How Do Banks Create Money?

Credit Creation Theory

three theories

of banking competing against each other

for over the past century and a half

the credit creation theory

the fractional reserve theory

and the financial intermediation period

in 2014 werner produced the first ever

empirical study in the 5000 year history

of banking and it proved that the credit

creation theory

is correct so let's look deeper into

this theory and how banks create credit

or money out of thin air

according to the credit correction

theory banks individually create credit

out of nothing whenever they issue a

loan

when a loan is granted by bank they

purchase a loan contract

legally this is considered a permissory

note issued by the borrower of the bank

this is reflected by an increase in the

bank's assets by the amount of

loan the borrower receives the money

when the bank credits for borrower's

account

and through this process of credit

creation 97

of the money supply is actually created

out of nothing it is

purely fictitious as verna said in 2005

How Banks Create Money

bank credit creation does not channel

existing money to new users

it nearly creates money but did not

exist beforehand and channels it to some

use

so how do banks actually create this

money out of thinner and what makes them

special to other firms

why are non-banks unable to do this to

explain

let's compare the accounting of a loan

when extended by a non-financial

corporation

such as a manufacturer to supply

a non-bank financial institution such as

a stock broker extending a margin loan

to a client

and a bank lending money to a small

business

in the uk any firm or individual can

actually grant a loan

it is not a regulated activity so how

are banks different to these non-bank

financial institutions

and non-financial corporations such as a

manufacturer

as you'll know all firms have a balance

sheet this consists of

assets liabilities and shareholders

equity at a specific point in time

let's start with the manufacturer giving

a loan of 10 million to its supplier

when the manufacturer grants the loan it

is purchasing a loan contract

or more specifically a promissory note

as we discussed earlier

this appears in the manufacturer's

balance sheet as an increase in assets

this increase in assets is actually the

manufacturer's claim on the debtor

or what is this claim this is the

supplier's promise to repay the loan to

the manufacturer

at the exact same time the manufacturer

has an increase on the liability side

as an accounts payable the supplier is

due to be paid as per the agreement

when the manufacturer disperses the loan

it is drawing down his cash reserves and

it now

no longer needs to pay the supplier so

accounts payable disappears

as a result one gross asset increase is

matched by an equally side

gross asset decrease leaving net total

assets unchanged

what's left on the balance sheet is

simply the loan contract

the cash reserves have been drawn down

and the accounts payable has disappeared

Margin Lending

next let's look at the stock broker

engaging in margin lending

so this is a non-bank financial

institution

the stock broker again purchases a

promissory note

a claim on the client who is borrowing

the funds the promise

by the client to repay the funds at a

future date

this increases the total assets at the

same time there is an increase in

accounts payable as a client is due to

be paid

the disbursement of a loan for example

by transferring cash to the client

lowers the cash on the asset side while

simultaneously reducing accounts payable

as a firm discharges its obligation to

pay the borrower

in the end both total assets and

liabilities remain

unchanged the only visible change is the

category of assets on the balance sheet

we now have a loan contract there

as you can see for both the non-bank

financial corporation and the

non-financial corporation such as the

manufacturer

the balance sheet total is not affected

by the granting and disbursement of the

loan

however this is not the same in the case

of a bank

which has a banking license to

understand the difference it is

important to disaggregate the lending

process into two steps

first step one the balance sheet upon

purchasing the permissory note and

having an accounts payable

and step two when the loan funds are

paid out and accounts payable disappears

in step one the situation looks pretty

much the same

the bank purchases a promissory note

from a borrower and the asset side of a

bank's balance sheet increases by 10

million pounds

on the liability side accounts payable

also increases by 10 million pounds as a

bank owes the borrower funds

the accounting is identical for all

three types of lenders

this means whatever makes banks special

must appear in step two

banks behave very differently when the

bank must provide the funds to the

borrower

instead of needing to make funds

available to the borrower by drawing

down cash

as needed in the other two cases a bank

doesn't have to give up

anything to pay out the loan there is no

requirement to draw down

on cash reserves so how is it then that

the borrower believes that the bank's

obligation to pay them has been met

well this is done through a very

powerful accounting change that takes

place on the liability side

during step two the bank does reduce its

accounts payable for 10 million

but at the exact same time it increases

deposits on the liability side

it reclassifies accounts payable as

deposits

why is this and what actually is a

deposit although it might surprise you

you do not own the funds in your bank

account you have

not deposited your funds and the bank is

certainly not holding them on your

behalf

in fact a deposit is a loan to the bank

a liability and an obligation for the

bank to pay back the lender

it is a record of debt to the public

therefore it has reclassified accounts

payable to another category of liability

namely a deposit the bank no longer

needs to pay an account

the bank just simply owes you the money

no

transfer of funds has actually taken

place from one person's account to a

borrower's account

although the small business has the

impression that the bank has transferred

money from its capital reserves

or someone else's account to a small

business account it has not

neither the bank nor the small business

has deposited

any money in step one

the bank had a liability to pay an

account the law states the most common

way to be discharged from liability

is through payment but no payment has

Bank Deposit

taken place in step two

so the bank's balance sheet remains

stuck in step one and the balance sheet

has lengthened

the bank's liability has simply been

renamed as bank deposit

bank deposits are defined by central

banks as being part of the official

money supply

so bank deposits are increasing the

money supply is increasing

therefore whenever a bank grants a loan

they invent

fictitious customer deposits which all

users of our monetary system consider to

be money

indistinguishable from real deposits

plus

banks do not just grant credit they

create it

they create money out of thin air banks

are thought of as deposit-taking

institutions that then lend out

well as you now know banks do not take

deposits and banks do not lend money

now let's consider what happens when the

customer of a bank a small business

wants to pay their supply using the

newly created money

now in a one bank system or whether bank

is sufficiently large enough that both a

small business and their supplier's

account are both held at the same bank

the deposit amount doesn't change

although the amount doesn't change

who it's owed to does the bank no longer

owes the money to a small business

but it owes it instead to the small

business supplier

if however the supplier holds an account

at another bank

the small business bank deposits are

going to fall

and with it an asset class for example

cash at the same time deposits at the

suppliers bank will increase

and again an asset class will increase

with it

overall credit has still been created

so although we're aware of the

accounting that allows banks to create

credit

Client Money Rules

what is it that actually allows the

accounting to take place

in the uk the so-called client money

rules

require all firms that hold client money

to segregate such money in accounts that

keep them separate

from the assets or liabilities of the

firm itself

a firm on receiving any client money

must promptly place this money into one

or more accounts open with any of the

following

a central bank a crd credit institution

a bank authorized in a third country or

a qualifying money market fund

neither the manufacturer or the stock

broker used in our earlier examples

have a banking authorization meaning

client deposits

must be held in segregated accounts with

banks or money market

funds this means the client assets

always remain off balance sheet

the depositor always remains the legal

owner of those funds

however things are different if one has

a banking license

the client money chapter does not apply

to a depository

when acting as such so therefore what

actually enables banks to create money

is their exemption from the client money

rules as burner said in 2014

banks do not have to segregate client

accounts and thus are able to engage in

an exercise for re-labeling and mixing

different liabilities