We have featured the paper by Dr. Richard Werner and the power of banks to create money out of thin air, and interest has been stirred, but not all our readers are familiar with the discipline and its terminology in which the discussion is taking place.
In the following, the wording has not been changed from the original but certain portions have been ‘cherry-picked’ in order to make clearer. Emphasis has been added throughout.
Thanks to the recent banking crises interest has grown in the details of how banks operate. In recent decades, the empirical and institutional micro-structure of how banks operate had not been a primary focus of attention by investigators. This lack of interest may partly be due to the predominance of the hypothetico-deductive* research methodology in economics, which begins by posing axioms and assumptions. Such a theoretical and hypothetical framework has also been the basis for bank regulations. As is well known to historians, reality may be less logical and rational than the designers of theoretical constructs may envisage. This is known in other areas of finance, where market and investor behaviour often does not conform to the precepts of theoretically posed ‘rational agents’. By contrast, an inductive approach begins by establishing the empirical facts.
(* Definition of hypothetico–deductive: relating to, being, or making use of the method of proposing hypotheses and testing their acceptability or falsity by determining whether their logical consequences are consistent with observed data.
Or as C.H. Douglas may have once asked: Do the nation’s accounting figures reflect the facts?)
Over the past century and a half, three competing theories of banking have been influential —
1. the financial intermediation,
2. the fractional reserve and
3. the credit creation theories of banking.
1. Financial Intermediation Theory
Most current models, theories and textbooks in finance and economics assert the validity of the financial intermediation theory.
Banks do not gather deposits and then lend these out, as the financial intermediation theory assumes.
2. Fractional Reserve Theory
The fractional reserve theory maintains banks do this ‘collectively’. Nor do they draw down their deposits at the central bank in order to lend, as the fractional reserve theory of banking maintains.
3. Credit Creation Theory
According to this theory banks create credit individually. According to this theory, banks can individually create credit and money out of nothing, and they do this when they extend credit.
Recently, two events have upset the status quo in this debate.
Firstly, The Bank of England has come forward clearly in support of the credit creation theory
([PDF] Money creation in the modern economy - Bank of England By Michael McLeay, Amar Radia and Ryland Thomas of the Bank's Monetary Analysis Directorate.
Secondly, the first empirical tests of the three theories have been conducted (Werner, 2014a, 2014c). These tests showed that the financial intermediation and fractional reserve theories are not supported by the evidence:
1. Banks do not gather deposits and then lend these out, as the financial intermediation theory assumes.
2. Nor do they draw down their deposits at the central bank in order to lend, as the fractional reserve theory of banking maintains.
3. The empirical facts are only consistent with the credit creation theory of banking.
According to this theory, banks can individually create credit and money out of nothing, and they do this when they extend credit. When a loan is granted by a bank, it purchases the loan contract (legally considered a promissory note issued by the borrower), which is reflected by an increase in its assets by the amount of the loan. The borrower ‘receives’ the ‘money’ when the bank credits the borrower's account at the bank with the amount of the loan.
Through the process of credit creation 97% of the money supply is created in the UK today (Werner, 2005), and similar proportions apply to most industrialised economies. Not surprisingly, the use to which bank credit is put to determines its effect, namely whether bank credit is extended for productive, consumptive, or speculative purposes (The Quantity Theory of Credit, see Werner, 1997, 2005, 2012a).
No Law, Statute, or Bank Regulation, Grants Banks This Right!
One reason for the neglect of the institutional and operational details of banks in the research literature in the past decades is likely the fact that no law, statute or bank regulation explicitly grants banks the right (usually considered a sovereign prerogative) to create and allocate the money supply. As a result, many economists, finance researchers, lawyers, accountants, even bankers, let alone the general public, have not been aware of the role of banks as creators and allocators of the money supply.
What Exactly is It That Enables Banks to Individually Create Credit Out of Nothing?
The question is considered of what exactly it is that enables banks to individually create credit and money out of nothing, and why or whether other financial firms and intermediaries, or ordinary corporations not active in the financial sector, cannot do likewise.
Is what enables banks to create money a feature unique to banks, or is Minsky's (1986) claim more relevant that “everyone can issue money"?
Being able to create money is a desirable ability, and if it was possible for other agents to do so, they would likely also engage in this activity.
Are non-bank financial institutions, including so-called ‘shadow banks’, engaged in money creation?
With financial deregulation and the development of hybrid financial instruments, the demarcation between banks and non-banks often is said to be elusive. Is it possible to pinpoint the difference?
Specifically, it remains a conundrum to economists why banks combine what are effectively very different operations, namely deposit-taking and granting of loans, and why securities or capital markets cannot substitute these functions, despite in theory being capable of doing so separately:
“...commercial banks are institutions that engage in two distinct types of activities, one on each side of the balance sheet-deposit-taking and lending. ...
While much has been learned from this work, with few exceptions it has not addressed a fundamental question: why is it important that one institution carry out both functions under the same roof?" (Kashyap et al., 2002, p. 33f).
They also argue that it is of utmost importance to answer this question:
"The question of whether or not there is a real synergy between deposit-taking and lending has far-reaching implications" (op. cit., p. 34).
They cite the question of monetary reform as one of the reasons why the question needs to be answered. Their own answer is based on the provision of loan commitments by banks — a particular institutional feature that does not apply to all banks and does not usually dominate bank lending.
It is hence difficult to argue that the question they raise has been answered fully. This is especially true, since the authors are adherents of the financial intermediation theory of banking which claims, erroneously, that banks gather deposits and then lend these deposits out.
It is the purpose of this article to offer new answers to these questions, which are in line with the empirical record. Joseph Schumpeter (1917/18) argued that banking is primarily accounting, and that banks vf Financial Analysis 36 (2014) 71 -77 are the ‘bookkeeping centre’ of the economy and act as its ‘social accountants’ (1934, p. 124).
Stiglitz and Weiss (1989) also consider banks as operating ‘society's accounting system’. Werner (2014a, 2014c) shows that the three theories of banking are distinguished by their differing bank accounting and that the crucial difference of banks and firms without a banking licence revolves around the issue of lending.
Werner (2005) had argued:
“Bank credit creation does not channel existing money to new uses. It newly creates money that did not exist beforehand and channels it to some use. . .. What makes this ‘creative accounting’ possible is the other function of banks as the settlement system of all non-cash transactions in the economy. Since banks work as the accountants of record - while the rest of the economy assumes they are honest accountants - it is possible for the banks to increase the money in the accounts of some of us (those who receive a loan), by simply altering the figures. Nobody else will notice, because agents cannot distinguish between money that had actually been saved and deposited and money that has been created ‘out of nothing’ by the bank" (p. 179).
However, surprisingly little has been written about the actual accounting details of bank operations, especially concerning their lending, and how precisely it differs from the accounting of non-bank firms. It is thus corporate accounting that we must turn to in order to analyse the questions at hand in a comparative analysis of the treatment of lending by different types of corporate lenders.
2. Comparative accounting of lending
Although the implementation of banking services relies heavily on accounting, hardly any scholarly literature exists that explains in detail the accounting mechanics of bank credit creation and precisely how bank accounting differs from corporate accounting of non-bank firms.
There is also virtually no scholarly literature on the question of which regulations precisely enable banks to create money. These issues are however of great interest, especially since the function of banks as the creators and allocators of the money supply is not explicitly stated in any law, statute, regulation, ordinance, directive or court judgement.
From the absence of explicit statutory powers to create money it can be deduced that this ability of banks is likely derived from the operational, that is, accounting conventions and regulations of banking.
These either differ from those of non-banks, so that only banks are able to create money, or else non-banks have missed out on the significant opportunities money creation may afford.