THE BANK CREDIT CREATION PROCESS / MACLEOD FINANCE

The bank credit creation process

Banks simply lend credit into existence. Ideas that they are simply financial intermediaries, or that they lend deposits are incorrect. This article explains why.

ALASDAIR MACLEOD

Introduction

Economists of all disciplines are seemingly unaware of the credit creation process. 

In their theoretical discourses of money and credit they assume that banks are intermediaries, taking in deposits and lending them out. 

Consequently, they are seen to have little consequence in economic analysis.

The exception, perhaps, is the Austrian school which posits that bank credit is destabilising. 

But even there, Ludwig von Mises in his The Theory of Money and Credit appears confused on this issue, writing,

“The activity of banks as negotiators of credit is characterized by the lending of other people's, i.e. of borrowed money. 

Banks borrow money in order to lend it; the difference between the rate of interest that is paid to them and the rate that they pay less their working expenses constitutes their profit on this kind of transaction”[i]

In a youtube interview of Richard Werner by Tucker Calson, Werner correctly identified the process of bank credit creation. 

It was subsequently followed by a commentary on this topic by two senior economists of the Austrian School, Bob Murphy and Jonathan Newman to whom the concept appeared to be new to them, having been schooled in von Mises’s analysis.

In this article I shall explain why the fractional reserve theory is incorrect, and Werner’s explanation of credit creation is what actually happens. 

For the avoidance of doubt and to clarify the position, we must make two important definitions at the outset:

· Gold is money, and everything else is credit. 

Gold has no counterparty risk and is final settlement, extinguishing credit. 

Credit is always on the other side of a balance sheet to a debt obligation.

· Banks are dealers in credit.

Defining credit

When both Werner and the Austrians talk of credit as money, they are factually incorrect. 

The difference was set out in Justinian’s Pandects in Roman law, which is the basis of common law in all the empire’s successor nations, their colonies, and dominions including the USA. 

No amount of gold ownership bans, executive orders, or confiscation alters this fact. 

Technically, gold is corporeal money, and credit which has no physical existence is incorporeal.

Gold needs no further definition. 

Credit exists in many forms, but it is always an obligation for future settlement. 

It is ubiquitous and governs all our business relationships, gold rarely being used in settlement. 

A tradesman will be employed in his work, extending credit to his customer until the work is completed satisfactorily when he expects payment to be made. 

Unless he is paid in advance, an employee will provide his skills extending credit to his employer until the end of the week, or month, when he also expects to be paid.

Bonds are an obligation to pay interest and repay the principal under the terms of a loan agreement or prospectus. 

Even shares in a company are credit, because they represent a commitment by the company’s management to deliver an income stream or to accumulate value in the company in trust for the shareholder. 

Everything works on credit, where payment is a promised obligation.

All financial instruments are credit. 

That they have value is again down to Justinian’s Pandects, which incorporated the findings of two Roman jurors, Ulpian and Julius Paulus in the second and third centuries AD. 

These two jurors ruled that a credit could be exchanged without a debtor’s agreement. 

No transfer, no value: even bad debts are bought and sold, and modern capital markets could not exist without their rulings.

It is vital to understand the all-embracing role of credit in an economy. 

It goes far beyond banking. 

Anyone can and does create credit, subject to his or her credibility.

Credit is wrongly termed money by economists and statisticians alike. 

A national currency is a promise to pay in gold and appears as such on the issuing central bank’s balance sheet as a liability. 

The best it ever was was a money substitute; today it is only fiat. 

Checking and deposit accounts with commercial banks are credit denominated in a national currency, representing a bank’s promise to pay its customers.

In practice, money in the form of gold coin or bars is almost never used as circulating media. 

When you pay someone with a bank deposit, it is either in cash which is a central bank’s liability, or by cheque or deposit-transfer from your bank to your creditor’s bank. 

In days of gold standards, nations and traders would settle trade imbalances in gold particularly when there was credit risk perceived in holding a foreign currency. 

But that finally ceased in 1971 when the Bretton Woods agreement was “suspended”.

How banks create credit

Werner referred to the Goldsmiths in London as the originators of modern banking. 

In fact, banking was invented by the Romans, but the basis of credit creation today was in London in the seventeenth century during the civil war (1642—1651). 

Goldsmiths routinely stored gold and silver for customers, issuing receipts as evidence of ownership and they soon discovered that these receipts changed hands as a more convenient form of payment than gold itself.

The goldsmiths then found that they themselves could issue credit based on customers’ gold so long as the customer was prepared to relinquish ownership in return for interest at 6% before ownership was returned on demand.

It should be noted that the interest paid by a goldsmith to a customer came from the goldsmith’s general profits and was by way of a dividend and not interest earned on his deposit by lending it out. 

Presumably, it was this error in understanding which led economists to incorrectly believe that deposit-taking was the basis of fractional reserve banking.

The goldsmiths soon found that they could safely issue more loans than they had gold to back them, based on a calculation of the likelihood of depositing customers demanding the return of their gold. 

It was from this practice that modern banking evolved, with bank credit extended to merchants and businesses being entirely responsible for financing the rapid development of Britain’s industrial revolution.

As dealers in credit, banks were doing what we all do by creating credit and obligations in our day-to-day business activities. 

They would simply offer credit at interest to a customer they deemed creditworthy , crediting his account to enable him to draw down the loan. 

The simplified illustration below shows how this works in practice, starting with the bank’s own capital:

The bank creates the loan and, in its books, a matching deposit. 

Notice how the bank does not use its own capital. 

By creating the loan, the bank doubles its own capital from interest earned in this example.

Importantly, as the customer draws down on the loan, the balance on his deposit reduces by the same amount exactly. 

The loan is drawn down in order to pay the customer’s own creditors who may or may not bank with the same bank. 

This creates deposits in other names some elsewhere, leading to an imbalance between the bank’s liabilities and assets. 

When this imbalance is not offset by other customer’s movements, the bank either has a surplus on its assets to lend to other banks, or a surplus on its liabilities which it has to fund from other banks. 

This is the purpose of bank clearing facilities and the function of the interbank market.

To confirm beyond any doubt that credit is loaned into existence, the following is extracted from a paper in the Bank of England’s Quarterly Review of 2014 Q1:

“The vast majority of money held by the public takes the form of bank deposits. 

But where the stock of bank deposits comes from is often misunderstood. 

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. 

In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

“In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. 

Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. 

Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. 

This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.”

It really is that simple.

Why fractional reserve banking is incorrect

Fractional reserve banking assumes that a customer first deposits currency or payment from another bank into his bank. 

The bank then lends most of it, typically assumed to be 90% of the deposit, keeping a reserve of 10% against the possibility of default. 

Hence the term, fractional reserve.

This begs the question as to where the first deposit comes from. 

It can’t come from another bank. 

Presumably, it is currency in the form of notes issued by the central bank.

The story then goes that the 90% is loaned out to be spent by the borrower, ending up as deposits in other banks. 

Other banks then lend out 90% of that. 

By a series of loans through the banking system, the original deposit is said to end up being multiplied nearly nine times through this iterative process.

A moment’s thought will dismiss the multiplier argument, because the closest the banking system can get to lending the entire deposit is only 90% of it, however many banks are involved. 

But it doesn’t stop claims that a money multiplier effect inflates bank credit, as the screenshot below from an article by Princeton University demonstrates:

The error is to not recognise that it is the same credit leant out by banks A to K. 

By the same token, you would say that a $100 banknote circulating from hand to hand increases the money supply by much more than its notional value. 

Obviously, it does not.

In any event, the fractional reserve banking theory is incorrect, as the Bank of England article and its extract above makes clear. 

I covered this point in a film for The Cobden Centre which was premiered at the House of Lords in 2023. 

My contribution starts at 9 minutes, and is confirmed at 8 minutes in by William White, who was an economic advisor to the Bank for International Settlements, having started his career at the Bank of England and spent 22 years at the Bank of Canada.

Richard Werner’s interview by Tucker Carlson threw up other insights in the world of bank credit which are derived from a proper understanding of bank credit creation, but these are beyond the scope of this article.

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[i] See The Theory of Money and Credit, Part 3, Chapter 1, section 2.