T P W I

In the introduction to this topic we saw that two forms of modern money can be defined, one that is produced by the state (state money) and the other that is produced by commercial banks (bank money). Bank money originated with the early goldsmith bankers of 17th century England. The goldsmith would take deposits from customers in the form of precious metal coins, the state money of the time, and keep them safe for a fee. The goldsmith would issue a ‘bearer receipt’ to the depositor confirming the amount of the deposit. The depositor, or any individual ‘bearing’ the receipt, could then present it to the goldsmith at a later date and claim back the sum deposited. As time passed, the goldsmith bankers realised that their customers preferred to leave most of their state money on deposit most of the time. The small amount of state money that was withdrawn from a bank by customers on any one day was generally replenished by fresh deposits of state money from other customers on that same day.

The goldsmiths’ customers found that the receipts issued to them would be accepted by merchants as payment for goods and services. The goldsmiths’ receipts had become bank money. Instead of going to withdraw their gold coins from the goldsmith, depositors would simply pass over the required amount of bearer receipts to a merchant in payment. The merchant in turn would be able to claim back the underlying gold coins from the goldsmith but more usually would choose to use those same receipts to pay for his own purchases. In this manner, receipts would stay in circulation for some time.

It soon occurred to the goldsmiths that if the public regarded their receipts as “money”, then they, the goldsmiths, could simply print paper receipts and lend them at interest. They would however need to keep sufficient quantities in reserve so as to meet requests for redemption of their paper receipts by customers. The proportion of coins thus kept in reserve against receipts issued came to be known as the ‘cash reserve ratio’, and because the net amount of receipts redeemed on any one day was usually small, only a small cash reserve ratio was required for a bank to operate safely under most circumstances. If it did happen that heavy withdrawals occurred at short notice, then the bank would have to close its doors. The crisis of confidence caused by the failure of one bank to meet its redemption obligations would naturally lead to a crisis of confidence in other banking institutions. In this manner there occurred numerous ‘bank runs’, in which customers would run to their bank to withdraw their deposits of state money before everyone else tried to do the same. In England, these events were to be witnessed many times, in particular during the early nineteenth century.

Confidence in the value of receipts would continue so long as the public believed that the goldsmith could exchange them for gold whenever the bearer requested him to do so. Aware that confidence was the key to their success, many goldsmiths devoted their efforts to persuading the public that the new banking institutions were ‘prudent’ and ‘safe’. These soon became catchwords among the banking profession.

In time, the subject of how large or small a reserve was required for safe operation became one of fierce debate. Some argued in favour of a 100% reserve on the basis that if bankers had issued £100 of receipts promising redemption on demand, then they should keep £100 of gold in the vault to honour this promise should they be required to. Others foresaw the hugely lucrative possibilities of holding a lower reserve ratio, perhaps as little as 20% or 30% of receipts issued. In justification of this approach they cited the tendency of most depositors to leave most of their gold on deposit most of the time.

The debate mattered vitally. If it was safe to keep, say, a 20% reserve ratio, then for every £100 of gold coin reserves, £500 of paper money could be printed. The depositors of the coins would receive receipts to the value of £100, and a further £400 of receipts could then be manufactured to lend at interest. As a result of this process, five legal claims of ownership would be created for every unit of gold in the bank vault. The lower the reserve ratio, the greater the risk of a bank collapse, but the more that could be lent out. And the more that could be lent out, the greater the interest revenue for the banker. In the meantime the banker would attempt to make agreements, primarily with other bankers, to borrow extra reserves of gold should there be heavy withdrawals from his own bank. This activity, referred to as ‘liquidity management’ in modern times, became an essential skill to master.

The ‘fractional reserve’ banking system described above relied crucially upon the use of interest in its operation. Why, it might be asked, did the banker not print receipts and spend them on his own consumption if he indeed had the power to manufacture money? The answer is that the act of spending his receipts would eventually lead to bankruptcy. If such a course was followed, it would be almost certain that at some future time the spent receipts would return for redemption in gold – gold which never existed in the first instance. By lending the receipts instead, the banker could charge interest on the amount lent. Upon repayment of the loan, the receipts could be destroyed as easily as they had been manufactured. But the interest charge would remain as revenue. And if a loan was repaid using gold coins, all the better. The gold coinage thus received could be kept not only as a reserve to redeem outstanding paper notes at a later date, but also as a basis for even more paper money creation.

Gradually, word spread among the wealthier classes that the provision of banking ‘services’ was nothing other than the most profitable business idea of all time. Increasing numbers of entrepreneurs established their own banks in order to cash in on the new game and banking became one of the largest sectors in the economy. Though competition today ensures that the rate of profit made by any one banking company is more modest than it once was, the amount of profit made by the banking sector as a whole is huge by virtue of its size within the overall economy. In 1999, the banking sector was the most valuable on the London Stock Exchange measured by market capitalisation, and according to Joseph Stiglitz, in 2006, 30% of all corporate profit in the United States was made by the banking sector (see Stiglitz, J., The Great GDP Swindle, The Guardian, 13 September 2009). In the first quarter of 2022 the financial sector as a whole in the United States accounted for 27.5% of total corporate profit (see Table 6.16d Bureau of Economic Analysis, US Department of Commerce, April 2025).

The bankers faced many practical hurdles in attempting to grow their business as we shall see. Not least was the fact that the banks charged interest on money that only they could create. How then could borrowers hope to repay loans of this manufactured money plus the interest charges? Imagine that, initially, the total amount of state money in existence is £10. If the banks now create £100 of bank money there will be a total money supply of £110. Let us further imagine that the £100 of bank money is loaned for one year at 20% interest, and that an amount of £120 will therefore be due for repayment. Now, if the total money supply at the beginning of the loan period is only £110, where will the extra £10 come from? Since this £10 does not exist at the outset, it would seem impossible to repay this part of the loan. How then is the situation resolved?

The required new amount of money can come from various sources. The banking sector might expand the supply of bank money, in other words lend yet more, in which case last year’s loan would be repaid through this year’s borrowing. Or the state could increase the supply of state money, and perhaps inject it into circulation through welfare payments or infrastructure spending. A third option is for the banking sector to buy assets or services from the non-bank sector, in which case the interest charges of the bank would be spent back into circulation and thereby cancel out the unrepayable portion of the interest charge. However, none of these three pathways to solvency would necessarily come into operation automatically, and this simple fact would have enormous repercussions for the economy as the practice of fractional reserve banking spread.

The unrepayability of old loans places society in a game of economic ‘musical chairs’. For those unfamiliar with musical chairs, it is a game often played in England in which, say, twelve children run around a group of eleven chairs whilst music is playing. When the music stops, all the children must find a chair to sit down on but because there is one more child than there are chairs, one child will always remain standing when the music stops. This is the child who has ‘lost’, and he or she is removed from the game. So it is with the unrepayable loans. When new loans are not forthcoming, old loans become unrepayable. Under these circumstances, everyone is trying to repay their debts, but a sufficient quantity of money with which to do so simply does not exist. At least one person must go bankrupt and be ‘removed from the game’. Life becomes an aggressive competitive struggle to avoid being the one who is left standing when the music stops. The policies of government, the actions of businessmen and the daily life of ordinary people are all affected by this ongoing struggle in a deep and disturbing way. The economic survival of all three groups depends in large part on the bankers’ willingness to extend loans of newly manufactured money.

In those periods of recession that occur when the quantity of new loans is insufficient to allow repayment of old debts, the state finds itself obliged to pay welfare benefits to the unemployed, to cut tax rates and so on. The money that the state requires to undertake this expenditure can be manufactured by the state itself or it can be borrowed from the banks in the form of bank money. Quite why the state would want to borrow money manufactured by the banks at interest when it could manufacture state money interest-free is one of the unanswered mysteries of our time. Yet this is what has tended to happen during the era of fractional reserve banking in most of the countries of the world. The responses to the 2008 crisis and the COVID pandemic forced a major departure from this tendency.

Since the greatest proportion of new money in an economy is nowadays created through loans made by the commercial banking system, money supply expansion is accompanied by a more or less continuous increase in the amount of debt in the economy as a whole. Combined private and public debt as a proportion of gross domestic product has therefore grown substantially in each of the seven largest economies of the world over the last thirty years. Every developed country runs a national debt and has a private sector that is also heavily in debt. Michael Rowbotham comments in The Grip of Death (1998), that despite decades of hard work using ever more productive technology, society in the developed world finds itself more in debt than it ever has been.

Year	UK	USA	Japan	Malaysia
1970	81	136	113	60
1983	85	151	198	144
1993	149	187	250	169
2006	213	231	304	119
2023	240	262	385	218

Total domestic debt (private plus public) as a % of gross domestic product

IMF IFS 2000: IMF IFS 2007, IMF Global Debt Database 2023

We are faced with a choice between continued expansion of debt on the one hand and widespread business and personal bankruptcy on the other. The increase in money supply that results from the creation of new debt can and often does encourage general price inflation, but, since almost every developed economy nowadays suffers from such inflation, this is widely regarded as an acceptable fact of modern life.

In the 17th Century when modern banking was just beginning, the long-term consequences of the industry’s standard practices were perhaps unforeseeable. Yet some individuals saw beneath the veneer presented by the bankers and their lobbyists in public life. They petitioned the state to legislate against the bankers, arguing that whilst most people had to work to earn money, the bankers could simply print it. But the state had other ideas.

The Bank of England

Naturally, the bankers would not wish to suffer loan losses. This kind of event would have the same ultimate effect as an expenditure of bank money by the banker himself, in other words a loss of control of the manufactured money. It therefore became common for bankers to avoid profit-sharing investments and to focus instead on interest-based loans supported by collateral. The collateral would act as a cushion to protect the loan in the event of failure of the borrower’s business. In this case, the banker would be able to seize and sell the collateral in order to reclaim full or part repayment of the loan amount.

These criteria for extending loans naturally biased the lending of manufactured money towards the rich. After all, the rich were the ones with the most wealth to offer as collateral. Those without collateral, the poor, though possessing potentially profitable business ideas, might not so easily attract the required funding. Thus it was that the government itself, having the right to raise tax and therefore being the most secure of all borrowers, would become the prime focus for the lending activities of the banks.

In 1694, King William III of England was persuaded to invite loan offers from private individuals as a means of raising funds with which to wage war against France. Interest at 8% would be paid on the borrowings, financed through a variety of taxes, predominantly upon beer and ale. Repayment of the principal amount would also be made from the revenues thereby generated. On condition of £1,200,000 being advanced within a certain period of time, a charter was to be given under the Tonnage Act of May 1694 to establish The Governor and the Company of the Bank of England.

The new Bank would be allowed to take deposits of coinage and issue paper money. Several kinds of paper were issued under the rather unclear requirements of the Act regarding the Bank’s issuing activities. The various papers included ‘sealed bank bills’, ‘cash notes’, and in due course ‘bearer banknotes’. The bank’s shareholders included many entrepreneurs who were keen to obtain a foothold in the new and highly profitable business of banking, but it was the bank itself that lent the King the required amount of money. £720,000 was paid in cash and the remaining £480,000 in sealed bank bills created by the Bank for the very purpose (for a fuller description see: Feaveryear, A. E., The Pound Sterling, Clarendon Press Oxford, 1931).

In evidence of amounts lent to the state by the Bank, the former would issue the latter with government debt obligations, these known at first as ‘tallies’, and later as ‘stocks’ or ‘funds’. (In this context, a stock is synonymous with a bond, that is a tradable document displaying the terms of a loan between the borrower of money, the issuer of the bond, and the one who has purchased that bond, the bondholder). Often the Bank would sell these bonds on to smaller investors, more or less immediately, at a profit margin. By avoiding ownership of the bonds for anything but a short period of time, the Bank would minimise the risk of incurring a loss should their market price unexpectedly fall.

The government increasingly came to fund part of its expenditure by borrowing money from the Bank of England. Fortunately, the Bank was in a position to aid the government in its times of need. It was privileged by the Act of Parliament with the right to manufacture promissory notes which were increasingly being used as money. The Bank was therefore able to meet the government’s borrowing requirement by printing more promissory notes. Thus money supply and government debt grew together. According to William Cobbett in Paper Against Gold (1846) the aggregate of the outstanding bonds and other borrowings, the ‘National Debt’ as it became known, grew from £16,394,702 in 1701, to £52,092,235 in 1727 and £257,213,043 in 1784. By 1810, it had reached £811,898,082. The state’s outstanding debts were beginning to spiral out of control.

Of course, the Bank could not simply print paper notes without maintaining a sufficient level of gold coin reserves. Over time, it therefore sought to attract greater amounts of gold coin as deposits for its vaults. Though no notes under £20 were issued until 1755, the outbreak of the Seven Years War in 1756 gave rise to a substantial borrowing requirement on the part of the state. The Bank of England now issued notes in the denomination of £10. By the time France had declared war upon England in 1793, notes in denominations as small as £5 were being issued in ever more strained attempts to obtain gold from depositors. In this manner the Bank maintained what it saw as a prudent reserve ratio whilst the lending of paper money to both the state and private borrowers expanded.

The insufficiency of reserves to meet large scale simultaneous demands for redemption of its promissory notes was one consequence of the Bank of England’s money manufacturing activities. Hence in February 1797, the Bank was permitted by an Act of Parliament to cease the redemption of promissory notes in gold. Following this ‘Suspension of Payments’, paper money issue increased with the production of £2 and £1 notes. In a letter to the King in 1805, the Earl of Liverpool commented:

When the situation of the Bank of England was under the consideration of the two Houses of Parliament in the year 1797, it was my opinion, and that of many others, that the extent to which the paper currency [system] had been carried was the first and principal, though not the sole cause, of the many difficulties to which that corporate body was then, and had of late years, from time to time been exposed in supplying the cash necessary for the commerce of the Kingdom.

Cobbett, W., Paper Against Gold, 1846, p. 198.

The Bullion Committee of 1810 reported to Parliament that the Bank of England had taken the opportunity of the Suspension to print large amounts of paper money that had no gold backing and had thereby profited itself substantially. The Committee was concerned that the scale of profits available to the creators of money was so great that the state should share these profits on behalf of the people. It also encouraged Parliament to insist that the Bank of England maintained a full reserve of gold against its paper note issues.

The Bank meanwhile feigned ignorance of the problem. It promoted the ‘real bills’ doctrine, whose proponents included Adam Smith, which held that the manufacture of money out of nothing was not harmful to the economy so long as it was used to finance real trade. Industrialists would issue bills of exchange in the normal course of their trade, and the Bank would purchase those bills with newly created money. However, the Bullion Committee rejected the Bank’s argument for it knew very well that the creation of money was the issue, not the use to which newly created money was put. They also recognised that industrialists are almost always bursting with new investment ideas and that their need for cash was therefore limitless. To use their need as a limiting factor in money creation was therefore a wholly erroneous policy.

In due course, Parliament made the decision to require the Bank to resume redemption of its note issue in gold and this occurred gradually in the years following 1816. Cobbett argued that this remedy did not address the dangers of a ‘paper money’ system at all. In Paper Against Gold he rages against the moneyed interests in the City. He talks of national debt and inflation as children of the paper money system, and introduces us to the monetary conditions of his time :

We see the country abounding with paper money; we see every man’s hand full of it; we frequently talk of it as a strange thing, and a great evil; but never do we inquire into the cause of it. There are few of you who cannot rememberthe time when there was scarcely ever seen a bank note among Tradesmen and Farmers … If you look back, and take a little time to think, you will trace the gradual increase of paper money and the like decrease of gold and silver money…

Cobbett, W., Paper Against Gold, 1846, p. 23.

Though Britain’s dominant position in international trade and increases in global gold production may have supported the gold coin circulation, the banking system continued to encounter crises even after the period of the Suspension had ended.

There was a great diversity of practice and many banks crashed – eighty‑nine between 1814 and 1817 alone, though many such were small indeed, with under fifteen shareholders.

Thomas, H., An Unfinished History of the World, 1979, p. 467.

Due to its perceived soundness, the Bank of England’s notes were often used by the so‑called country banks (those operating outside London) as part of their reserves. A double pyramid of money supply expansion thus came to operate. Let us imagine that, for every one pound of gold held at the Bank of England, three pounds of Bank of England paper money were created. If now, for every one pound of Bank of England paper money held in a country bank, three pounds of country bank notes were issued, then for every one pound of gold at the Bank of England a maximum of nine pounds of bank money could come into circulation.

The 1825 crisis exemplifies the type of problem that can be encountered when there is a shortage of reserves in the banking system. Many customers of country banks were demanding redemption of their country bank promissory notes and would accept only gold coins or Bank of England notes. Representatives of the country banks were in turn approaching the Bank of England in order to acquire (by withdrawal of deposited money or by outright borrowing) gold coins or Bank of England notes. With these amounts, the country banks hoped to satisfy their own depositors’ demands for withdrawal. The double pyramid was now working in reverse.

The Bank of England duly obliged, lending freely so as to provide the necessary cash to the country banks and others. The Royal Mint worked flat out in order to turn gold bullion into coinage and the printers printed Bank of England notes as fast as they could. In December 1825, six London banks and sixty-one country banks ceased payment in gold. Chown quotes Clapham’s account of the period:

The public was clamouring … for money, Bank [of England] notes or gold. Neither notes nor sovereigns could be made fast enough … By the evening of Saturday the seventeenth, the Bank [of England] had run out of £5 and £10 notes. However a supply came from the printers on the Sunday morning.

Chown, J. F., A History of Money, 1994, p. 153.

So the system wavered between banking crisis and reserve shortages on the one hand, and the profitable operation of fractional reserve banking on the other.

From Receipts to Cheques

The authorities eventually acted to counter the dangers posed to the health of an economy in which numerous private issuers of paper money were active. Under Peel’s 1844 Bank Charter Act, the right to issue most kinds of note was restricted to the Bank of England (which was of course obliged to redeem its notes in gold). It was envisaged that this reform would cure the banking system of its previous ills but new banking technology, in the form of the cheque and account statement system, would soon render the legislation ineffective.

At the time of Peel’s Act, the country banks had not adopted cheques as a means of clearing payments to any great extent. However, they moved quickly to do so as their right to print notes was removed. Once more, public confidence was essential to the successful operation of the new system. Where once the public felt sure of its ability to convert receipts into gold, it had now to be persuaded that the figures printed on account statements could also be converted into gold.

Let us examine the cheque and account system as if there was only one bank operating in the economy. This bank has several customers of which A and B are two. Both A and B start with a zero balance on their current accounts. Customer A now gives customer B a cheque for £100 in payment for goods, and customer B deposits this cheque with the bank. The banker credits account B with £100 and debits account A with the same amount. B is now in credit and A in overdraft to the amount of £100 and the goods have been paid for. The amount of new bank money in existence is the £100 that forms the total of customer B’s account.

Two simple conclusions can now be drawn. Firstly, that one group of bank customers must always be in debt to an amount that equals the existing supply of bank money. Secondly, that if A now repays his overdraft by depositing a cheque of £100 drawn on Customer B, then the bank money transferred from B to A simply vanishes. Bank money therefore stands in complete contrast to commodity money. For example, gold coins are never destroyed in the act of repaying a loan.

Confusion on the above matters can arise because the banking system is seen merely as an intermediary between depositors of money and borrowers of money, profiting only from the margin (or ‘interest spread’) between interest rates paid to savers and interest rates charged to borrowers. But if the entire banking system is viewed as one very large bank, then it has the potential to act not only as an intermediary between saver and borrower, but also as a creator of money. It is however unjustified to single out commercial banks in this analysis since deposit-taking institutions in general, building societies for instance, play their own part in the money creation process. Though the issues raised in the following discussions relate to deposit-taking institutions in general, we will continue to focus on the commercial banking system only.

The following analysis is similar to that given by most standard economic texts on the subject of the ‘deposit multiplier’. Imagine an economy in which there are three Banks, A, B and C. Each operates a 20% reserve ratio. Initially there is £100 of state money (notes and coins) in circulation and none of this state money is deposited with the commercial banks. Now, if the holder(s) of the state money deposit all of the notes and coins with Bank A, that bank’s balance sheet will read:

ASSETS	LIABILITIES
cash              £100	deposits         £100

To meet its reserve requirement, Bank A decides to keep £20 of the deposited sum and lend the remaining £80. Having done so, Bank A’s balance sheet appears thus:

ASSETS	LIABILITIES
cash              £20	deposits         £100
loan               £80

The borrower of the £80 now spends this sum and the individual receiving it deposits it with his bank, Bank B. Bank B maintains a 20% reserve ratio, and therefore lends £64 of the £80 deposited with it. Its balance sheet is then:

ASSETS	LIABILITIES
cash              £16	deposits                   £80
loans             £64

The borrower of the £64 spends it in turn and the individual receiving the £64 deposits it with his bank, Bank C.  Bank C’s balance sheet now reads:

ASSETS	LIABILITIES
cash              £64	deposits                   £64

In this example, the amount of deposits outstanding in banks A, B and C is now £244. This is the total money supply in this simple economy since it represents the amount of money that can be used by customers who wish to pay by cheque. The process of depositing and re-depositing funds that is seen above, often referred to as ‘multiple deposit expansion’, finds its limit under certain assumptions when the total amount of deposits in the banking system reaches £500. This amount is given by the quantity of state money initially deposited, multiplied by the inverse of the reserve ratio (£100 ´ 1 ÷ 0.2 = £500). The deposit multiplier has a value of 5 here. Before the process of multiple deposit expansion began, in other words before the intermediation of the banks in the financial system, the money supply stood at £100, which was entirely comprised of state money.

The banks have reasoned that all of the deposits made by depositors will not be withdrawn on one day. If this reasoning is proved incorrect then each of the banks may collapse. If the maximum amount of deposits withdrawn in the form of state money on any one day does not exceed reserves, then there will be no collapse on that day. This type of banking system is especially unstable in times of crisis if large numbers of depositors wish to withdraw state money. The bank run at Northern Rock in the United Kingdom during 2007 is one such example.

Liquidity and the Banking System

Realising the dangers posed by sudden withdrawals on this scale, modern banks, like the goldsmiths of old, also make arrangements to source new reserves of state money at short notice. However, in the modern financial system it is the central bank that guarantees to lend an unlimited amount of state money to the commercial banks should it ever be required. This ‘lender of last resort’ function, essential to the stability of the modern economy, neutralises the impact of bank runs so long as sufficient amounts of state money are quickly made available when required. In the case of Northern Rock, newly printed Bank of England notes were despatched to each branch in substantial volumes as part of an emergency loan package at a penalty rate of interest. Depositors queuing to withdraw cash outside Northern Rock branches were thereby satisfied in full at the counter, and the bank run in due course subsided.

It is worth noting that the lender of last resort guarantee can only be given because the state too has now adopted paper (and more recently computer entries) as the basis of state money. Were state money to be made of precious metal, no such guarantee could be completely trusted. Like everyone else, the state’s access to supplies of gold and silver is limited.

The lender of last resort function carried out by the central bank is only one line of defence, the last line by definition, against a collapse in the banking system. We shall briefly review the other avenues that are available to modern banks for sourcing reserves when so required.

In the event that cash reserves (state money in physical form) at any one bank branch are severely depleted, the bank in question may of course transfer surplus cash from other branches. Often, commercial banks make the withdrawal of large amounts of cash by customers subject to at least one day’s notice. This requirement provides the bank with sufficient time to acquire the necessary cash, if not from their own branches then from other sources described below.

Instead of withdrawing state money from a bank in order to buy goods or services, customers may prefer to pay by cheque or debit card, for example. Where payment is effected in this manner, and where it takes place between two customers of the same bank, that bank merely alters the balances on the two customers’ accounts as described in our earlier example. Otherwise, where payment is made to a customer banking with a different bank, then the ‘paying bank’ must transfer reserves of state money to the ‘payee bank’.

For the purpose of making transfers of state money reserves to other banks, each commercial bank holds an account with the central bank. The balances in these accounts are termed ‘operational deposits’ (and are distinct from ‘non-operational deposits’ which cannot be withdrawn and which are called for by the central bank from time to time in order to implement monetary policy of one description or other). State money held in operational accounts can be transferred to the central bank accounts of other commercial banks. This is the normal method for settling the net amount of payments between banks due on any one business day, a process for which a central ‘clearing house’ or ‘clearing system’ is responsible. The balance on an operational account can also be withdrawn by a bank in the form of cash, for which purpose the central bank operates regional storage centres where cash is held and disbursed as required.

Since payments made between commercial banks tend to cancel one another, in the same manner that gold coin withdrawals and deposits cancelled one another in our earlier example of the goldsmith, commercial banks only need to maintain a small balance on their operational account at the central bank. However, in the event that a bank has insufficient reserves of state money in its operational account to meet payments due, it will be necessary to source extra reserves or arrange to go into overdraft. The sourcing of reserves may be carried out in several ways.

Reserves may be obtained by borrowing from other banks on the wholesale interbank money market (sometimes known as the ‘parallel market’ in the UK since it operates alongside the ‘discount market’ to be described shortly). A bank with surplus reserves may in this way lend its surplus to obtain interest on otherwise idle funds and the borrowing bank may simultaneously alleviate its reserve shortage. The interbank money market is now a feature of every developed economy.

As a second option, commercial banks in the UK may obtain new amounts of state money by approaching the discount market. The word ‘discount’ arises from the principal activity of institutions which lend money by buying short-term bills at a discount to face value. For example, a three month government bill is an instrument in which the government promises to pay, to the holder, three months after the issue date, the face value written on the bill. A buyer may pay 95% of that face value to own this three month bill on the day of issue and will therefore have discounted the bill by 5% (or, more precisely, discounted it at an annualised rate of 20%). It should be noted that a discount rate is not the same as an interest rate. If one pays £95 for a bill that repays £100 in three months’ time, the rate of the discount is 5% (£5 divided by £100) but the rate of interest is 5.26% (£5 divided by £95).

Financial market operators closely monitor the amount of the discount because it may act as a signal of trends in the level of short-term interest rates throughout the economy. The central bank influences the discount rate by withdrawing state money from, or injecting it into, the discount market at appropriate times. Injection of state money may be carried out by buying ‘eligible bills’ from institutions in the discount market, or by lending money to them directly. On the other hand, when the central bank sells eligible bills to the discount market, state money is received in return and is thereby withdrawn from the market. (Eligible bills are simply government bills, or the bills of major companies, so‑called ‘commercial bills’, that the Bank of England is prepared to purchase at a discount).

In the United Kingdom, for many years, a select group of institutions (“discount houses”) stood between the commercial banks and the Bank of England. With state money borrowed from the commercial banks, the discount houses could buy government bills from the Bank of England, in other words lend to the government. With state money borrowed from the Bank of England, they could lend to commercial banks (by buying bills from them). The understanding in the discount market was that both the discount houses and the Bank of England would lend whatever amounts of money were required of them.

Most of the loans advanced to the discount houses by the commercial banks were available for immediate or very short notice withdrawal, being ‘money at call’ or ‘overnight money’. In satisfying their requirements for state money, commercial banks would often withdraw these deposits as a first resort. If such amounts, and others, proved insufficient, then the commercial banks could become outright borrowers from the discount houses and such borrowing could in turn force the discount houses to borrow from the central bank. In either case, money withdrawn or borrowed from the discount market would be placed in the central bank account of a commercial bank and hence alleviate any shortage of reserves.

The structure of the discount market changed in the years following 1997 when a larger number of institutions were allowed to deal with the Bank of England in order to access supplies of state money. The use of repurchase agreements (‘repos’) now became common. In a repo, one institution lends money to another using a debt security (commonly a government bond) as collateral. The formal mechanism for enacting a repo is a sale of the underlying security from A to B, combined with an agreement for A to repurchase the security from B at a later date. The price that B pays for the security at the outset is, in effect, the amount of the loan, and the price that A pays to repurchase the security represents the repayment of the loan plus interest. (One complicating factor here will be the existence of any interest payments to be received by B on the security during the period of the repurchase agreement. These will be taken into account when calculating the repurchase price).

Because the central bank agrees to lend the discount and repo markets whatever amount of state money is required, it cannot necessarily control the amount of state money supply in existence. State money supply is therefore said to be determined ‘endogenously’. The central bank’s action in this regard effectively provides a safety net that enables fractional reserve banking to be practised with impunity. This is one major reason that bankers in every nation have at one time or another lobbied for (and succeeded in obtaining) a central bank to oversee the banking system. With a central bank, even if bank runs do occur, the bankers need not worry too much. They can simply ask the central bank to create as much state money as is required to meet demands for withdrawal.

Commercial banks may also bolster their reserves by selling investment holdings, or by issuing new bonds and shares of their own for sale to investors. The purchase by the UK Treasury of newly issued equity shares in in 2008 (over £45 billion to acquire an 84% stake in Royal Bank of Scotland, and over £20 billion to acquire a 43% stake in Lloyds Banking Group) is a notable example of this procedure. Here, not only are new reserves of cash made available to the bank, but its ratio of capital to loan assets (the so-called ‘capital-asset ratio’) is improved.

The clearest sign of a liquidity shortage, as far as the public are concerned, arises when commercial banks attempt to improve their reserve ratios by ‘calling in’ overdrafts and other loan facilities. This action increases the ratio of cash to deposits on a commercial bank’s balance sheet and also the ratio of cash to loan assets.