

Mention money, and most people still think of the crumpled notes and shiny coins that we keep in our pockets. But today almost all money is digital, usually stored as electronic numbers in a bank’s database. The money in your bank account is no more substantial than a number typed into an Excel spreadsheet. 

Who creates this electronic money? It would be natural to assume that the Bank of England, Federal Reserve, or European Central Bank have kept up with the times and started issuing electronic equivalents of their notes and coins around the time that debit cards were first released. But the reality is that these central banks have never created an electronic form of cash that could be used by the public. 

So who created the money that appears in your bank account? The Bank of England explains this best: 

“Commercial banks create money, in the form of bank deposits [the money in your account], by making new loans. … When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.” (Money creation in the Modern Economy, Bank of England, 2014)

When you walk into a bank and take out a loan, the money you borrowed doesn’t come from anyone else’s life savings, and the bank isn’t lending you money that they borrowed from the Bank of England or the Fed. Instead, they create new money, effectively out of nothing, through a very simple accounting entry. This is possible cause the money you see in your account is actually just an IOU, or in accounting terms a ‘liability’, from the bank to you. When you sign a contract promising to repay the money, that contract becomes an asset of the bank. They can then simply match this new asset with a new liability – the money that you borrowed, which they credited to your account.

Again, the money doesn’t come from someone else’s account: it’s created.  Around 97% of money in the UK – and a similar amount in other countries – was created in this way. 

“This is the fairytale story of banking; our banks haven’t been like this for decades.”

Since banks create most of our money, what they do with that money matters. Many economists and politicians have been taught that banks are there to lend money to entrepreneurs, who will boost employment and grow the economy. But this is the fairytale story of banking; our banks haven’t been like this for decades. In the UK, of all the money that banks created and lent in the decade before the financial crisis, only 8% went to businesses outside the financial sector, while over 51% went to the property market in the form of residential or commercial mortgages. This flood of newly created money pushed house prices up, creating a frenzy of speculation by investors, and panic buying by first-time buyers who feared being forever priced out of being able to buy a home. 

This increase in house prices – fueled by a huge rise in household debt – drove up inequality, as those with the money to buy property rode the bubble, whilst everyone else was left paying ever-higher rents. In 2009, research by economists Moritz Shularick and Alan Taylor found that a rapid rise in bank lending and household debt almost always lays the foundation for a financial crisis. When that financial crisis hit for the first time in 2007-2009, it led to recession, job losses, declining government finances, cuts in public services, and the removal of environmental protections. 

The global economy is more fragile than ever

After a global crisis caused by excessive debt – and excessive money creation by banks – you’d be forgiven for assuming that we’ve all spent the last 7 years paying down our debts. In reality, research by McKinsey has found that global debt has risen by over 5% every year on average – by an extra $57bn. The global economy is now more fragile than ever. 

Since the crisis, regulators have issued thousands of pages of loophole-heavy regulations, which they hope will make the system safer. But the former head of the UK’s bank regulator, Adair Turner, has written that “they have still failed to address the fundamental issue – the ability of banks to create credit, money and purchasing power, and the instability which inevitably follows. As a result, the reforms agreed to date still leave the world dangerously vulnerable to future financial and economic instability”.

“They have still failed to address the fundamental issue – 
the ability of banks to create credit, money and purchasing power.”

A number of campaigns such as Positive Money argue that it’s dangerous to leave the power to create money in the hands of the banks that caused the financial crisis. Along with others, we’ve been warning of the risk of repeating the same mistakes and sleepwalking straight into another financial crisis. 

There is now growing support for the idea of stopping banks from creating money altogether: Martin Wolf, the chief economics commentator at the Financial Times, has argued that we should “strip banks of their power to create money”. In Switzerland, more than 110,000 citizens signed a petition calling for the central bank to reclaim exclusive power to create money, meaning that a referendum on the subject will be held. In the Netherlands, nearly 114,000 people signed a similar petition, triggering an official debate in the Dutch parliament. 

If banks were no longer allowed to create money, money creation would be done exclusively by central banks. So instead of going into property bubbles or financial market speculation, new money would be used to finance public investment or even distributed directly to every citizen.