How Do Banks Create Money? A Walk-Through of Richard Werner's Papers

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 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 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 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 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

Channel: Werner Economics

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Length: 9min 56sec (596 seconds)

Published: Mon Aug 02 2021