Let’s cut right to the chase. Even though the Independent Commission on Banking (ICB) has published a raft of proposals for financial reform, none of them will make much of a difference until Sir John Vickers and his panel abandon some cherished myths about how modern banks operate.

In its interim report, the ICB says of lending: “Banks do not take deposits simply to provide safety for the savings of the public. They use funds deposited with them to provide loans to businesses to allow them to undertake productive economic activities, and also to consumers”.
What’s the problem with this? Well, as NEF has been arguing for over a decade, the idea that banks take their customers’ deposits and lend them out to other customers is a complete fiction.

The truth is that when a bank makes a loan it simply makes a note on its account that the borrower owes it a sum of money. This is now the bank’s asset. It also makes a note on the customer’s account that he has a bank deposit of the same amount. This is the bank’s liability. No other customers’ deposits are altered in any way.

The borrower then spends that loan somewhere else. So the bank has created new purchasing power without taking away purchasing power from anyone else. After the loan has been spent, it ends up in another (or perhaps even the same) bank as a deposit. This electronic note of a deposit is money. It will be accepted by everyone in the UK economy because it carries the same status as paper notes and is accepted to pay tax. Deregulation and advances in technology, in particular debit and credit cards, mean that 97 per cent of the money in the UK is this ‘bank-money’ and only three per cent is paper notes.

The implications of this fact are enormous. Banks create nearly all of the new ‘money’ in our economy through their loan activity. They play an absolutely central macroeconomic role. The tens of thousands of loan officers making decisions every day about who should receive loans are shaping the outcomes of the economy. The Bank of England has little to no influence over how much credit – in other words, money – a bank creates. And no authority has any say over how banks allocate this new credit.

It would be great if the ICB’s suggestion that banks allocate money to “productive economic activities” could actually be put into practice. Sadly, the last two decades of UK banking activity show that banks tend to prefer creating credit for either short-term speculative return – trading in financial markets – or longer-term non-productive credit creation, such as mortgages and commercial property.

The result has been a massive asset bubble in housing and the ‘financialisation’ of the UK economy, as profits made through financial speculation account for an ever-greater proportion of GDP.

Until the ICB, the Bank of England and the Treasury start to understand the role that banks play as the creators of nearly all of the new purchasing power in the economy, there is little hope for effective reform. The government will instead continue to prop up a banking model that specialises in speculative credit creation, that gets underwritten by the taxpayer, and that offers nothing of value to society, the environment or the real economy.

Written by Josh Ryan-Collins, senior researcher on monetary reform at NEF, the New Economics Foundation