How is money created? That’s a question that has received considerable attention in recent years. Yet, despite the emergence of a plausible theory, a feeling of unfinished business lingers. And I wanted to offer some thoughts here.
In this article, I am going to focus on a specific type of money: the money created by banks usually in form of electronic deposits. As a reminder, different types of money exist (physical money created by central banks in form of coins and banknotes; central banks reserves created by central banks and used by banks to make payment between themselves; money created by commercial banks; commodity money, etc.) but money created by banks accounts for more than 80% of the money in circulation in Europe.
So having a clear understanding of the mechanisms at play behind this process of money creation is key.
Three contenders, one winner
For a long time, three theories have been competing:
- The Financial intermediation theory which posits that banks are intermediaries that collect deposits that are then lent out, creating in doing so money.
- The Fractional reserve theory which postulates that banks can only loan out a certain amount of the deposits they collect as they are required to keep reserves. As such, banks are intermediaries without the power to create money, but the banking system collectively is able to create money through the systemic interaction and multiplier effects. Central banks are controlling the fraction of reserves required, and thus the money creation.
- The Credit creation theory which states that each bank has the power of creating money ex-nihilo, just by extending credit. Money is created when the bank grants a loan.
In 2014, the economist Richard A. Werner set out to test empirically which one of these three theories explained best observable facts. The results of his analysis can be found in a now famous research paper called “Can banks individually create money out of nothing? — The theories and the empirical evidence” published in International Review of Financial Analysis. His conclusions are very clear:
This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, “out of thin air”.
Since then, other studies have come up with similar conclusions: Money is created ex-nihilo by banks when they extend credit.
These pieces of evidence in favor of the credit creation theory have prompted many academics and professionals to think about the workings of the financial system differently. From banking regulations to monetary policy transmission, the modern approach is sort of predicated on the assumptions that the other two theories are correct. So, if both the financial intermediation theory and the fractional reserve theory are rejected, the approach should be changed. The sensationalism around these results also helped raise awareness amongst the general public. The fact that banks can create money “out of thin air” is a bold claim. And one that I have never been comfortable with.
Thin air, really?
Don’t get me wrong: I am not questioning the validity of the credit creation theory, rather the fact that most reasonings around it stop halfway. By saying that banks create money out of credit – or more precisely that they create deposits as a consequence of lending – you certainly provide a decent answer to the question “how is the money created?” but not to the corollary and most important one: “From what?”. Deposits created from loans may be “thin air”, but loans are rarely created out of “thin air”.
The starting point of a loan is a collateral. I am using a very broad definition of the term collateral here: It is anything on which banks are willing to place a value. A piece of property, a good, an investment portfolio, a business plan, or an expected stream of income. It can be pledged or not and it is used to determine the creditworthiness of the debtor.
If you really believe banks grant loans out of nothing, go check by yourself. Pick the financial intermediary of your choice and try to get a mortgage without giving any details about the property you want to acquire or about your personal financial situation.
On the contrary, the process of loan origination by banks is subject to strict rules, especially for large sizes. The characteristics of the collateral are carefully assessed, often with the help of external experts (real estate experts, credit rating agencies, etc.) to derive a loanable value. Both the balance sheet of the debtor and the one of the bank are factored in the calculation of the loan spread and the equity required for making the loan. For example, the spread at origination is determined taking into account, amongst other variables, the debtor’s creditworthiness (credit score, credit rating, etc.), the expected loss premium on the collateral (i.e., the expected loss on the loan obtained by multiplying the default probability times the loss given default) and the cost of debt and equity of the lender (which are tightly linked to the reserves). At aggregated level, a book of loans is not without consequences for a bank as it will impact its risk weighted assets. As such, it has a direct link with its reserves so you can’t entirely dismiss the fact that reserves play a role.
So, my main argument here is that money is not created out of thin air. It is created by banks, through credit creation, from collateral.
It is created by banks, through credit creation, from collateral
Why it matters
Collateral is the heart of the economy. All investors based their decisions out of something they can place a value on. Banks have a huge responsibility in the creation of money, but the management of collateral is a collective affair and this, for a number of reasons:
- Collateral assessment is inherently subjective. Different economic agents will value the same collateral differently.
- Collaterals can be poolable, exchangeable and reusable. Cross-collateralization and dependencies through financial intermediaries ‘interconnected balance sheets can create severe issues.
- There is a reflexive relationship between collateral and money creation. The higher the value of the collateral, the higher the size of the loan. Which is worrying when you think that central banks focus their efforts mainly on inflation and not asset price inflation.
In short, understand money creation and control it efficiently, you have to consider all the links in the chain. From collateral to credit to deposit to money…and back to collateral.