Banks' Right to Invent Deposits and Thereby Create Money

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The subsequent text consists of excerpts from Richard Werner's paper "How Do Banks Create Money ..." in which he demonstrates that banks do not intermediate savings to create loans but take advantage of a legal exemption that allows them to extend loans and ipso facto generate fictitious deposits, thereby lengthening their balance sheet and creating new money ex nihilo. 

By contrast, non-bank lending involves an exchange of assets, whereby an asset item like "bank reserves" is drawn down while being replaced with a commensurate new claim on the asset side of the balance sheet: the loan:

In order to identify the difference in accounting treatment of the lending operation by banks, we adopt a comparative accounting analysis perspective. For this purpose, we compare the accounting of a loan extended by (a) a non-financial corporation (NFC, such as a manufacturer extending a financial loan to a supplier), (b) a non-bank financial institution (NBFI, such as a stock broker extending a margin loan to a client) and (c) a bank. Table 1 shows the changes in balance sheets of a new loan of $100 m, after its issuance and remittance.

Table 1



This table shows how accounting conventions handle the granting and disbursing of a loan by different types of firms: a non-financial corporation (NFC), a non-bank financial institution (NBFI, e.g. a stock broker), and a bank. In this and the following tables, only the change in balance sheet items is shown. As can be seen, something is different in the case of the bank.


When the non-financial corporation, such as a manufacturer, grants a loan to another firm, the loan contract is shown as an increase in assets: the firm now has an additional claim on debtors — this is the borrower's promise to repay the loan. The lender purchases the loan contract, treated as a promissory note. Meanwhile, when the firm disburses the loan (and hence discharges its obligation to make the money available to the borrower), it is drawing down its cash reserves or monetary deposits with its banks. As a result, one gross asset increase is matched by an equally-sized gross asset decrease, leaving net total assets unchanged. 

In the second case, of a non-bank financial institution, such as a stock broker engaging in margin lending, the loan contract is the claim on the borrower that is added as an asset to the balance sheet, while the disbursement of the loan – for instance by transferring it to the client or the stock exchange to settle the margin trade conducted by its client – reduces the firm's monetary balances (likely held with a bank). As a result, total assets and total liabilities remain unchanged. 

While the balance sheet total is not affected by the granting and disbursement of the loan in the case of firms other than banks, the picture looks very different in the case of a bank. While the loan contract shows up as an increase in assets with all types of corporations, in the case of a bank the disbursement of the loan takes a different form from that of the other firms: it appears as a positive entry on the liability side of the balance sheet, as opposed to being a negative entry on the asset side, as in the case of non-banks. As a result, it does not counter-balance the increased gross assets. Instead, both assets and liabilities expand. The bank's balance sheet lengthens on both sides by the amount of the loan (see the empirical evidence in Werner, 2014a, Werner, 2014c). Thus it is clear that banks conduct their accounting operations differently from others, even differently from their near-relatives, the non-bank financial institutions. 

What precisely, however, causes this very different treatment of lending on bank balance sheets as opposed to its treatment by all other types of firms? In order to answer this question, the comparison of the above accounting information is insufficient. It is necessary to gain further, more detailed insight into the accounting operations shown in Table 1. Specifically, what is it that enables banks to discharge their loan without drawing down any assets (as both the financial intermediation and fractional reserve theories of banking had indeed maintained, erroneously)?

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Breaking the act of lending into two steps, it was possible to isolate just what makes bank accounting different from the accounting of non-financial firms and non-bank financial institutions, and precisely how banks manage to create money newly. The act of signing the loan contract and purchasing it as a promissory note of the borrower without yet making the borrowed funds available to the borrower (Step 1) has the same accounting implications for banks, non-banks and non-financial corporations alike. In all cases, the balance sheets lengthen, as an asset (the loan contract) is acquired and a liability to make money available to the borrower is incurred (accounts payable). In Step 2, the lender makes the funds available to the borrower. The fact that in Step 2 the bank is alone among firms in showing the same total impact on assets and liabilities as everyone else at Step 1, when the money had not yet been made available to the borrower, demonstrates that the bank did not actually make any money available to the borrower. This means that the bank still has an open ‘accounts payable’ liability, as it has not in fact discharged its original liability. What banks do is to simply reclassify their accounts payable items arising from the act of lending as ‘customer deposits’, and the general public, when receiving payment in the form of a transfer of bank deposits, believes that a form of money had been paid into the bank. As a result, the public readily accepts such ‘bank deposits’ and their ‘transfers’ to defray payments. They are also the main component of the official ‘money supply’ as announced by central banks (M1, M2, M3, M4), which is created almost entirely through this act of re-classifying banks' accounts payable as fictitious ‘customer deposits’. No wonder an expert in bank accounting has warned me, upon presentation of my analysis, that I must never use the concept of ‘accounts payable’ in the context of bank accounting! In my view, the only reason why one would not wish to use it as presented in this paper is because through this device the truth is revealed for all to see.

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The ‘lending’ bank records a new ‘customer deposit’ and informs the ‘borrower’ that funds have been ‘deposited’ in the borrower's account. Since neither the borrower nor the bank actually made a deposit at the bank — nor, in connection with this transaction, anyone else for that matter, it remains necessary to analyse the legal aspects of bank operations. In particular, the legality of the act of reclassifying bank liabilities (accounts payable) as fictitious customer deposits requires further, separate analysis. This is all the more so, since no law, statute or bank regulation actually grants banks the right (usually considered a sovereign prerogative) to create and allocate the money supply. Further, the regulation that allows only banks to conduct such creative accounting (namely the exemption from the Client Money Rules) is potentially being abused through the act of ‘renaming’ the bank's own accounts payable liabilities as ‘customer deposits’ when no deposits had been made, since this is also not explicitly referred to in the banks' exemption from the Client Money Rules, or in any other statutes, laws or regulations, for that matter.

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In the UK, the cradle of modern banking, financial regulations, specifically, the so-called ‘Client Money Rules’ (FCA, 2013), 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 ...

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But not banks, which are exempted from "Client Money Rules"

It follows then that what enables banks to create credit and hence money is their exemption from the Client Money Rules. Thanks to this exemption they are allowed to keep customer deposits on their own balance sheet. This means that depositors who deposit their money with a bank are no longer the legal owners of this money. Instead, they are just one of the general creditors of the bank whom it owes money to. It also means that the bank is able to access the records of the customer deposits held with it and invent a new ‘customer deposit’ that had not actually been paid in, but instead is a re-classified accounts payable liability of the bank arising from a loan contract.