First – what is money? It is cash (coins and Bank of England notes), and balances held at the Bank of England. Who has a Bank of England account? It used to be that anyone could have a current account at the Bank of England, but nowadays it seems to be only the government and the banks. (I'd be grateful if anyone could provide more information on that). I have read that there was a move in just the last few years to force other account holders to move to the commercial banks. I even saw that HMRC has been moved to Nat West (part of RBS), so if RBS were to be or become insolvent then collected taxes could well be lost.
Where do Bank of England notes come from? Well, the Bank of England essentially has an ATM. A bank can ask the Bank of England for a withdrawal. The Bank of England reduces the balance in the bank's account, and sends round a big van with lots of new Bank of England notes, which the bank can load into an ATM, put in the cashiers' tills, and/or put in the petty cash box. The same process can work in reverse - the bank can send back some tatty old Bank of England notes (which are then shredded) and have their balance increased.
Where the original balances at the Bank of England come from is a subject for another post.
So, banks have accounts with the Bank of England. Let's look again at the example from the last post, where I have opened an account with Lloydclays Bank of Corporation (LBoC). I paid in £20 in Bank of England notes (money), and had my account credited with £20 of bank credit. LBoC put the money in the till — it belonged to them at that point. What happens if I write a cheque for £10 to Fred Madeupname, who also has an LBoC account? It's fairly simple:
- I write a cheque showing the amount and my bank sort code and account number.
- I hand the cheque to Fred.
- Fred completes a paying-in slip showing the amount and his bank sort code and account number.
- Fred hands the paying-in slip and the cheque to a cashier at his local branch of LBoC, who checks that the amounts match.
- The branch send both slips of paper to a national cheque-processing centre.
- The cheque-processing centre reads all the details from the paying-in slip and the cheque, re-checks that the amounts match, and sorts the cheque into a pile to be sent to LBoC in case manual checking is required later. It also adds an entry to an electronic file to transmit to LBoC at the end of the day indicating the amount to be transferred, which account's balance is to be reduced, and which account's balance is to be increased.
- When LBoC receives the electronic file, it reduces the balance in my account by £10, and increases the balance in Fred's account by £10.
The end result is that my bank credit is reduced by £10, and Fred's bank credit is increased by £10. No money was involved.
Now let's instead assume that Fred has an account with a different bank, say Hong Kong of Scotland (HKoS). The process is almost the same, except that:
- The cheque sorting centre adds entries to two electronic files. LBoC are told to reduce my balance by £10, and HKoS are told to increase Fred's balance by £10.
- The Bank of England is notified that it must reduce LBoC's balance by £10 and that it must increase HKoS's balance by £10.
The Bank of England isn't interested in getting a notification of every single cheque written, so the amounts transferred are aggregated into a single transfer per pair of banks per day.
Note that in this case, there is a transfer of money. £10 was transferred from LBoC to HKoS — Bank of England deposits were modified.
Debit card processing and bank transfers
Let's say I use my LBoC debit card at Sainscose to pay for some shopping. What happens then? Well it's basically the same as the cheque processing, except that the whole thing is electronic, outsourced to a card-processing company, and quicker.
If Sainscose banks with LBoC, my account balance is decreased, and Sainscose's is increased. No money is involved, only bank credit.
If Sainscose banks with HKoS, my account is decreased, Sainscose's is increased, and a transfer of money takes place at a suitable point between the accounts of LBoC and HKoS at the Bank of England.
The same is true for bank transfers (BACS). Bank credit accounts are increased and decreased, and if the accounts are held at different banks, a money transfer is made between the respective banks' accounts at the Bank of England.
Bank credit vs money
We've looked at cheques, debit card payments, and bank transfers. As far as the bank account holder is concerned, there's very little difference between spending cash and spending bank credit. Cash and bank credit are pretty-much fungible — they can be used interchangeably when paying for goods and services. Cheques, debit card payments and bank transfers are very convenient in that they avoid the need to withdraw money, give it to the recipient, and for the recipient to deposit the money in their bank. But always remember that money and bank credit are separate things — bank credit relies on the bank being able to honour its promise to pay.
So far, we've only looked at bank credit being transferred or exchanged for cash. And cash can only come from deposits at the Bank of England, so unless there is something else we haven't yet considered, the amount of bank credit is limited to the amount of money in the system. In fact, there is something else, which will be the topic of a future post.