Capital Requirements Constrain Money Creation by Banks

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Commercial banks’ ability to create money is constrained by capital. When a bank creates a new loan, with an associated new deposit, the bank’s balance sheet size increases, and the proportion of the balance sheet that is made up of equity (shareholders’ funds, as opposed to customer deposits, which are debt, not equity) decreases. If the bank lends so much that its equity slice approaches zero – as happened in some banks prior to the financial crisis – even a very small fall in asset prices is enough to render it insolvent. Regulatory capital requirements are intended to ensure that banks never reach such a fragile position. We can argue about whether those requirements are fit for purpose, but to imply – as Williams does – that banks can lend without restraint is simply wrong. There is no "magic money tree" in commercial banking.

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