The most important feature of banks: credit creation

The most important feature of banks: credit creation
(Extracted from: New Paradigm in Macroeconomics, Richard Werner*, Palgrave Macmillan, 2005; pp. 174-180) (Printable version here) (Italian version here)
http://labancaperbene.be/creditcreation.html

Many economics textbooks that mention banks still acknowledge that they can 'create credit'. However, it appears that the original meaning of this expression has been lost. Those textbooks and authors that mention the words credit creation now give it quite a different meaning. Proponents of the present-day 'credit view' define credit creation as 'the process by which saving is channeled to alternative uses' (Bernanke, 1993, p.50). To Bernanke, 'credit creation' is therefore the 'diversion' or transfer of already existing purchasing power. This is also the understanding of the concept by economists from other persuasions, including monetarists like Meltzer (1995). They all therefore agree in classifying banks as mere financial intermediaries, providing services similar to and in parallel with non-banks and capital markets. [21] Clearly, thus defined, credit creation would not be a unique feature of banking. proponents of the credit view consequently also argue that credit aggregates are not to be considered an 'independent casual factor affecting the economy'; rather,

credit conditions - best measured, by the way, by the external finance premium and not the aggregate quantity of credit - are an endogenous factor that help shape the dynamic response of the economy to shifts in monetary policy. Thus the theory has no particular implications about the relative forecasting power of credit aggregates. (Bernanke and Gertler, 1995, pp. 43ff.)

The representation of banks as mere intermediaries is perpetuated by the explanation of credit creation in textbooks, which depict it as a process of successive lending of already existing purchasing power by intermediating banks. Figure 12.1 reproduces the textbook representation of credit creation: Bank A receives a new deposit of US$100. If the reserve requirement is 1%, textbooks say that the bank will lend out US$99, and deposit US$1 with the central bank as reserve. The US$99 will, however, be deposited with another bank, Bank B, which will also be able to lend out 99% of that amount (US$98.01) . and keep 1% as reserve. This process continues until in the end a total of US$9900 has been lent out. Textbooks represent credit creation as successive financial intermediation. According to this description, a single bank is unable to create credit.
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Deposit 1% - reserve - loanable funds

Bank A US$100 US$1 US$99.00 -->

Bank B US$99 US$0.99 US$98.01 -->

Bank C US$98.01 US$0.9801 US$97.0299 -->

--> ...

--> ...

--> maximum amount eventually lent by the banking system: US$9,900.00

Figure 12.1 The textbook representation of money multiplication
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While even this description does conclude that the overall banking system creates money, credit creation seems to be the result of a diffuse process, in which money 'circulates' in the economy (in line with the concept of 'velocity' in the quantity equation). Most of all, we are told that each bank can only lend 99% of the money deposited with it. This renders banks similar to fund managers who lend out savings deposited with them and thus they are considered mere financial intermediaries. Thus Bernanke's understanding of credit creation as the (successive?) 'channelling of savings' to investors is not far-fetched and most economists do consider banks merely an alternative channel to capital market or other intermediation. [22]

Phillips' (1920) 'money multiplier' concept, linking cash and reserves to bank deposits (the money supply), has not helped in resolving this misunderstanding. However, Goodhart (1989b) has clarified that the multiplier identities suffer from a 'lack of any innate theoretical, or behavioural, content' (p.133) so that accounts of the underlying dynamic processes based on them 'are at best misleading and often wrong'. [23]
Given our empirical observation of banks, such as the London goldsmiths, we conclude that the textbook representation of the actions of each bank is inaccurate (Figure 12.1 ). Firstly, the frequent description of banks' activity as 'lending' is misleading. The definition for this word according to the Oxford English Dictionary is as follow:

lend
• verb (past and past part. lent) 1 grant to (someone) the use of (something) on the understanding that it shall be returned. 2 allow (someone) the use of (a sum of money) under an agreement to pay it back later, typically with interest. (Compact Oxford English Dictionary)

As can be seen, the standard use of the concept of lending implies that an item is physically removed from use by A and instead transferred to the use by B. Lending thus describes a transfer, a diversion of an existing commodity to the exclusive use somewhere else. Given the laws of physics, this usage is only natural. However, the credit extended by banks does not remove purchasing power or claims on resources from anywhere else in the economy. Therefore, strictly speaking, it cannot be described as 'lending'. Banks do not lend money, they create it. Meanwhile, 'credit creation' does not refer to mere 'financial intermediation', as many recent authors have argued. According to the OED:

creation
• noun 1 the action or process of creating 2 a thing which has been made or invented, especially something showing artistic talent. 3 (the Creation) the creating of the universe regarded as an act of God.

create
• verb 1 bring into existence 2 make (someone) a member of the nobility.
- ORIGIN Latin creare 'produce'. (Compact Oxford English Dictionary)

The word 'creation' refers to 'the act of creating' or something that 'has been made or invented'. To create, in turn, is defined as to 'bring something into existence'. If the savings already existed, their transfer could not possibly be called 'credit creation'. Indeed, the etymology of the term 'credit creation' reveals quickly that it originally referred to the new creation of credit (or money) that did not exist before. Instead of referring to the transfer of already existing purchasing power, as Bernanke describes it, many authors recognized that it described the ability of each individual bank to create money 'out of nothing'. [24]
In line with this alternative view, a more accurate presentation of credit creation can be shown in Figure 12.2, which depicts the balance sheet of a bank that receives a new deposit of US$100, recorded as a new liability of the bank. Instead of lending out US$99, as the textbooks tell us, the bank will use the US$100 as reserve with the central bank (entered as asset on its balance sheet). The US$100 can now become the 1% on the basis of which the bank can lend out 99 times as much. Thus this very first bank can grant a new loan amounting to US$9900. The moment the loan is granted, the bank simultaneously increases its assets by US$9900 (the amount of the loan, which is an asset for the bank) and its deposits by US$9900 - the person or company who receives the loan of US$9900 in his or her deposit account - money that can now be spent on transactions. The money the bank has created, US$9900, is 99% of the increase in the bank balance sheet (US$100 new deposit plus US$9900 in loan/deposits). [25] Thus the reserve requirement is met.
Contrary to the standard depiction of the credit creation process in most textbooks, each individual bank creates credit and money when it extends a loan. The original deposit of US$100 becomes the 1% reserve on the basis of which loans 99 times as large can be granted by the same bank. Credit creation has 'lengthened' the bank's balance sheet.
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Balance sheet of Bank A

Step 1 Deposit of US$100 by customer at Bank A

Assets Liabilities
.........US$100

Step 2 US$100 used to increase the reserve of bank A

Assets Liabilities
US$100 US$100

Step 3 Loan of US$9,900 granted, by crediting borrower's bank account with deposit

Assets Liabilities
US$100 US$100
...+ .......+
US$9,900 US$9,900

Figure 12.2 A more accurate representation of credit creation
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The crucial question is: 'Where did the US$9900 come from? The money was not withdrawn by the bank from other uses. It was not diverted or transferred from any other part of the economy. Most of all, although it is shown as a deposit, it was not actually deposited by anyone. The bank simply created the money by writing the figures into its books and the customer's account book. In effect, the bank pretends that its borrower has made a deposit that was not actually made. Unlike the textbook representation, we see that each individual bank can thus create money when it extends a loan.
Showing this truth in textbooks would not only be more memorable, but it would also teach students about what banks really do: they create money out of nothing. The bank just pretends it has the US$9900, credits someone's books with them, and nobody knows the difference.

In the words of Schumpeter (1954),

this alter the analytic situation profoundly and makes it highly inadvisable to construe bank credit on the model of existing funds being withdrawn from previous uses by an entirely imaginary act of saving and then lent out by their owners. It is much more realistic to say that the banks 'create credit', that is, that they create deposits that have been entrusted to them. And the reason for insisting on this is that depositors should not be invested with the insignia of a role which they do not play. The theory to which economists clung so tenaciously makes them out to be savers when they neither save nor intend to do so; it attributes to them an influence on the 'supply of credit' which they do not have. The theory of 'credit creation' not only recognizes patent facts without obscuring them by artificial constructions; it also brings out the peculiar mechanism of saving and investment that is characteristic of fully fledged capitalist society and the true role of banks in capitalist evolution. (p.1114)

Wicksell (1898) also knew that each individual bank could create money:

The banks in their lending business are not only not limited by their own capital; they are not, at least not immediately limited by any capital whatever; by concentrating in their hands almost all payments, they themselves create the money required... (Wicksell, 1907, pp.214-215)

In a pure system of credit, where all payments were made by transference in the bank-books, the banks would be able to grant at any moment any amount of loans at any, however diminutive, rate of interest. (Wicksell, 1907, p.215)

Hahn (1920) emphasized that each bank can create money 'out of nothing' and pointed out the macroeconomic consequences. Schumpeter (1912) referred to this creation of new money as being equivalent to the issuance of new 'tickets' to a game. According to him, the banker is 'not so much primarily a middleman in the commodity "purchasing power", but instead he is 'a producer of this commodity'. Banks issue additional claims on existing resources. Bank credit creation does not channel existing money to new uses. It newly creates money that did not exist beforehand and channels it to some use.
This process was more obvious in the time when there was no central bank with a monopoly on the issuance of paper currency - such as until 1913 in the US. As Goodhart (1989c) stresses, in those days the main liabilities of banks consisted not of deposits, but issued bank notes. The latter increased on a net basis only when more loans were granted. Thus the loans were effectively paid out by printing bank notes.
What makes this 'creative accounting' possible is the other function of banks as the settlement system of all non-cash transactions in the economy. If they so wish, they can extend loans to agents not in the form of withdrawals of funds from elsewhere in the financial system, but by creating the accounting fiction that the borrower has deposited sums with the banking system. Since banks works as the accountants of record - while the rest of the economy assumes they are honest accountants - it is possible for the banks to increase the money in the accounts of some of us (those who receive a loan), by simply altering the figures. Nobody else will notice, because agents cannot distinguish between money that had actually been saved and deposited and money that has been created 'out of nothing' by the bank. [26]
This, then, is also a major distinguishing feature between credit creation in the banking system and the debasement of coinage that was implemented by monarchs in their attempts to increase the money supply: debased coins can be checked and identified as such by experienced traders or professional assayist. However, bank credit creation is impossible to distinguish from 'legitimate' deposits, especially when the majority of transactions already take place in a cashless form via the banking system.
We conclude that the feature of banks as creators of credit (what could equally be called their ability to 'create money') is what renders them special. this feature also explain why bankers quickly became powerful and influential, and could easily expand into various industries, quickly becoming the core of a network of affiliated companies that they either founded or bought up (life is much easier when one has a licence to print money).
Thanks to the special ability of banks to create credit, clear statistical demarcations between various form of fundraising can now be drawn, and an accurate description of the 'money supply' found. Only the central bank (usually allowed to engage in banking business) and banks can create new credit and money and use it to settle transactions directly via the main settlement system of the economy. This differentiates them both on the microeconomic and the macroeconomic level from other agents and renders funding from banks and the central bank 'imperfectly substitutable'. Thus when analysing the economy, banks and the central bank need to be considered separately from others. Government banks, when as usual funded from the Treasury, non-bank financial intermediaries (such as leasing firms, life insurers, mutual funds), households, corporations and the government itself all have one thing in common: they cannot (legally) fulfil this function of banks and the central bank.[27] While banks are credit creators, other financial institutions are financial intermediaries. In this, macroeconomic, sense bank credit can never be perfectly substitutable with intermediated loans. Moreover, in this sense a 'bank credit channel', defined by the creation of new credit, must not only exist, but must also dominate other transmission channels. Banks therefore also cannot but play the pivotal role in every economy.
The example of Figure 12.2, however, remains an example: for in actual practice, banks are rarely, if ever, limited in their lending by the reserve requirement. As Goodhart (1989c) has argued, central banks that set targets for inter-bank interest rates will supply any necessary amount of reserves to banks so that at the time of the monthly deadline for reserve requirements to be met, short-term interest rates do not rise precipitously. This raises issues for monetary policy, namely how bank credit creation can be most effectively controlled, especially when we recognize the existence of imperfect information.
Further, the fact that banks do not have money, but create it, explain why financial fragility is such a major issue in the banking sector. To be able to consider the issue of banking crises, how to respond to them and how to avoid them in the first place, it will next become necessary to render explicit the link between banking and the macroeconomy. This, indeed, should solve the enigma of the link between money and the economy.


Footnotes:

* Professor Richard Werner is Director of International Development and founding Director of the Centre for Banking, Finance and Sustainable Development at the University of Southampton. Richard is also a member of the School of Management's Executive Board, as well as its Advisory Board.

21 'Intermediation' is the process by which banks and other financial institutions tailor the maturity, terms and types of financial claims to meet the demands of households and businesses' (Meltzer, 1995, p.62)

22 The exception are the endogenous money and Austrian economics school of thought, which recognize credit creation.

23 'The bank multiplier shows only that if you can observe the change in the monetary base between two occasions, and can predict the two relevant ratios, then you will be able to predict the change in the money stock with a high degree of confidence. This allow very little to be deduced about the process of adjustment. Indeed, most of the accounts of the dynamic process of adjustment which are derived from the multiplier approach are at best misleading and often wrong' (1989b, p.136). Goodhart also explains that virtually any multiplier can be construed in order to link a larger aggregate to one of its smaller components. He gives the hypothetical example of the 'potato multiplier' of total consumer expenditure to argue eloquently that such exercise do not illuminate behavioural, let alone casual relationships.

24 Evidence for this can be found in the work of Law (1705), Thornton (1802). Mueller (1816), Rau (1826, 1832), Wagner (1857, 1872), Knies (1873), Macleod (1855/56), Wicksell (1898), Spiethoff (1905), Schumpeter (1912) and Hahn (1920). A number of economists also continued to recognize this in the postwar era, though their influence remained limited. For instance, Trescott (1960) points out that to grant a loan of US$1000 to a customer, 'a bank needs only to credit his account with $1,000.00 in its books by a stroke of the pen... The process of creating deposits is obviously a simple and painless one for the banks...' (p.55).

25 As bank loans increase by US$9900, so do bank deposits. The initial deposit becomes reserve R of US$100, which allows deposits D of US$10,000. Thus the reserve requirement (R/D) of 1% is met.

26 It could even be said that the bank just 'pretends' it has money, and nobody realizes. Such action could easily be construed as fraudulent. Historically, the lending of gold that was promised to be on deposit with the goldsmiths, as well as the issuance of deposit receipts without any deposits having taken place (note issuance) could possibly be considered illegal at the time. Today, banking legislation has legalized this process. Nevertheless, there is an academic tradition, the 'Austrian School' of economics, which argues that bank credit creation remains illegal, since claims on the same resources are simultaneously issued by banks to different customers (see Hoppe et al. 1998).

27 The exception is the US government. The authors of the US Constitution ensured that the government has the right to issue money, a prerogative last used by President John F. Kennedy in one of his last executive orders (No. 11,110) on 4 June 1963.

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