TYPE OF MONEY

7/24/2019 TYPE OF MONEY

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1. Cash:Physical money, or cash, is created under the authority of the Bank of

England, with coins manufactured by the Royal mint, and notes printed by

specialist printer De La Rue. The prots from the creation of cash !known as

seigniorage" go directly to the go#ernment. $f course, it is incon#enient and

risky to use cash for larger transactions. This is one of the reasons why today

cash makes up less than %& of the total money supply. 'owadays people use

credit and debit cards, which allow money to be transferred electronically

between bank accounts !see point %".

2. Central bank reserves(entral bank reser#es are a type of electronic money, created by the central

bank and used by banks to make payments between themsel#es. )n some

respects they are like an electronic #ersion of cash. *owe#er, members of

the public and normal businesses cannot access central bank reser#es, as

they are only a#ailable to those organisations who ha#e accounts at the Bank

of England, i.e. banks. (entral bank reser#es are not counted as part of the

money supply for the economy, due to the fact that they are only used by

banks to make payments between themsel#es.

3. Commercial bank moneyThe third type of money accounts for appro+imately -& of the money in

circulation. *owe#er, unlike central bank reser#es and cash, it is not created

by the central bank or any other part of go#ernment. )nstead, commercial

bank money is created by pri#ate, highstreet or /commercial0 banks, usually

in the process of making loans !as described below". 1hile this money is

electronic in form, it need not be 2 before computers, banks could still /create

money0 by simply adding deposits to their balance sheets.


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(ommercial bank money is referred to by #arious names, including3 bank

deposits, sight deposits, demand deposits, time deposits, term deposits,

bank liabilities and bank credit.

'E4T3 Part 5 )ntroduction to balance sheets

There is no reason to be put o6 by the accounting terminology7 if you ha#e

e#er borrowed money from a friend and left a note on the fridge to remind

you to repay them, then you ha#e already done one half of the accounting

necessary to understand banking.

)n short, a bank0s balance sheet is a record of e#erything it owns, is owed, or

owes. The balance sheet comprises three distinct parts3 assets, liabilities and

shareholder e8uity.

Assets

$n one side of the balance sheet are the assets. The assets include

e#erything that the bank owns or is owed, from cash in its #aults, to bank

branch buildings in town centres, through to go#ernment bonds and #arious

nancial products. Loans made by the bank usually account for the largest

portion of a bank0s assets.

!)n fact, if you lend 9:;; to a friend, your friend0s agreement to repay you

can be recorded as an asset on your own personal balance sheet."


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borrower signs a contract committing to repay the full loan, plus interest.

This legally binding contract is worth as much as the borrower commits to

repay !assuming they will repay", and so can be considered an asset in

accounting terms.

Liabilities

1hat about the other half of the balance sheet= This side is called the

/liabilities0 of the bank.

Liabilities are simply things that the bank owes to other people,

organisations or other banks. (ontrary to the perception of most of the

public, when you !as a bank customer" deposit physical cash into a bank it

becomes the property !an asset" of the bank, and you lose your legal

ownership o#er it. 1hat you recei#e in return is a promise !an )$>" from the

bank to pay you an amount e8ui#alent to the sum deposited. This promise is

recorded on the liabilities side of the balance sheet, and is what you see

when you check the balance of your bank account.

Therefore the /money0 in your bank account does not represent money in the

bank0s safe, it simply represents the promise of the bank to repay you 2

either in cash or as an transfer to another account 2 when you ask it to. The

bulk of a typical bank0s liabilities are made up of /deposits0 which are owed to

the /depositors0. These will generally be indi#iduals, businesses or other

organisations.

Deposits in a bank can be split into two broad groups3 demand !or sight"

deposits and time !or term" deposits. Demand deposits are deposits that can


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be withdrawn or spent immediately when the customer asks, in other words

/on demand0 or /on sight0 of the customer. These accounts are commonly

referred to as current accounts !in the >?" or checking accounts !in the >@A",

or instant access sa#ings accounts. )n contrast, time deposits ha#e a notice

period or a +ed maturity date, so that the money cannot be withdrawn ondemand. These accounts are commonly referred to as sa#ings accounts.

Equity

The nal part of the balance sheet is the e8uity. E8uity is simply the

di6erence between assets and liabilities, and represents what would be left

o#er for the shareholders !owners" of the bank if all the assets were sold and

the proceeds used to settle the bank0s liabilities !i.e. pay o6 the creditors".

E8uity is calculated by subtracting liabilities from assets. A positi#e net

e8uity indicates that a bank0s assets are worth more than its liabilities. $n

the other hand a negati#e e8uity shows that its liabilities are worth more

than its assets 2 in other words, that the bank is insol#ent.

Creating Central Bank Reserves

Lets start by seeing how the Bank of England creates the electronic money that banks use tomake payments to other banks. Central bank reserves are one of the three types of money, andare created by the central bank in order to facilitate payments between commercial banks.

In the following example we will show how the central bank creates central bank reseres for useby a commercial bank, in this case !B". Initially the bank of Englands balance sheet appears as

so #this is a simplified example where wee ignored eerything except this particular

transaction$%


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!B"s shareholders hae put up &'(,((( of their own money which has been inested in

goernment bonds. "o !B"s balance sheet is%

)s a customer of the central bank, !B" contacts the central bank and informs them that they

would like &'(,((( in central bank reseres.

*or the purposes of this example it will be assumed that the Bank of England purchases the gilts

from !B" outright. +nce the sale is completed the Bank of England has gained &'(,((( of gilts,but it now has a liability to !B" of &'(,(((, which represents the balance of !B"s resere

account, as so%


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he Bank of Englands balance sheet has -expanded by &'(,(((, and &'(,((( of new central

bank reserves hae been created, effectiely out of nothing, in order to pay for the &'(,((( in

gilts.

oweer, from the point of iew of !B"s balance sheet it has simply swapped &'(,((( in gilts

for &'(,((( in reseres%

!B"s balance sheet has not expanded at all/ it has simply swapped one asset for another,without affecting its liabilities. !B" can now use these reseres to make payments to other

banks, as described below.

0.B. he central bank could alternatiely lend !B" the reseres #in this case the assets side of

the central banks balance sheet would show a &'(,((( loan to !B" rather than &'(,((( of gilts

and the !B" balance sheet would show the new reseres as an additional asset on top of itsholdings of gilts, and its obligation to repay the loan as an additional &'(,((( liability$.

ale an! re"urchase agreements #Re"os$oweer, the standard method by which the Bank of England creates reseres is through what is

known as a sale and repurchase agreement #a repo$, which is similar in concept to a collateralisedloan. Essentially !B" sells an interest in an asset to the central bank #usually a gilt$ in exchange

for central bank reseres, while agreeing to repurchase its interest in said asset for a specific

#higher$ price on a specific #future$ date. If the repurchase price is '(1 higher than the purchaseprice #i.e. '(1 higher than &'(,((( 2 &'',((($ then the -repo rate is said to be '(1. ) repo

transaction has different accounting rules from an outright sale. he Bank of England balancesheet would not show the gilts as the asset balancing the reseres, but the alue of the interest inthe gilts #alued at the &'(,((( paid, not the &'',((( promised$, whilst !B" would retain the

gilts on its balance sheet in addition to the central bank reseres but record as an additional

liability its &'(,((( obligation to complete its end of the repurchase agreement. he extra &',(((does not appear on either balance sheet but, when paid, is recorded as reenue #profit$ for the

Bank of England and an expense #loss$ for !B".


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3ou may ask where does !B" get the money to pay the repo rate4 5 i.e. the interest on the repo.

he Bank of England actually pays a rate of interest on central bank reseres e6uals to the repo

rate 5 so if !B" borrows &'(,((( using a repo at '(1 it must repay &'(,((( plus &',((( ininterest. 7rior to !B"s repayment the Bank of England pays interest on the reseres at '(1.

his gies !B" &',((( extra reseres which it must promptly use to repay the outstanding

&'',(((.

8hilst this process may seem a bit of a odd, there is actually a good reason for paying interest on

reseres in this manner. *irst, it means that banks are not penalised for holding reseres 5 haingto borrow reseres at interest but not receiing interest on them meant that banks would be

effectiely charged for holding reseres. Correspondingly, it means that banks will not try to

minimise their holdings of reseres. Before the Bank of England paid interest on reseres bankswould attempt to hold as few as reseres as possible, which could pose a problem for settling

payments.

"econdly, and most importantly by controlling the rate of interest paid on reseres, as well as the

interest rate it charges banks to borrow in an emergency #it charges a premium interest rate onreseres lent through its -oernight lending facility$, the Bank of England creates a -corridoraround its desired 7olicy #interest$ rate. his -corridor allows it to set the interest rate at which

banks lend to each other on the interbank market. *or example, if the rate paid on deposits is 91,

and the rate charged on emergency lending is :1, normally a bank will neer lend reseres toanother bank at a rate of interest below the rate it could receie from depositing its reseres at the

Bank of England #91$, or borrow reseres from another bank at a rate of interest higher than it

could borrow from the Bank of England #:1$. Because of this the interest rate banks will be

willing to lend reseres to each other on the interbank market will be around ;1. #oweertoday, due to the excess reseres in the system from


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)nd !B"s balance sheet appears as%

If !B" decides it is expecting an increase in demand for cash 5 for example before a bank

holiday weekend 5 then it may wish to exchange some of its #electronic$ central bank reseres

for #physical$ cash. he process by which it does so is ery simple 5 !B" simply exchanges&'(,((( of its central bank reseres for &'(,((( cash with the central bank.

he Bank of Englands liabilities change from &'(,((( in !B"s central resere account, to&'(,((( of -cash outstanding. #he Bank of England records cash as a liability on its balance

sheet, for historical reasons that we wont go into here$%


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=eanwhile, !B"s assets hae changed from &'(,((( of central bank reseres, to &'(,((( in

cash%

0ote that neither balance sheet has expanded or contracted/ it is >ust the nature of assets and

liabilities that hae changed. 8hen the cash is worn out, damaged, or not needed anymore, thetransaction is reersed and !B" simply sells back the cash to the Bank of England at face alue,

receiing &'(,((( in central bank reseres in return.

0E?% 7art 9 @ ow commercial banks create money

(. Creating commercial bank money'ow lets look at how /commercial0 or highstreet banks create the type of

money that appears in your bank account.

LoansA customer, who we shall call Robert, walks into RB@ and asks to borrow

9:;,;;; to buy a new car. Robert signs a contract with the back conrming

that he will repay 9:;,;;; o#er a period of #e years, plus interest. This

legally enforceable contract represents a future income stream for the bank,

and when the bank comes to draw up its balance sheet it will be included as

an additional asset worth 9:;,;;;3
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Robert, ha#ing committed to pay the bank 9:;,;;;, wants to recei#e his

/loan0. @o RB@ opens up an account for him, and types in 9:;,;;;. This is

recorded as a liability on RB@0s balance sheet as so3

'otice that no money was transferred or taken from any other account, the

bank simply updated a computer database. A bank does not /lend money0 2

to lend one must ha#e money to lend in the rst place. )n reality a bank

creates money 2 when it ad#ances loans.

Buying AssetsBanks also create money when they buy assets, be they real or nancial. or

e+ample, say Barclays Bank wished to buy a 9:;; go#ernment bond from a

pension fund. )nitially Barclays balance sheet appears as so3


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)n order to buy a bond Barclays creates an account for the pension fund, and

adds 9:;; to the balance. )n e+change the bank recei#es a go#ernment bond

worth 9:;;. Because Barclays owns this asset it can be placed on its balance

sheet of the bank3

'E4T3 Part C *ow payments are made
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TYPE OF MONEY

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