HMSM #02: - Is the money in your bank account really there?

When we think about money being stored in a bank, people make various assumptions about how this works. Some people still think that the money they have in their bank account is backed by an equivalent amount of gold or silver stored within a vault in the bank. After all, the Great British Pound derived its name from being equivalent to a pound in weight of sterling silver coins. However, this is no longer the case. In 1931 the United Kingdom left the gold standard, a system where a country’s currency has a value directly linked to gold. Since that time, the Great British Pound has not been redeemable for any precious metal.

Some people may assume that the money held within their bank account is there in full, ready to withdraw and spend as they please. This is a system called 100% reserve banking, where every single customer of a bank can demand to take out their money and the bank will have all of it available. Discussions around 100% reserve banking have taken place amongst economists and policymakers for centuries, particularly in response to financial crises, but such a system has never been adopted in the UK.

Others that may be well-versed in global economics might believe that the UK adopts a fractional reserve banking system. Within this system, a bank is required to keep only a fraction of a customer’s money in its cash reserves, say 1%, and then use the customer’s remaining money to invest or to loan to other banks in return for interest. As the bank only stores a fraction of its customers' deposits, there is a risk that if all customers lose confidence in the bank and attempt to withdraw all of their money at the same time, then the bank can go bankrupt because it doesn’t actually have the money to hand.

That last system may sound risky right?

Well, the UK banking system does not actually require any percent or fraction of a customer’s money to be held in its reserves, unlike in some other countries. In fact, a bank in the UK can theoretically invest 100% of a customer’s bank deposit. In order to have some cash on hand for withdrawals, banks use risk analysis to estimate how much cash is needed at various branches, barring any unforeseen events such as all customers withdrawing their funds at the same time.

In terms of the ‘money’ in your bank account, the figure displayed in your banking app is not tied to actual money stored on your behalf. It’s more akin to a promise that the bank will borrow that amount from somewhere else to fund your withdrawal, when needed.

So instead of picturing money being held in your bank account, it’s more accurate to imagine that your bank account is just a ledger entry held within the bank, recording that you are owed a certain amount of money. When you spend your money, the ledgers are updated to reflect that somebody’s account has gone down in money whilst somebody else’s has gone up, even if actual ‘money’ hasn’t moved at all or was there to begin with.

At this point, you may be wondering - where on earth is my money if it’s not in my bank account? Typically, banks will use customer deposits for the following:

• Investments in government bonds, securities, stocks and mutual funds.

• Lending to other banks in the inter-bank market. This is done on a short-term basis in return for interest.

• Funding their own costs such as salaries, branch maintenance and other day-to-day expenses.

• Holding some cash reserves with the Bank of England so that they have funds set aside for unexpected withdrawal demands.

On a side note, contrary to what is still taught in some economics textbooks, banks don’t actually use your money to lend to other customers. This is mainly because they don’t have to. Instead, they are allowed to ‘create’ new money which expands the money supply. The bank can then loan that newly created money to individuals and businesses. They then earn interest on the loan repayments for their trouble.  

In the event that the bank has invested all of your money and you need to make a large withdrawal from the bank, they can typically settle the payment by drawing from their cash reserves, selling investments or borrowing from another bank. Then they will update their ledger records accordingly to reflect who’s owed what.

In developed, wealthy countries, this system works most of the time. However, there is always the risk that a bank can go bust if a large proportion of its customers attempt to withdraw all of their deposits at once, faster than the bank's ability to sell other assets or borrow from other banks to fulfil their obligations. In previous times, customers would have to travel to a bank’s local branch within its opening hours, queue and then ask to make a withdrawal. These steps usually slowed all customers from being able to make withdrawals all at the same time. They also bought the bank some time to recoup funds from elsewhere. Now, within a digital age, all customers can actually withdraw their money instantly 24/7, simply with a click of a button in a mobile banking app.

If confidence in a bank’s ability to return their customers’ funds wanes, then a collapse can happen quickly. A good example of this is the Silicon Valley Bank collapse in March 2023 where questions around the bank’s solvency began to circulate across social media platforms. This led to mass customer withdrawals within a 24-hour period, largely facilitated by the ease and speed of online banking. Unfortunately, the bank did not have the cash because it was tied up in long-term investments. As a result, the bank had to sell its government bonds at a significant loss to meet the spike in withdrawal demands. This caused further panic as customers realised that if the bank continued to incur losses on bond sales to fund withdrawals, there might not be sufficient reserves left for them to withdraw their money later. Predictably, this led to the bank's eventual collapse as customers raced to pull their funds as quickly as possible.

To deal with such occurrences and to maintain financial stability, the Bank of England and regulatory bodies have some tools at their disposal to prevent widespread collapse in confidence within the banking system. The most commonly known tools are:

• Government bailouts. This is where banks are given significant injections of capital from the government in order to prevent their collapse. This can be a contentious issue because many people feel that banks are allowed to invest their customers money in various investments and keep any profits made. However, if they lose this money, then the taxpayer effectively foots the bill. This means that in theory, many banks within the UK cannot fail, even if they do partake in risky practices.

• The Financial Services Compensation Scheme (FSCS). This scheme guarantees bank deposits of up to £85,000 per person. This ensures that most individual depositors do not lose all of their money if their bank fails. However, if an individual has more than £85,000 held within a failed bank then that additional money is unlikely to be protected by the scheme.

For the most part, these methods are usually effective in stabilising the banking system. Although, they can cause knock-on effects within a nation such as diverting government spending from other national services to support the banks.

Nevertheless, banks in the western world benefit from significant protections that reduce the likelihood of individuals losing all their money when a bank collapses. In contrast, in countries without such protections, the same banking practices can result in people losing their entire life savings overnight. Unfortunately, in an era when banks can invest or lend out their customers' money with relative impunity, where you are born can matter more than how much money you have in your bank account.

TL;DR: Is the money in your bank account really there? The short answer is no. Banks in the UK are not required to store a fraction or percentage of a customer’s deposit at any one time. Instead, they can theoretically invest or loan out the entire amount of a customer’s deposit. A bank account balance is essentially a ledger entry showing the amount of money the bank owes the customer. If the customer needs to spend or withdraw their money, the bank may borrow from elsewhere or sell its investments to fulfil this obligation. This can be risky, as demonstrated by the Silicon Valley Bank collapse in 2023. If all customers withdraw their money simultaneously, the bank may not have sufficient cash on hand. In Western countries, bailouts and compensation schemes aim to prevent individuals from losing their money due to a bank failure. However, in other countries, such protections may not be available.

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