Article Abstract

How do banks operate and where does the money supply come from? The financial crisis has heightened awareness that these questions have been unduly neglected by many researchers. During the past century, three different theories of banking were dominant at different times:

(1) The currently prevalent financial intermediation theory of banking says that banks collect deposits and then lend these out, just like other non-bank financial intermediaries.

(2) The older fractional reserve theory of banking says that each individual bank is a financial intermediary without the power to create money, but the banking system collectively is able to create money through the process of ‘multiple deposit expansion’ (the ‘money multiplier’).

(3) The credit creation theory of banking, predominant a century ago, does not consider banks as financial intermediaries that gather deposits to lend out, but instead argues that each individual bank creates credit and money newly when granting a bank loan.

The theories differ in their accounting treatment of bank lending as well as in their policy implications. Since according to the dominant financial intermediation theory banks are virtually identical with other non-bank financial intermediaries, they are not usually included in the economic models used in economics or by central bankers. Moreover, the theory of banks as intermediaries provides the rationale for capital adequacy-based bank regulation. Should this theory not be correct, currently prevailing economics modelling and policy-making would be without empirical foundation. Despite the importance of this question, so far only one empirical test of the three theories has been reported in learned journals.

This paper presents a second empirical test, using an alternative methodology, which allows control for all other factors. The financial intermediation and the fractional reserve theories of banking are rejected by the evidence. This finding throws doubt on the rationale for regulating bank capital adequacy to avoid banking crises, as the case study of Credit Suisse during the crisis illustrates.

The finding indicates that advice to encourage developing countries to borrow from abroad is misguided. The question is considered why the economics profession has failed over most of the past century to make any progress concerning knowledge of the monetary system, and why it instead moved ever further away from the truth as already recognised by the credit creation theory well over a century ago. The role of conflicts of interest and interested parties in shaping the current bank-free academic consensus is discussed. A number of avenues for needed further research are indicated.

Article Review

How Banks Really Work & Why It Matters
For over a century, economists have debated how banks operate and where money comes from. There have been three dominant theories:

1. Financial Intermediation Theory – The prevailing view today, which sees banks as mere intermediaries that collect deposits and lend them out, just like non-bank financial institutions.
2. Fractional Reserve Theory – This older theory argues that while individual banks can’t create money, the banking system collectively does so through the money multiplier effect.
3. Credit Creation Theory – A theory dominant a century ago, which states that banks create new money and credit each time they issue a loan, without needing prior deposits.

This study challenges the first two theories and provides empirical evidence supporting the credit creation theory. This raises critical questions about the foundation of modern economic models and bank regulations, including capital adequacy requirements aimed at preventing financial crises. The case of Credit Suisse during the financial crisis illustrates that such regulations might be misguided. The research also highlights potential conflicts of interest that have shaped the dominant, yet flawed, economic theories.

In short, if banks truly create money through lending rather than just recycling deposits, our entire approach to banking regulation and monetary policy may need a rethink.

Rethinking Banking—The Credit Creation Theory Holds True
For decades, mainstream economic theories have largely ignored the crucial role of banks in the economy. Research has traditionally treated banks as mere financial intermediaries, either collecting deposits and lending them out (financial intermediation theory) or facilitating money creation only at the system-wide level (fractional reserve theory). However, recent empirical tests challenge these views and validate the credit creation theory, which asserts that individual banks create new money when issuing loans (Werner, 2014b).

A groundbreaking controlled study using banking software simulations confirmed that bank lending is not simply the transfer of existing funds but the creation of new money through accounting entries. This finding has major policy implications, particularly for capital adequacy regulations like Basel III, which are shown to be ineffective in preventing banking crises. The 2008 case of Credit Suisse illustrates this failure. Instead, research suggests that central bank guidance of credit and systems favoring small banks lead to more stable economic growth.

This study also raises critical questions about why mainstream economics has neglected these insights for over a century. The role of conflicts of interest in shaping economic theories and policies is explored, with calls for a paradigm shift in banking research and regulation.

The Three Main Theories of Banking Explained

1. The Financial Intermediation Theory (Dominant Today)
This widely accepted view sees banks as intermediaries—collecting deposits and then lending them out, much like non-bank financial institutions. Economists from Keynes (1936) to modern scholars like Krugman (2015) argue that banks facilitate savings and investment but do not create new money. This theory justifies why banks are often excluded from macroeconomic models and why capital adequacy regulations (e.g., Basel III) are considered essential for stability.

2. The Fractional Reserve Theory
This theory suggests that while individual banks do not create money, the banking system as a whole does through a process called the money multiplier. Essentially, banks hold only a fraction of deposits as reserves and lend out the rest, which leads to multiple rounds of deposit creation throughout the banking system. This view underpinned traditional monetary policy assumptions but has faced empirical challenges.

3. The Credit Creation Theory
This older but increasingly supported theory argues that individual banks create money out of nothing when issuing loans. Each new loan generates a corresponding deposit, expanding the money supply without needing prior deposits. Empirical tests, such as Werner (2014b), confirm that banks do not merely lend existing money but actively create it through accounting operations. This challenges mainstream economic models and raises questions about the effectiveness of bank regulations based on capital reserves.

Key Takeaway
The prevailing financial intermediation theory downplays the role of banks in money creation, leading to flawed policy decisions. Empirical evidence increasingly supports the credit creation theory, which has major implications for banking regulations, monetary policy, and economic stability.

Testing Banking Theories with a €200,000 Loan

A study tested three banking theories by analyzing how a €200,000 loan is recorded on a bank’s balance sheet:

1. Financial Intermediation Theory: Banks are like non-bank financial institutions and don’t record customer deposits on their balance sheets. It predicts no change in the balance sheet when a loan is issued.
2. Fractional Reserve Theory: Banks need prior deposits and reserves to lend. It predicts that both deposits and loans increase, but only if a prior deposit exists.
3. Credit Creation Theory: Banks create money by issuing loans, directly increasing both assets (loans) and liabilities (deposits) without needing prior deposits.

Findings:

• The bank’s balance sheet increased by €200,000, with both loans (assets) and customer deposits (liabilities) rising.
• No prior deposits or reserve increase were needed, disproving fractional reserve theory.
• Customer deposits appeared on the balance sheet, rejecting financial intermediation theory.
• The results fully aligned with credit creation theory, confirming that banks create money when issuing loans.

In conclusion, banks don’t just intermediate deposits or rely on prior reserves; they create money through loans.

The Flaws in Banking Theories
Financial Intermediation Theory Flaws

• Banks vs Non-Banks: Unlike stock brokers or mutual fund managers, banks don’t just hold customer funds in custody; they own them, enabling money creation when loans are issued.

Fractional Reserve Theory Flaws

• The idea that banks can only lend existing money is wrong. In reality, banks create money out of thin air when issuing loans, increasing both their assets and liabilities. Traditional models, like Samuelson’s, fail to explain how this actually works.

Interbank Transfers and Money Creation

• Deposits don’t “leave” a bank; they just move between banks, creating interbank liabilities rather than shrinking money supply. As long as banks expand credit at a similar rate, there’s no fundamental limit to how much money can be created.

In short, existing banking theories oversimplify and misunderstand how money is created in the banking system.

Implications for Bank Regulation: A Shift in Understanding Banking
Recent findings challenge the traditional theories of banking and suggest that current regulatory frameworks based on these outdated views are ineffective.

1. Regulation via Reserve Requirements
   • The fractional reserve theory led to the use of reserve requirements as a regulatory tool. However, since reserves are just accounting entries, they don’t directly influence money circulation, making reserve requirements impractical. Many central banks have moved away from this approach.
2. Regulation via Capital Adequacy
   • With the financial intermediation theory becoming dominant, capital adequacy ratios were introduced to regulate bank behavior. However, banks can effectively “create” capital by issuing shares, as shown in the Credit Suisse case during the 2008 crisis. This practice renders capital adequacy regulations ineffective, as banks can manufacture capital when needed.
3. The Case for Credit Guidance
   • Instead of relying on reserve or capital requirements, credit guidance (regulating the allocation and quantity of bank credit) has proven successful. Countries like Japan, Korea, and China have used such policies to avoid banking crises, by steering credit towards productive uses and away from asset bubbles. This approach has supported stable, non-inflationary economic growth.

In conclusion, banking regulations based on outdated theories are inadequate. A shift towards credit guidance could offer a more effective solution to prevent financial instability and foster sustainable economic growth.

Implications of Bank Credit Creation for Development Policies
The study of bank credit creation has significant implications for development and economic growth policies, particularly for developing countries.

Key Takeaways:

• Flaws in Traditional Models: Theories like Keynesian growth models and the financial intermediation theory have shaped policy advice from the IMF and World Bank. These models argue that savings are necessary for investment and that developing countries need foreign loans to fuel growth. However, these loans often come with high interest and foreign currency risk, leading to rising debt without real economic benefit.
• Foreign Debt Burden: Many developing countries have accumulated large amounts of foreign debt, often in foreign currencies. As commodity exporters, their currencies tend to weaken over time, increasing the burden of debt. This creates a transfer of wealth from poor to rich countries, contrary to traditional economic theory that predicts capital should flow from rich to poor countries.
• The Banking Reality: The foreign loans often don’t even enter the borrowing countries’ economies. In many cases, these loans are just records in the foreign banking system, while domestic banks end up creating credit in local currencies. This means developing countries could have funded growth themselves through domestic credit creation, avoiding foreign debt entirely.
• Alternative Approach: Successful East Asian economies like Japan, Taiwan, Korea, and China showed that guiding domestic bank credit to productive uses can promote sustainable growth without relying on foreign debt. This approach has been proven effective in generating stable, long-term economic growth.
• Relevance for Developed Economies: Developed countries facing low GDP growth, like Japan or Greece, could also benefit from understanding bank credit creation. Shifting government funding from bond issuance to borrowing from domestic banks could stimulate the economy by expanding the money supply and increasing growth.

In conclusion, the traditional advice of borrowing from abroad to fuel growth is flawed. Developing countries could have avoided foreign debt by leveraging their own banking systems to create credit, just as successful economies like those in East Asia have done.

Implications for Economics – How Bank Credit Creation and Methodology Affect Economic Theories
For much of the past century, misleading theories about banking have dominated economics, contributing to flawed policies and a public misunderstanding of money. This article explores two key factors behind the persistence of these erroneous ideas: research methodology and the role of interested parties.

Key Takeaways:

1. Methodology in Economics:
   • Deductive vs. Inductive: Classical and neo-classical economics rely on a deductive methodology, which starts with untested assumptions to build theories that often confirm pre-determined conclusions. This approach allows economists to shape models to justify their preferred policies, rather than engaging in empirical, evidence-based research.
   • In contrast, inductive methodology, which builds theories from real-world data and observations, is proposed as a more scientific and unbiased approach for economics. The paper advocates for a shift toward inductive methods to produce more accurate and reliable research.
2. Information Management:
   • Economics has regressed on understanding how banks function, particularly their role in credit creation. The shift from the correct credit creation theory to the flawed fractional reserve and financial intermediation theories has misled economists and the public about how banks create money.
   • Despite occasional acknowledgments, like in Stiglitz’s 2003 book, that banks create money when they extend loans, these insights have been downplayed or ignored, leading to confusion and a lack of progress in the field.
   • It’s suspected that powerful institutions, including central banks and major financial players, may have intentionally obfuscated the truth about money creation, manipulating research to avoid challenging the status quo.
3. The Role of Central Banks and Academic Influence:
   • Central banks have engaged in information management, controlling the research they publish to suppress inconvenient truths, like the importance of bank credit creation. Their research outputs often avoid or misrepresent these facts.
   • The involvement of central banks in academic economics, through funding and awards (e.g., the Riksbank Prize), has helped promote certain economic theories, ensuring that alternative views, particularly around money creation, remain marginalized.
4. Implications for Policy and Research:
   • Credit Creation: Banks create money out of nothing when they issue loans, a process that could be harnessed for domestic growth, especially in developing countries. This debunks the need for foreign borrowing, which often doesn’t even enter the local economy and leads to rising debt.
   • Policy Change: The paper advocates for direct regulation of bank credit to ensure it supports productive economic activities, rather than speculative or harmful ones that contribute to instability.

The study calls for a rethinking of how economic theories are built, urging the inclusion of real-world institutional and accounting realities. Economics needs to shift toward inductive, empirical research, incorporating cross-disciplinary insights from law, accounting, and other fields, to avoid another century of misguided theories.

Overall, it’s crucial that future research in economics moves beyond abstract models to focus on the practical realities of how money is created and how banking systems function.