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 profits from the creation of cash (known as
seigniorage) go directly to the government. Of course, it is inconvenient and
risky to use cash for larger transactions. This is one of the reasons why today
cash makes up less than 3% of the total money supply. Nowadays people use
credit and debit cards, which allow money to be transferred electronically
between bank accounts (see point 3).

2. Central bank reserves

Central bank reserves are a type of electronic money, created by the central
bank and used by banks to make payments between themselves. In some
respects they are like an electronic version of cash. However, members of
the public and normal businesses cannot access central bank reserves, as
they are only available to those organisations who have accounts at the Bank
of England, i.e. banks. Central bank reserves 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 themselves.

3. Commercial bank money

The third type of money accounts for approximately 97% of the money in
circulation. However, unlike central bank reserves and cash, it is not created
by the central bank or any other part of government. Instead, commercial
bank money is created by private, high-street or commercial banks, usually
in the process of making loans (as described below). While this money is
electronic in form, it need not be before computers, banks could still create
money by simply adding deposits to their balance sheets.

Commercial bank money is referred to by various names, including: bank

deposits, sight deposits, demand deposits, time deposits, term deposits,
bank liabilities and bank credit.
NEXT: Part 2 - Introduction to balance sheets
There is no reason to be put off by the accounting terminology; if you have
ever borrowed money from a friend and left a note on the fridge to remind
you to repay them, then you have already done one half of the accounting
necessary to understand banking.
In short, a banks balance sheet is a record of everything it owns, is owed, or
owes. The balance sheet comprises three distinct parts: assets, liabilities and
shareholder equity.

Assets
On one side of the balance sheet are the assets. The assets include
everything that the bank owns or is owed, from cash in its vaults, to bank
branch buildings in town centres, through to government bonds and various
financial products. Loans made by the bank usually account for the largest
portion of a banks assets.

(In fact, if you lend 100 to a friend, your friends agreement to repay you
can be recorded as an asset on your own personal balance sheet.)
You may find it counter-intuitive that a loan made by the bank is recorded as
an asset; after all, once youve lent money, you no longer have the money,
so how can you record it as an asset? However, when a loan is made, the

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

What about the other half of the balance sheet? This side is called the
liabilities of the bank.
Liabilities are simply things that the bank owes to other people,
organisations or other banks. Contrary 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 over it. What you receive in return is a promise (an IOU) from the
bank to pay you an amount equivalent 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 money in your bank account does not represent money in the
banks safe, it simply represents the promise of the bank to repay you
either in cash or as an transfer to another account when you ask it to. The
bulk of a typical banks liabilities are made up of deposits which are owed to
the depositors. These will generally be individuals, businesses or other
organisations.
Deposits in a bank can be split into two broad groups: demand (or sight)
deposits and time (or term) deposits. Demand deposits are deposits that can

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

on demand or on sight of the customer. These accounts are commonly
referred to as current accounts (in the UK) or checking accounts (in the USA),
or instant access savings accounts. In contrast, time deposits have a notice
period or a fixed maturity date, so that the money cannot be withdrawn on
demand. These accounts are commonly referred to as savings accounts.

Equity
The final part of the balance sheet is the equity. Equity is simply the
difference between assets and liabilities, and represents what would be left
over for the shareholders (owners) of the bank if all the assets were sold and
the proceeds used to settle the banks liabilities (i.e. pay off the creditors).
Equity is calculated by subtracting liabilities from assets. A positive net
equity indicates that a banks assets are worth more than its liabilities. On
the other hand a negative equity shows that its liabilities are worth more
than its assets in other words, that the bank is insolvent.

Creating Central Bank Reserves

Lets start by seeing how the Bank of England creates the electronic money that banks use to
make payments to other banks. Central bank reserves are one of the three types of money, and
are 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 reserves for use
by a commercial bank, in this case RBS. Initially the bank of Englands balance sheet appears as
so (this is a simplified example where weve ignored everything except this particular
transaction):

RBSs shareholders have put up 10,000 of their own money which has been invested in
government bonds. So RBSs balance sheet is:

As a customer of the central bank, RBS contacts the central bank and informs them that they
would like 10,000 in central bank reserves.
For the purposes of this example it will be assumed that the Bank of England purchases the gilts
from RBS outright. Once the sale is completed the Bank of England has gained 10,000 of gilts,
but it now has a liability to RBS of 10,000, which represents the balance of RBSs reserve
account, as so:

The Bank of Englands balance sheet has expanded by 10,000, and 10,000 of new central
bank reserves have been created, effectively out of nothing, in order to pay for the 10,000 in
gilts.
However, from the point of view of RBSs balance sheet it has simply swapped 10,000 in gilts
for 10,000 in reserves:

RBSs balance sheet has not expanded at all; it has simply swapped one asset for another,
without affecting its liabilities. RBS can now use these reserves to make payments to other
banks, as described below.
N.B. The central bank could alternatively lend RBS the reserves (in this case the assets side of
the central banks balance sheet would show a 10,000 loan to RBS rather than 10,000 of gilts
and the RBS balance sheet would show the new reserves as an additional asset on top of its
holdings of gilts, and its obligation to repay the loan as an additional 10,000 liability).

Sale and repurchase agreements (Repos)

However, the standard method by which the Bank of England creates reserves is through what is
known as a sale and repurchase agreement (a repo), which is similar in concept to a collateralised
loan. Essentially RBS sells an interest in an asset to the central bank (usually a gilt) in exchange
for central bank reserves, while agreeing to repurchase its interest in said asset for a specific
(higher) price on a specific (future) date. If the repurchase price is 10% higher than the purchase
price (i.e. 10% higher than 10,000 = 11,000) then the repo rate is said to be 10%. A repo
transaction has different accounting rules from an outright sale. The Bank of England balance
sheet would not show the gilts as the asset balancing the reserves, but the value of the interest in
the gilts (valued at the 10,000 paid, not the 11,000 promised), whilst RBS would retain the
gilts on its balance sheet in addition to the central bank reserves but record as an additional
liability its 10,000 obligation to complete its end of the repurchase agreement. The extra 1,000
does not appear on either balance sheet but, when paid, is recorded as revenue (profit) for the
Bank of England and an expense (loss) for RBS.

You may ask where does RBS get the money to pay the repo rate? i.e. the interest on the repo.
The Bank of England actually pays a rate of interest on central bank reserves equals to the repo
rate so if RBS borrows 10,000 using a repo at 10% it must repay 10,000 plus 1,000 in
interest. Prior to RBSs repayment the Bank of England pays interest on the reserves at 10%.
This gives RBS 1,000 extra reserves which it must promptly use to repay the outstanding
11,000.
Whilst this process may seem a bit of a odd, there is actually a good reason for paying interest on
reserves in this manner. First, it means that banks are not penalised for holding reserves having
to borrow reserves at interest but not receiving interest on them meant that banks would be
effectively charged for holding reserves. Correspondingly, it means that banks will not try to
minimise their holdings of reserves. Before the Bank of England paid interest on reserves banks
would attempt to hold as few as reserves as possible, which could pose a problem for settling
payments.
Secondly, and most importantly by controlling the rate of interest paid on reserves, as well as the
interest rate it charges banks to borrow in an emergency (it charges a premium interest rate on
reserves lent through its overnight lending facility), the Bank of England creates a corridor
around its desired Policy (interest) rate. This corridor allows it to set the interest rate at which
banks lend to each other on the interbank market. For example, if the rate paid on deposits is 4%,
and the rate charged on emergency lending is 6%, normally a bank will never lend reserves to
another bank at a rate of interest below the rate it could receive from depositing its reserves at the
Bank of England (4%), or borrow reserves from another bank at a rate of interest higher than it
could borrow from the Bank of England (6%). Because of this the interest rate banks will be
willing to lend reserves to each other on the interbank market will be around 5%. (However
today, due to the excess reserves in the system from Quantitative Easing, most banks have too
many reserves, and as a result the central bank is setting interest rates through a floor system)
Top

How Central Banks Create Money (as

Cash )
The process by which the central bank sells cash to banks is similar to that used for reserves.
Initially the Bank of Englands balance sheet appears as so:

And RBSs balance sheet appears as:

If RBS decides it is expecting an increase in demand for cash for example before a bank
holiday weekend then it may wish to exchange some of its (electronic) central bank reserves
for (physical) cash. The process by which it does so is very simple RBS simply exchanges
10,000 of its central bank reserves for 10,000 cash with the central bank.
The Bank of Englands liabilities change from 10,000 in RBSs central reserve account, to
10,000 of cash outstanding. (The Bank of England records cash as a liability on its balance
sheet, for historical reasons that we wont go into here):

Meanwhile, RBSs assets have changed from 10,000 of central bank reserves, to 10,000 in
cash:

Note that neither balance sheet has expanded or contracted; it is just the nature of assets and
liabilities that have changed. When the cash is worn out, damaged, or not needed anymore, the
transaction is reversed and RBS simply sells back the cash to the Bank of England at face value,
receiving 10,000 in central bank reserves in return.
NEXT: Part 4 - How commercial banks create money

4. Creating commercial bank money

Now lets look at how commercial or high-street banks create the type of
money that appears in your bank account.

Loans
A customer, who we shall call Robert, walks into RBS and asks to borrow
10,000 to buy a new car. Robert signs a contract with the back confirming
that he will repay 10,000 over a period of five 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 10,000:

Robert, having committed to pay the bank 10,000, wants to receive his
loan. So RBS opens up an account for him, and types in 10,000. This is
recorded as a liability on RBSs balance sheet as so:

Notice that no money was transferred or taken from any other account, the
bank simply updated a computer database. A bank does not lend money
to lend one must have money to lend in the first place. In reality a bank
creates money when it advances loans.

Buying Assets
Banks also create money when they buy assets, be they real or financial. For
example, say Barclays Bank wished to buy a 100 government bond from a
pension fund. Initially Barclays balance sheet appears as so:

In order to buy a bond Barclays creates an account for the pension fund, and
adds 100 to the balance. In exchange the bank receives a government bond
worth 100. Because Barclays owns this asset it can be placed on its balance
sheet of the bank:

NEXT: Part 5 - How payments are made