Can banks individually create money out of nothing? — The theories and the empirical evidence

This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. 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".     

Modelling credit in the transmission mechanism of the United Kingdom

Studies have focused heavily on money in the transmission mechanism of monetary policy. In this article we explore the empirical importance of credit. The paper provides a framework in which to analyse the balance sheets of, and financial flows between, different sectors of the UK economy, and an econometric model of the interactions between non-financial firms, households and credit offered by banks and non-bank financial intermediaries. The paper also provides a dynamic structural model of bank and building society credit, money and decisions to consume and invest and then adds credit from non-bank financial intermediaries. Our bottom line is that credit is an important part of the transmission process of UK monetary policy.     

The competition for deposits and the impact of monetary policy

Financial intermediation in Britain can be said to have reached maturity before the war, since when the growth of banks has been critically a question of market share. Until the shift in monetary policy away from direct restriction of bank lending that began about nine years ago, credit restriction added to other factors, like taxation and the bank cartel, limiting the ability of the banks to compete. The author argues that an open-market policy directed toward money supply control need not discriminate against banks. However, the re-introduction of bank lending restrictions through the use of Special Deposits and, even more so, through the use of Supplementary Special Deposits has worked to favour non-bank deposit intermediaries. The distortions caused by the Supplementary Special Deposits not only discriminate against the banks; they are also likely to undermine the use of monetary policy itself. What are required are government policies, especially with regard to the size of the public sector borrowing requi rement, that make possible the goal of a non-discriminatory open-market policy, without the need for direct controls on lending by financial institutions.     

Circuit theory of banking and finance

Drawing on monetary circuit theory, this study develops an approach to analyze the integrated functions of banking and finance in a monetary production economy. The study proposes a micro-founded, circuit-sequenced model of a decentralized-decisions economy, where production, exchange, and investment from households and firms are integrated through money creation and funds allocation operated, respectively, by banks and non-bank financial intermediaries. The model is used to draw implications on: the special nature of banks and the role of non-bank financial intermediaries; the relationship between saving and investment; and the channels through which finance may cause the circuit process to break down. The study also discusses how the circuit approach can be used for an integrated analysis of economic and financial structural change.     

How Theories of Financial Intermediation and Corporate Risk-Management Influence Bank Risk-Taking Behavior

This paper examines the rationales for risk-taking and risk-management behavior from both a corporate finance and a banking perspective. After combining the theoretical insights from the corporate finance and banking literatures related to hedging and risk-taking, the paper reviews empirical tests based on these theories to determine which of these theories are best supported by the data. Managerial incentives are the most consistently supported rationale for describing how banks manage risk. In particular, moderate/high levels of equity ownership reduce bank risk while positive amounts of stock option grants increase bank risk-taking behavior. The review of empirical tests in the banking literature also suggests that financial intermediaries coordinate different aspects of risk (e.g., credit and interest rate risk) in order to maintain a certain level of total risk. The empirical results indicate hedgeable risks such as interest rate risk represent only one dimension of the risk-management problem. This implies empirical tests of the theories of corporate risk-management need to consider individual sub-components of total risk and the bank's ability to trade these risks in a competitive financial market. This finding is consistent with the reality that banks have non-zero expected financial distress costs and bank managers cannot fully diversify their bank-related personal investments.     

Unstable banking

We propose a theory of financial intermediaries operating in markets influenced by investor sentiment. In our model, banks make, securitize, distribute, and trade loans, or they hold cash. They also borrow money, using their security holdings as collateral. Banks maximize profits, and there are no conflicts of interest between bank shareholders and creditors. The theory predicts that bank credit and real investment will be volatile when market prices of loans are volatile, but it also points to the instability of banks, especially leveraged banks, participating in markets. Profit-maximizing behavior by banks creates systemic risk.     

Banking and commerce: A liquidity approach

This paper looks at the advantages and disadvantages of mixing banking and commerce, using the “liquidity” approach to financial intermediation. Bringing a nonfinancial firm into a banking conglomerate may be advantageous because it makes it easier for the bank to dispose of assets seized in a loan default. The conglomerate's internal market increases the liquidity of such assets and improves the bank's ability to perform financial intermediation. More generally, owning a nonfinancial firm may act either as a substitute or a complement to commercial lending. In some cases, a bank will voluntarily refrain from making loans, choosing to become a non-bank bank in an unregulated environment.     

Interbank tiering and money center banks

This paper provides evidence that interbank markets are tiered rather than flat, in the sense that most banks do not lend to each other directly but through money center banks acting as intermediaries. We capture the concept of tiering by developing a core-periphery model, and devise a procedure for fitting the model to real-world networks. Using Bundesbank data on bilateral interbank exposures among 2000 banks from 1999 to 2012, we find strong evidence of tiering in the German banking system. This extent of tiering is unlikely to arise in standard random networks. Indeed, we show that bank specialization and balance sheet variables predict how banks position themselves in the interbank market. This link provides a promising avenue for understanding the formation of financial networks.     

非银行金融科技与上市公司借贷成本——竞争压力还是信息溢出？

金融科技作为技术驱动的金融创新,是深化金融供给侧结构性改革、增强金融服务实体经济能力的重要引擎。基于我国A股上市公司数据,本文实证分析了针对中小微企业和个人的非银行金融科技发展对上市公司借贷成本的溢出效应。结果表明,非银行金融科技发展每提高10%,上市公司借贷成本平均下降1.6个百分点。进一步分析表明,这一结果同时受到“竞争压力”与“信息溢出”两种机制的作用:前者表现为在银行业竞争程度更高的地区,非银行金融科技的发展更能显著降低企业的借贷成本;后者表现为,非银行金融科技的发展能够显著降低商业银行不良贷款率,同时也能降低商业银行业务及管理费用开支。本文探索金融科技如何影响上市公司融资成本,为金融科技进一步增强金融服务实体经济能力提供了新的启示。     

Financial intermediation and economic growth: the post-liberalization Indian experience

The paper is concerned with the relationship between economic growth and financial intermediation, in particular stock market development, in post-liberalization India. It identifies three possible relationships: (a) the relationship between growth of manufacturing and growth of the stock market; (b) the relationship between growth of the stock market and growth of traditional financial intermediaries like banks; (c) the relationship between the growth of the primary stock market and that of the secondary stock market. These three relationships are empirically tested using Indian data. While the growth of turnover in the stock market is found to be positively correlated with the change in the growth of manufacturing and the growth of sales of new shares is found to positively affect the secondary market, evidence on the relationship between sales of new shares and traditional banking activities is mixed. The primary stock market is found to crowd out bank deposits, but crowd in bank credit.     

Banks as Tax Planning Intermediaries

We provide the first large‐scale empirical evidence of banks functioning as tax planning intermediaries. We posit that some banks specialize in assisting corporate clients with tax planning. In this role, banks make use of their centrality in financial relationships; access to private information; and ability to structure, execute, and participate in tax planning transactions for clients. We measure bank‐client relationships using loan contracts and measure client tax planning using either the cash effective tax rate or the unrecognized tax benefit balance. Using a difference‐in‐differences design, we find that firms experience meaningful tax reductions when they begin a relationship with a bank whose existing clients engage in above‐median tax planning. The effects of pairing with such tax intermediary banks are concentrated in relationships with larger or longer maturity loans, clients with foreign income or greater credit risk, and when the bank is an industry specialist or has above‐median investment banking activities. Finally, we find that potential clients are more likely to choose tax intermediary banks than nontax intermediary banks, suggesting that tax intermediary banks benefit by attracting new business. Collectively, our results suggest that some banks act as tax planning intermediaries, a role beyond the traditional one of financial intermediary.     

Ownership and technical efficiency of microfinance institutions: Empirical evidence from Latin America

By using stochastic frontier analysis, this article examines the technical efficiency of different types of microfinance institutions in Latin America. In particular, it tests whether differences in technical efficiency, both intra- and interfirm, can be explained by differences in ownership. With a focus on non-governmental organizations, cooperatives and credit unions, non-bank financial intermediaries, and banks, the data set contains 1681 observations from a panel of 315 institutions operating in 18 Latin American countries. The results show that non-governmental organizations and cooperatives have much lower interfirm and intrafirm technical efficiencies than non-bank financial intermediaries and banks, which indicates the importance of ownership type for technical efficiency.     

How do banks create money,and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking

Thanks to the recent banking crises interest has grown in banks and how they operate. In the past, the empirical and institutional market micro-structure of the operation of banks had not been a primary focus for investigations by researchers, which is why they are not well covered in the literature. One neglected detail is the banks' function as the creators and allocators of about 97% of the money supply (Werner, 1997, Werner, 2005), which has recently attracted attention (Bank of England, 2014a, Bank of England, 2014b, Werner, 2014b, Werner, 2014c). It is the purpose of this paper to investigate precisely how banks create money, and why or whether companies cannot do the same. Since the implementation of banking operations takes place within a corporate accounting framework, this paper is based upon a comparative accounting analysis perspective. By breaking the accounting treatment of lending into two steps, the difference in the accounting operation by bank and non-bank corporations can be isolated. As a result, it can be established precisely why banks are different and what it is that makes them different: They are exempted from the Client Money Rules and thus, unlike other firms, do not have to segregate client money. This enables banks to classify their accounts payable liabilities arising from bank loan contracts as a different type of liability called ‘customer deposits’. The finding is important for many reasons, including for modelling the banking sector accurately in economic models, bank regulation and also for monetary reform proposals that aim at taking away the privilege of money creation from banks. The paper thus adds to the growing literature on the institutional details and market micro-structure of our financial and monetary system, and in particular offers a new contribution to the literature on ‘what makes banks different’, from an accounting and regulatory perspective, solving the puzzle of why banks combine lending and deposit-taking operations under one roof.     

Shadow Banks and Macroeconomic Instability

We develop a macroeconomic model in which commercial banks can offload risky loans to a “shadow” banking sector, and financial intermediaries trade in securitized assets. The model can account both for the business cycle comovement between output, traditional bank, and shadow bank credit, and for the behavior of macroeconomic variables in a liquidity crisis centered on shadow banks. We find that following a liquidity shock, stabilization policy aimed solely at the market in securitized assets is relatively ineffective.     

银行业危机:金融泡沫视角的分析

自20世纪80年代以来,银行业危机爆发越显频繁。然而,通过对银行业危机内部形成机理分析可以发现,银行业危机的爆发其实是伴随着金融泡沫的形成与破灭这一过程的。在金融泡沫的形成过程中,银行往往会给一些高风险行业发放贷款,从而增加银行经营风险;而在金融泡沫破灭之后,这将直接或间接地导致银行产生大量的不良贷款,从而使银行业危机最终爆发。因此,我国应尽快化解国有商业银行的不良资产;完善银行微观治理结构;建立和完善金融监管机制。     

Financial crises,bank risk exposure and government financial policy

A macroeconomic model with financial intermediation is developed in which the intermediaries (banks) can issue outside equity as well as short term debt. This makes bank risk exposure an endogenous choice. The goal is to have a model that can not only capture a crisis when banks are highly vulnerable to risk, but can also account for why banks adopt such a risky balance sheet in the first place. We use the model to assess quantitatively how perceptions of fundamental risk and of government credit policy in a crisis affect the vulnerability of the financial system ex ante. We also study the effects of macro-prudential policies designed to offset the incentives for risk-taking.     

准备金率和资本充足率影响商业银行贷款规模的机制分析

货币银行传统理论认为:货币当局以准备金率控制贷款规模,以资本充足率控制贷款风险。本文从分析准备金与资本充足率对贷款规模的约束机制入手,引入银行资产负债表模型,证明银行贷款规模主要受资本充足率影响。研究结论是:准备金率对贷款规模的控制作用已经弱化,资本充足率对贷款规模的控制作用趋强。     

A model of unconventional monetary policy

We develop a quantitative monetary DSGE model with financial intermediaries that face endogenously determined balance sheet constraints. We then use the model to evaluate the effects of the central bank using unconventional monetary policy to combat a simulated financial crisis. We interpret unconventional monetary policy as expanding central bank credit intermediation to offset a disruption of private financial intermediation. Within our framework the central bank is less efficient than private intermediaries at making loans but it has the advantage of being able to elastically obtain funds by issuing riskless government debt. Unlike private intermediaries, it is not balance sheet constrained. During a crisis, the balance sheet constraints on private intermediaries tighten, raising the net benefits from central bank intermediation. These benefits may be substantial even if the zero lower bound constraint on the nominal interest rate is not binding. In the event this constraint is binding, though, these net benefits may be significantly enhanced.     

Banking crises,financial dependence,and growth

This paper contributes to the literature that analyzes the mechanisms linking financial shocks and real activity. In particular, we investigate the growth impact of banking crises on industries with different levels of dependence on external finance. If banks are the key institutions allowing credit constraints to be relaxed, then a sudden loss of these intermediaries in a system in which such intermediaries are important should have a disproportionately contractionary impact on the sectors that flourished due to their reliance on banks. Using data from 38 developed and developing countries that experienced financial crises during the last quarter century, we find that those sectors that are highly dependent on external finance tend to experience a substantially greater contraction of value added during a banking crisis in countries with deeper financial systems than in countries with shallower financial systems. Our results do not suggest, however, that on net the externally dependent firms fare worse in deep financial systems.     

Bank credit risk and macro-prudential policies: Role of counter-cyclical capital buffer

This paper investigates the impact of macro-prudential policy (proxied by the counter-cyclical capital buffer (CCyB)) on bank credit risk during uncertain times, as banking sector stability is crucial in promoting financial intermediation. Using a unique daily data set consisting of 4939 credit default swaps (CDS) of 70 banks from 25 countries over the period 2010–2019, we find that CCyB tightening decreases bank-level CDS spreads, while CCyB loosening increases CDS spreads. This heterogeneous effect of CCyB arises due to its asymmetric effect on the capital ratio (i.e., the equity-to-total assets ratio) of banks. Tightening CCyB significantly increases capital, whereas loosening CCyB does not impact capital. Thus, the risks that emanate from the banking sector during periods of heightened uncertainty and financial distress can be significantly dampened when CCyB regulation is enabled. Consequently, macro-prudential policies for banks to hold higher levels of capital during good times are justified to contain financial market risks during downturns.