Transcription
I am professor of banking, and, um, I've also, before becoming professor of banking, studied banking. And so, I realized that there are actually three theories of banking. The one that's currently dominant, the one that you learned, is banks as financial intermediaries. They gather deposits, and they then do their analysis of borrowers, and then they lend out these deposits based on their analysis and risk management and whatever.
But there's an older theory, which was dominant until the 1960s, and this is known as the fractional reserve theory of banking. Yeah, and this one says that, similar to the financial intermediation theory, it says that yes, each individual bank is a financial intermediary, just as you heard. They gather deposits, they lend it out, but in aggregate, there's something happening in the banking system collectively. As the banks interact with each other, money is being created. It's kind of intriguing. There's an interesting point, and certainly that's when students start to listen: money creation by the banks, but only in aggregate. It's through some kind of diffuse process, which is kind of hard to understand. There's the money multiplier formula and so on.
But that's only the second theory of banking. And there is a third theory, and that one is the oldest. That one was dominant until the fractional reserve theory took over in the 1920s, so the sort of, um, yeah, 30 years before the 1920s. And this one is called the credit creation theory. Now, this one is the most shocking. This one says, "Wrong. Banks are not financial intermediaries. They do not gather deposits and lend them out." They do, or that, as the fractional reserve theory says, because for fractional reserve, ultimately, you need excess reserves at the central bank. You know, as we observe now, there's excess reserves, and that's the money you can lend. That's what the fractional reserve theory says is happening now. It's a typical fractional reserve theory argument: "Oh, the banks have excess reserves at the central bank. They should really be lending this to companies. Then the economy is held." And the fractional reserve theory says that yes, when you have extra excess reserves, you can lend it.
But the credit creation theory, um, the third theory, the oldest theory, says it's that's wrong. Both of the other theories are wrong. Banks are not financial intermediaries. They're not financial intermediaries on an aggregate basis, and not on an individual basis. Banks are different. Banks are creators of money, but not just in aggregate, as the fractional reserve theory admits. Actually, this happens individually. Each individual bank, when it gives out a loan, this has nothing to do with deposits, or very little, only indirectly to do with deposits. It's not lending out deposits. It is creating new money, which is added to the money supply, and that's the money that is being lent out. It's newly created money.
So, these three theories, and they've existed at least for, well, for the last century. You can find people, you know, arguing, um, over this, and, you know, different proponents. There's famous people supporting each of these three theories. There's actually some famous economists who support sequentially all three. And John Maynard Keynes is an example of this. He, when he was young, supported the credit creation theory. He sort of went chronologically, and then he was a key proponent of the fractional reserve theory, and then he became, in his older days, he became a key proponent of the financial intermediation theory. So he became wronger and wronger in his analysis. But yes, so we have three theories. And I thought, "Well, hang on, what's the scientific thing to do? Why do we even have to argue?" And of course, I already had a view based on my empirical observation. But I also thought, "Look, I shouldn't need to argue with other economists about this. We just need an empirical test. We need empirical study of the three theories of banking."
And again, it was amazing that in the 5,000-year history of banking, because banking is as old as Babylonia, where there were banks in the modern sense: cashless transactions, loans, collateralized, uncollateralized, you know, international FX, all there. But in this 5,000-year history of banking, of course, the bank has always wanted to keep the nuts and bolts and the mechanics of banking somewhat hidden. And as a result, we've never had such an empirical test bringing it out into the open. How do banks actually work? And so, I conducted the first such empirical test. In fact, there are two papers on this. If you Google "Can banks individually create money out of nothing?", you will immediately get it. It's one of the most downloaded papers of all Elsevier scientific journal articles. The other one is called "Lost Century in Economics" and then there's a subtitle, but you also quickly get it. These are the two empirical tests.
And the conclusion is: banks are not financial intermediaries. They do not lend out deposits. I did this by actually going to the bank. And then, well, I had to look for a bank that would collaborate with me in this. And I told them, "Look, I want to take out a real loan, but I want to look inside your system, look into your accounting as I take out a loan. We are empirically observing exactly what you're doing." Because the three theories of banking are different in one respect. That's the biggest difference, and that's where you can see and test which one is right. It is the source of money. When the bank lends out, banks give credit, where does the money come from? That will tell you which theory is correct. Because the financial intermediation theory says, "Oh, we're using deposits." The fractional reserve theory says, "Are we using excess reserves at the central bank?" Which is what they're saying now with this, you know, argument: "We need negative rates because that will then drive the money from the central bank to lending." Or is it the credit creation theory, which has big implications for everything and for policy, and would actually also explain a lot of the puzzles?
So, I did the test, and the conclusion is, as I borrowed this money for real, 200,000 euros, they were a little bit nervous because they, because I insisted, "No, I actually have to withdraw this money. It's otherwise it's not real." And that was the point. They were slightly concerned about, "Maybe this is all just a big hoax by a fraudster trying to run away with 200,000 euros." Um, I didn't. I repaid it fairly quickly, but only after we had all the documentation of the accounting and, you know, administrative operational steps.
In conclusion, as I got the money, they did not draw down any deposits. In fact, total deposits increased initially by my loan amount. Secondly, they did not use their reserves, sorry, by the same amount. Well, if you can find and separate it in that moment, because banks are, you know, a live organism, there are so many transactions taking place. If you could, in theory, hold everything constant, it would be by the same amount. And I show this in the second experiment, which is more controlled. But also, it's not excess reserves. The reserves were not touched at all. They didn't even bother to ask, "Do we have enough reserves?" So that also was rejected. And where did the money come from? It was newly invented out of nothing.
The explanation for those who have never heard this or are not aware of this, um, the easiest explanation is if you look at it from a legal perspective. The law of banking, the legal status of what a bank does, that gives it away. And the best place to start with that is the mother country of banking, because modern banking started in England in its modern and formalized version, where also the legal aspects were clarified in the 17th century City of London. And the legal status is very clear. Now, economists, just to remind ourselves, what do economists say about banks? They say, and I just, you know, this is above the three theories of banking in general, what is a bank to an economist? It is, um, a deposit-taking institution to take deposits, okay? That's a reasonable description. That's how economists describe it.
But when you study the law, it becomes very clear that this is not true. And at law, banks do not take deposits, and banks do not lend money. Why is that so? The first thing that becomes clear is the status of bank deposits at law. When we use the word "deposit," "I've got deposits at the bank," and "your money at the bank," we're talking as if that money belongs to us. Why? Well, we've deposited it there. We've given it to the bankers, and it's like held in custody by the bank. In fact, when you invest in stocks and shares, you open an account with a stockbroker, and the money is held in custody. That's the sort of principle we have in mind when we talk about a bank deposit. So we're in control, it's our money, and it's held by the bank as a bailment at law, or in custody.
But the law is very clear: that's not what a bank deposit is. In fact, surprisingly, there is no such thing as a bank deposit at all. It has no legal status. But when you do what we call "bank deposit," that at law is simply a loan we've given to the bank. So deposits are loans we've given to banks. That's what a deposit is. Now, now, then what is a loan that the bank gives? Well, at law, the bank, the law says the bank does not lend money. At law, the bank is in the business of purchasing securities. It's purchasing securities. Namely, when you go to the bank, you want to borrow money, or when I did this for this experiment, correct? Yeah, it is the loan contract that you've signed, in which you promised to repay this money. It's your promise. It's a promissory note or an IOU, as they say in the US, yeah, which is a debt contract, and it's a security you've issued. And the bank is in the business of purchasing that. That's what they're doing. So they're not lending your money, they're purchasing it.
And now that's the moment where you probably say, "Okay, that's too much detail. Just give me the money." Any borrower will say, "Okay, that's lots of technicalities. I just need the loan. I need the money." And the banker will say, "Well, yes and no." Well, the banker will probably say, "Yes, yes, you will find it." If the bank is careful and wants to say it correctly, they would say, "You'll find your funds in your account with us." Which, on the bank balance sheet, you know, the purchase of the loan contract is on the asset side. They've purchased your IOU, your debt instrument, and they've increased the assets now by the same amount. Say it's a 200,000 euro loan, that's the loan contract they've purchased. So the balance sheet rises, lengthens by 200,000 euro. And they say to you, "You'll find the money in your account."
Now, what is the account where are these deposits, in inverted commas, held? There's a liability. The liabilities for the bank, it is our claims on banks. And the bank says, "Well, obviously, you know, you're borrowing money from us, you have to open an account with us, and that's where you'll find the money." But actually, it is simply deposit accounts are, as I said earlier, money that the bank owes to us. We've lent it to the bank. Yeah. So they're now crediting the borrower by debiting themselves and noting this liability. Because essentially, bank deposits is just a record of the bank's liabilities to us. Because the loan contract says also they have to give you money. They have a liability. And it's that liability that people are using as money. In other words, the accounts payable liability that arises from the loan contract is now recorded on the liability side of the bank balance sheet as, and this is the slight incorrect, well, slight of hand, where they're slightly, you know, this is a slight trick. They're renaming this type of liability, accounts payable liability, that's really what it is, as a liability of another type known as customer deposit. Because, nope, it's it's that's really misleading because no customer has deposited this money. Certainly the borrower hasn't, that's why they went to the bank in the first place. And no one else has also deposited it. They just write the figure. That's how the money supply is created. As the bank pretends the borrower has deposited the money, and other people can't tell the difference. Is this really deposited, or is this invented by the banks? And that's the money supply. And this is how 97% of our money supply is created.
And so, um, this is what the law says. And this is also, obviously, what the credit creation theory of banking had been saying. In fact, one of the first voices on this in the 19th century, who described this quite correctly, was, surprise, surprise, a lawyer who knew about the legal status, which is much, much clearer. So the money that we have at the bank, in bank deposits, is not our money. It's the wrong terminology. We don't have money at the bank. The bank owes us money. We have a claim, and that's it. We've lent it to them. And at law, when you lend something, the borrower has full control, has possession, they own the money. It's their money. We just have a claim, a chosen action, the lawyers say, that we need to enforce. But that's the process. It's not our money. It's the bank's money. And so that's how the money supply is created by the banks inventing these fictitious deposits.