In this article we describe how money is created by credit institutions (e.g., commercial banks, savings banks, credit unions, etc.).
Misconceptions vs Reality
“The process by which money is created is so simple that the mind is repelled. Where something so important is involved, a deeper mystery seems only decent.” — John Kenneth Galbraith
The previous quote captures the current state of affairs pretty well. According to a poll conducted in Austria in 2020, among the 2,000 respondents, 82% believe that money — which was defined in the question as cash and deposits — is created by the central bank (Kraemer et al. 2020). Of course, the correct answer is that private banks — or credit institutions — are responsible for the creation of 90–97% of our money stock. Only 12% of respondents knew this.
Werner’s empirical test
We know this to be a fact. This is because in 2014, Prof. Richard Werner (Chair at Valhalla Network) carried out an empirical test to prove the obvious (see Werner, 2014). He was allowed, by the kind cooperation of the staff of a small but fully-licensed bank in lower Bavaria, Germany, to carry out a ‘live loan test’. The experiment went as follows: Werner took a loan from the bank of €200,000 and inspected the accounting entries that were recorded on the bank’s internal core banking system software. The goal was to determine: where did the funds for the loan come from?
What Werner found is as follows: the bank, when giving the loan, credited the funds to the borrower’s (Werner’s) newly opened current account. The internal accounting system revealed that these funds had not been subtracted from any other customer account, nor had the funds been transferred from any of the bank’s own accounts (e.g., reserves with the central bank or a nostro account with a correspondent bank). The bank had simply written up the current account (a liability of the bank) and the loan (an asset of the bank).
In other words, new funds were created ‘out of thin air’. The funds in the account of the borrower did not previously exist, for no record could be found, either inside or outside the bank, of any other account being debited (the balance reduced) to compensate for the new funds that appeared on the borrower’s current account.
Of course, during the day the loan was made, many other things were going on, as a bank balance sheet is a ‘dynamic entity’ always busy with activity (e.g., customers making deposits, withdrawing funds, transferring money to other accounts, and so on). But Werner was able to isolate the relevant entries, and after some computations, he was able to show what I’ve just described.
Here’s a simplified version of what he found. When granting the loan, the credit institution simply recorded a financial liability to Werner (a promise to pay) in the form of a current account, and a loan asset. Werner’s balance sheet looked like the mirror image of that of the credit institution. The funds in the current account were newly created, without any other account either internal or external to the bank having been debited. At that moment, the total stock of money in the economy had increased by €200,000.
In contrast, a non-bank financial institution (NBFI) like a money market fund (MMF) would disburse loaned funds in quite a different way. The balance sheets below show an example of a MMF buying €1mn worth of government bonds in the primary market (directly on the issuance auction). To settle the transaction, the MMF would be debited its current account (its asset) and the government credited its (its asset). The government would register a liability (the bonds) to the MMF, and the MMF would register the bonds as its financial asset (a claim for repayment on the government). As a result of this operation, the total stock of money in the economy would remain unchanged, for funds would simply have been moved from one account to another by transfer.
Is this counterfeiting or fraud?
Although for some people this may intuitively feel so, it is not. Just like you are allowed to issue financial liabilities (that is, to borrow, e.g., by issuing a mortgage loan liability), credit institutions are allowed to issue current account liabilities — it is their business to do so. A credit institution is defined in EU regulations as:
“an undertaking the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account”. 
We ordinarily accept payments from employers, customers, friends, by allowing them to transfer funds into our current account. It is not surprising, then, that we also accept in payment those very account balances when credit institutions offer them to us in discharge of their payment obligations, e.g., when they grant loans to us.
In contrast, what a counterfeiter does is quite different. When a counterfeiter replicates €20 banknotes with such perfection as to appear indistinguishable from official ones, it has effectively created an asset for himself ‘out of nothing’, which makes him wealthier. When a bank creates deposits, on the other hand, it does so by recording a financial liability to someone, often to the borrower, and the bank’s net worth remains unchanged. Therefore, the constraints both types of ‘money creators’ face are, at a minimum, of a different nature. The counterfeiter is primarily constrained by his capacity to conceal his activity from the police and to get hold of the necessary raw materials, tools and machinery in the black market. The bank, on the other hand, is constrained by factors related to profitability (i.e., whether there is sufficient demand for loans by creditworthy borrowers), interest rates, capital ratios (Tier1 ratio, leverage ratio) and liquidity ratios (NSFR, LCR) set by regulatory authorities (Basel III/IV), collateral eligibility, and so on.
Advantages and Disadvantages For Banks
The capacity to issue current account liabilities comes with advantages and disadvantages.
One clear advantage is the fact that, since by definition credit institutions are borrowing from current account holders, current accounts constitute a cheap source of funding for banks. This can be seen in the next two figures. Figure 4 computes the median interest rate paid on current accounts held by households across the 19 euro area countries over the period of 2003–2022. As can be appreciated, the interest rates are very low. Credit institutions are borrowing from households at very low cost.
Figure 5 shows the spread between the rate paid on current accounts of households and the 12-month EURIBOR, which measures the interest rate paid by banks to borrow from each other for a maturity of 12 months. The figure shows a negative spread, which means that it is cheaper for banks to borrow from households short-term than it is to borrow from other banks (and remember, interbank borrowing tends to be one of the cheapest sources of borrowing in most economies).
In contrast, an NBFI seeking to fund the acquisition of a longer-term yielding asset would need to first issue a non-current liability (say and 1-month repurchase agreement, or “repo”) to raise the necessary funds, and only afterwards use those funds to purchase the asset.
Credit institutions, on the other hand (as we have seen in Figure 2), can effectively skip the first step, and fund the asset (e.g., a loan) directly by issuing funds themselves, in effect creating their own funding on the spot.
When you look at it closely, what the credit institution in Figure 1 is doing is discharging its obligation to disburse the loaned funds by issuing another payment obligation of a slightly different kind, namely, a current account. The credit institution is, in effect, saying “We could disburse the funds in cash (banknotes), but since the amount involved is quite high, I hope Mr. Werner will agree that this is too cumbersome and that it is far more advantageous if you re-deposit the banknotes with us, and we credit your account with those funds”.
Strictly speaking, the credit institution does not pay up, it issues a promise to pay, and the borrower is happy to accept that tender and declare the payment settled — why? Because it is a convention that current accounts are used to discharge payment obligations.
This mindboggling trickery has rightfully been called the “alchemy of banking” (Mehrling, 2017), and this alchemy brings very tangible benefits to the banking system in the form profits from what amounts to “electronic seignorage”. Says the Bank of International Settlements:
“In a two-tier banking system, income from issuing money partly accrues to commercial banks” (BIS, 2018, p. 26)
Issuing what is perhaps one of the most liquid financial instruments that exist — that is, current accounts — doesn’t come without costs. This is because current accounts have not pre-specified maturity, that is, account holders can demand their funds back at any time without giving prior notice (this is what “current” means, that is, it is a debt that is presently due, actionable or callable “on demand”, i.e., with a couple of swipes in your bank app). Credit institutions, by their capacity to grant credit, seek to put the deposited funds to use, and invest in earning assets like loans and bonds, and keep only a fraction of the funds deposited in the form of balances with the central bank, instantly available to meet withdrawals or transfers from customers.
This is, in fact, the art of banking: striking a balance between being able to meet all contingent demands for repayment by current account holders, and investing some of the funds deposited in yielding assets like loans and bonds. By this art, credit institutions allow the existence of what appears to be a paradox, that of “double usability”. That is to say, account holders feel they can use their funds instantly without giving prior notice to banks, but so can credit institutions use the funds deposited by account holders to grant credit.
To put it into perspective, imagine you were set up a business that consisted of borrowing salt from friends, and signing and agreement with them which states that they can ask for their ‘salt deposits’ at any time, and you’ll have to be able to deliver them the equivalent killograms of salt they deposited. Furthermore, imagine you pay them some interest in the form of an additional % of salt every month (payment in kind). Unless you were able to use the salt that your friends have deposited for profitable purposes, you would be out of business very soon. One option would be to lend salt to third parties for longer periods, say, for 1 year, with the agreement that they will return to you the equivalent amount of kilograms of salt one that period expires (“salt loans”).
To be profitable, you would have to set up a system able to predict with some reliability the fraction of friends that would, at any given time, show up demanding their salt back, so that you wouldn’t commit salt long term (salt loans) in amounts beyond that which salt depositors would demand from you at any given day.
This is the essence of ‘fractional reserve banking’.
As can be imagined, this is an operationally challenging task. Banks are in no small regard in the business of managing highly liquid liabilities that can be redeemed on demand. To give a sense of this, Figure 6 shows the turnover or ‘velocity’ of current accounts. On average, in the EU, the value transacted using current accounts is around 30 times the value in those accounts. This means that a person holding on average €10,000 will make €300,000 worth of transactions over the course of 12 months, or €25,000 every month. Although not all payments will lead to deposit outflows (for some are settled ‘in-house’ between two customers of the same bank), this high level of turnover means that banks have a lot of deposits and withdrawals to deal with every day.
In reality, however, unlike salt, balances in current accounts are indispensable for the economy to function, and most people can’t go about their day without them (think of your the direct debits you have set up in your account to pay your bills, for example). This is why, in practice, current accounts are quite sticky, meaning, they are a reliable source of funding. This is why credit institutions don’t pay much interest on them — they don’t feel they have to to attract deposits.
Do banks “lend money and take deposits”?
Although it seems intuitive and we hear this expression commonly, strictly speaking, it is wrong to describe banks as ‘lending money’. The reason is straightforward: you can’t lend a liability, and liabilities are all that non-banks (e.g., households) are left holding after they borrow from credit institutions. Banks only lend to each other (they lend reserves at the central bank, their asset), but not to non-banks. What they do when they transact with non-banks is to issue a promise to pay (a current account liability), which the bank does not fully honour throughout the entirety of the loan.
Similarly, it is wrong to describe banks as ‘taking deposits’, if by that we mean what we seem to mean when using that expression, i.e., that the bank is holding the funds as a custodian, bailee, or trustee. In actual practice, the deposit contract (and hence the current account contract, the Terms and Conditions of which you accept when opening an account) is very clearly a contract of debt, and the depositor is a creditor to the bank, the bank is a debtor to the depositor. Legal scholars are unanimous on this point, but this will be explored in a separate article. For now let us simply quote Justice Lewinson, who observed in FSA v. Anderson (No 1) (2010) that:
“to call something a loan is not inconsistent with its being a deposit”