Are we sleepwalking straight into another financial crisis?
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? Read More
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.
Stop banks from creating money!
But banks are powerful, and masters at lobbying, so such big changes will not happen overnight. We may even need another financial crisis to get such fundamental reforms through. In the meantime though, fintech companies entering the payments field could – and almost certainly will – help to take some of the power away from the banks.
Part of the reason that banks are so powerful is that they run the payment systems on which the rest of the economy depends. Banks make payments between themselves using accounts they hold at the Bank of England, Fed or ECB, but because the rest of us aren’t allowed to hold accounts at the central bank, we’re forced to use bank deposits to make our payments. The same applies to businesses and most financial markets, traders, and investors.
We may even need another financial crisis to get such fundamental reforms through.
The problem is that the deposits in our bank accounts are backed by a whole load of inherently risky loans, mortgages, and other financial instruments. If the bank makes bad lending decisions and goes bust, then those deposits are effectively ‘frozen’, and customers lose access to their funds. So if the banks fail, the whole payment system fails, and our economy grinds to a halt.
In fact, Alan Greenspan, the former Chairman of the Federal Reserve Board, suggested in his book The Age of Turbulence that terrorists might try breaking the payment system to destroy the economy: “We’d always thought that if you wanted to cripple the US economy, you’d take out the payment systems. Banks would be forced to fall back on inefficient physical transfers of money. Businesses would resort to barter and IOUs; the level of economic activity across the country would drop like a rock.”
While he was Governor of the Bank of England, Mervyn King hinted that we should look at separating the payment systems from the risky lending of banks, saying that, “If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.”
COULD FINTECH OR BLOCKCHAIN BE AN ALTERNATIVE?
This is where fintech comes in. Fintech companies want to apply innovations in technology to financial services (where the current technology is often obsolete and user-experience is poor).
At the heart of it, banks provide two services – a way of making payments, and a way of making loans. Peer-to-peer lenders are starting to take away some of the banks’ loan-making business, cutting out the banks as middlemen. But we need the same thing to happen on the payments side too; we need fintech firms to compete with the banks to provide better and safer payment accounts. This would start to separate payments from lending.
Most traditional payment providers are already banks or want to become banks. But we’ve spoken to fintech payment providers who say that they don’t want to take any risk with customers’ money (or get buried under all the regulation that comes with the territory); they just want to provide the best payment services possible.
However, there are obstacles and barriers that make it hard for fintech firms to go into the payments industry. Because they’re not allowed to open accounts at the Bank of England (or their own central banks), regulations requires them to ‘safeguard’ customers’ funds by storing them at an existing bank – even though those existing banks will take risks with those funds, whereas the fintech firm would not. The banks decide which fintech firms they’re willing to open an account for, and how much those firms have to pay for each transaction. Sometimes the fintech firm ends up paying 6 times the real cost of a transaction, making it almost impossible to compete with the existing banks.
The good news, in the UK at least, is the authorities have been working to expose the banks to competition. The Bank of England is reviewing who should have access to its all-important settlement accounts, and may allow fintech firms to open payment accounts with it, so they will have access to the main national payment systems. The Payment Services Regulator is trying to remove other barriers, and European legislation coming into force next year will radically break apart the banks’ stranglehold on payment accounts.
Even more radical steps may be on the table. The Bank of England is currently researching the potential for a new payment system based on the blockchain-technology that has grown out of Bitcoin. Although we’re a few years away from seeing anything like this in action, it could make it far easier for the Bank of England to let everyone – including you and me – to hold our money ‘at’ the Bank of England instead of at one of the commercial banks. This would open the door to a load more innovation from fintech.
Nearly a decade after the crisis started, it’s clear that banking is still broken. In the next few years, fintech has the opportunity to fix it, or even better, simply replace it.