2   Official: Banks Create Money!

Copy of letter from HM Treasury: [Added comments by James Robertson]

HM Treasury, I Horse Guards Road, London, SWIA 2HQ

Greg Clark MP

House of Commons


SW1A OAA 5 August 2008

Dear Greg

As you have previously written to Alistair Darling regarding Northern Rock enclosing correspondence from your constituent, Mr Brian Leslie of 12 Queens Road, Tunbridge Wells, Kent, TN4 9LU, I thought you might find it useful to have an update on where we are now following last year's events. I apologise for the delay in responding to you.

The Government's response to the situation at Northern Rock has been set out in statements to Parliament and the wider public. These statements explain the background to Northern Rock's difficulties, how the situation developed, the actions taken by the Bank of England (BoE), Financial Services Authority (FSA) and HM Treasury collectively the Tripartite authorities - and the objectives and principles within which the Authorities operate. The objectives of the Tripartite throughout have been to protect taxpayers and depositors and to promote financial stability.

The Government has consistently taken action to meet these objectives. The provision of loan facilities through the Bank of England and guarantee arrangements to the Company successfully averted a threat to the stability of the financial system and avoided a serious disturbance in the wider economy. The loan facilities to Northern Rock are secured against all the assets of the Company. None of the guarantees have been called and therefore there has been no cost to the taxpayer in respect of the Company's liabilities.

After considering a range of options, the Government has decided that a period of temporary public ownership is the best way of meeting the stated objectives. This option is better value for money for the taxpayer than either of the two private sector proposals the Government had received.

Currently, the Government's focus is ensuring that Northern Rock will deliver the strategic objectives set out in the Company's business plan published on 31 March 2008, including repaying the BoE loan facilities by the end of 2010 and enabling the Government to release its guarantee arrangements gradually by 2011. Some progress has been made. As reported in Northern Rock's audited accounts for 2007 published on 31 March 2008 and its latest trading statement of 12 May 2008, the outstanding loan due to the BoE has been reduced from 26.9 billion as of 31 December 2007 to 24.1 billion at 31 March 2008.

Your constituent raised some specific questions in relation to the loan facilities to Northern Rock. The loan facilities are provided by the BoE, meaning that the funds are not drawn from tax revenue collected by the Government. The loan facilities are treated as assets in the BoE's balance sheet, and are matched by a liability in the form of "reserve balances" which is money held by the banking system in accounts at the BoE. These balances are a form of money, i.e. central bank money. It is important to note that the funds lent by the BoE to Northern Rock do not lead to an expansion of the money supply because the BoE lends less to the market than it would otherwise have done to offset the impact of loans to Northern Rock.

As set out in Budget 2008, the Government will, during 2008-09, replace the Bank of England's loan to Northern Rock with direct Treasury funding. As for the BoE lending, this change will have no effect on the money supply.

[If this is "a form of money" which is not part of the money supply, does it change its nature and become part of the money supply if Northern Rock has to use it, so putting it into circulation? And what are the effects of the BoE lending less to the market than it would otherwise have done, had it not had to make this non-money-supply form of money available to Northern Rock?

In other words this is an unsatisfactory explanation of what now has to be done to minimise the damage done by the irresponsible greed of bankers exploiting a ludicrously out-of-date method of creating the overwhelming majority of our public money supply.]

Your constituent asked some questions about the way in which credit is created and the causes of the current problems in the banking system1. By far the largest role in creating money is played by the banking system itself. Banks accept retail deposits from members of the public and businesses and wholesale deposits from other banks and investors in financial markets, and lend that money to others which could be retail or wholesale customers. When banks make loans, they at the same time create a new deposit for those that have borrowed the money. [My italics BL] As borrowers spend their new deposits for example, to pay a retailer for goods this same money is returned back to the banking system as a new deposit in the bank account of the retailer. The bank is then able to lend this new deposit to create further credit. Eventually, the original loan will be repaid. In the meantime, the banks' ability to accept new deposits and to lend them again when they are returned to the banking system leads to an on-going process of credit creation. There is nothing at all new in this process of credit creation by the banks. The same process operates in much the same way in banking systems the world over, and its origin goes back centuries.

The distinction between retail and wholesale deposits helps to explain what happened at Northern Rock. When Northern Rock converted to a bank in 1997, most of its lending was funded by retail deposits from the general public. Thereafter Northern Rock - and other institutions like it around the world increasingly funded its lending with very short-term deposits from investors in capital markets. For a number of years this business model allowed banks to expand their lending rapidly. But the market conditions in last August turned decisively as a result of the collapse of the US sub-prime mortgage market. Investors became much more cautious in providing the money (deposits) needed to fund new and existing lending. In Northern Rock's case this meant that it had to come to the Bank of England to find funds previously sourced from money markets in September 2007. Furthermore, these developments posed a challenge for the financial authorities, in the UK and abroad, given the continued uncertainty about the scale and location of losses in the banking system. Ultimately, it is for the financial regulator to assess the difficulties involved in supervising financial institutions.

In response to some of the broader issues raised, later this year, we plan to bring forward legislation to introduce a significant package of reforms designed to address issues raised during the turbulence in financial markets over recent months and to ensure resilience of our financial stability framework in the longer term.

The FSA already published2 a summary of a review into its supervision of Northern Rock. The review identifies a number of areas for improvement in the execution of supervision, which will be advanced urgently by the FSA's management. A number of improvements are already in train.

The Bank of England is fulfilling its role as central bank. It announced a special liquidity scheme on 21 April 083 to provide the necessary liquidity to banks while ensuring the risk of losses on the loans they have made remains with the banks. This will help take pressure off the banking sector and increase confidence in financial markets during the present period of uncertainty.

The Government is also working at international levels to take action to improve the ability of the global financial system to deal with the challenges it faces. For instance, the Chancellor and the Prime Minister have called for the International Monetary Fund to work closely with the Financial Stability Forum to strengthen its financial sector surveillance and act as an early warning system to identify risks to stability and develop coordinated regulatory responses to them.

Please pass on my thanks to Mr Leslie for taking the trouble to make me aware of these concerns.


1 The underlying causes of the credit crunch were discussed in the Bank's October 2007 Financial Stability Report ( see the Overview of the Report.