Why everything you were taught about banks is wrong and why it matters</div>

C</span>reate, don't intermediate</strong>

We've been told to think of the business of banks as accepting deposits from savers and lending them out to those who need funds to invest. From this simple understanding flow many implications about how monetary policy and banking regulation affect the rest of the economy. The problem is that the "folk" view of banking is wrong</strong>. Does it follow that policy thinking implicitly based on it is wrong, too?

The Bank of England has for some time been providing sterling public service in explaining how banking actually works - even though the public's ear remains frustratingly uncocked. Two very accessible papers in the BoE quarterly review at the beginning of last year (an introduction</a> and a more detailed paper</a>) explained the magic by which banking works: rather than waiting for pre-existing savings to be deposited to then lend them out, things work in reverse.</strong> Banks create deposits and credit them to borrowers whenever they want to make a loan - that is how the loan is made - and they will do so when they find the profit of making the loan outweighing the risk.</strong> Private commentators have also done a good job of explaining this - see for example Cullen Roche's blog post on the basics of banking</a>. And for the simplest way in, the BoE has a video explainer</a>, filmed against the backdrop of the Bank's gold vaults.</p>
The fact that banks create money "out of thin air" has three profound implications for how we think about credit and monetary policy and financial regulation.</strong>

The first is that it invalidates common views about the effect of central bank reserves - the banks' own deposits that they are required to hold with their central bank in proportion to their deposits. Roche succinctly explains that when you know how banking works, you will know that inflation will not explode</a> </strong>because of "quantitative easing" (QE) - central banks' policy of creating reserves to buy securities in the market. That is because the quantity of central bank reserves does not</strong> typically constrain the amount of lending - and thus money creation</strong> - the banks engage in; instead the constraints are expected profitability and equity requirements. The flip side is that QE will not necessarily increase lending</strong> - though it will make non-bank financing cheaper. And as Frances Coppola explains in detail, the interest rate on reserves still influences interbank rates</a> (the rates banks charge one another) and therefore, indirectly, lending rates to the public, even when the system is flush with reserves, as now. All the more reason to lower the rate on reserves below zero to break through the so-called zero lower bound on interest rates.</p>

The second is that the right model of how banks work gives rise to a more correct - and much scarier - appreciation of how banking affects the macroeconomy.</strong> A new working paper from the BoE compares the "financing" model to the conventional, but incorrect, "intermediation" model. The comparison is sobering</a>: "Following identical shocks to financial conditions . . . [financing] models predict changes in the size of bank balance sheets that are far larger, happen much faster, and have much greater effects on the real economy . . . [They] also predict pro-cyclical rather than countercyclical bank leverage, and a significant role for quantity rationing of credit rather than price rationing during downturns." Banking is even more dangerous for your health than you may have thought</strong>.</p>

This both makes proposals for nationalising money creation more attractive</strong> (such as Martin Wolf's call for narrow banking</a> or Laurence Kotlikoff's limited-purpose banking</a> proposal) and risky</strong>, as other advocates of banking system reform worry</a>. For abolishing private banks' money-creating prerogative leaves you with the choice between purely public creation of money - and loans</em>, or no out-of-nothing creation at all.</p>

The third is that "shadow banking system" is a bit of a misnomer. That's the label commonly given</a> to a swath of the financial sector outside of formal banks. The idea is that many non-bank institutions (such as money market funds) perform the same function as banks - and therefore should be regulated in a similar way lest destabilising behaviour simply migrates from the formal banking sector by the time the regulation has fully caught up with it. Creating rules for shadow banks is one of the main goals of the Financial Stability Board</a>, the global forum for financial regulators.</p>
This argument relies on an important thing banks and the relevant non-banks have in common: they engage in maturity transformation, which is a way to say they have liabilities their clients can demand at any time (such as deposits) but assets that will only be returned in the long term (such as 30-year mortgages). But there is a key difference, too, because unlike banks, "shadow banks" do, in fact, need to attract pre-existing savings before they can channel them into investments. So if the biggest systemic risk created by the banking system is that it creates and destroys money willy-nilly, there is no equivalent problem in the shadow banks, which in this regard are not banks at all. Regulators should beware of taking their eyes off the (banking) ball when they go off chasing shadows.