International Review of Financial Analysis, 2014, vol. 36, issue C, 1-19 Abstract:This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air". Keywords: Bank credit; Credit creation; Financial intermediation; Fractional reserve banking; Money creation (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:36:y:2014:i:c:p:1-19 DOI: 10.1016/j.irfa.2014.07.015 Access Statistics for this article International Review of Financial Analysis is currently edited by B.M. Lucey More articles in International Review of Financial Analysis from Elsevier |
FAQs
Can banks make money out of nothing? ›
According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction.
Can banks create their own money? ›Creating money
Banks also create money. They do this because they must hold on reserve, and not lend out, some portion of their deposits—either in cash or in securities that can be quickly converted to cash.
Legally, a bank can lend only to the extent of its excess reserves. 2. Transaction 7: When banks or the Federal Reserve buy government securities from the public, they create money in much the same way as a loan does (see Balance Sheet 7).
What is one of the ways banks can create a money supply? ›When that loan is made, it increases the money supply. This is how banks “create” money and increase the money supply. When a bank makes loans out of excess reserves, the money supply increases.
Can banks make infinite money? ›That being said, a bank needs to have access to liquid reserves to create money. In other words, a bank can't just conjure infinite amounts of money. Plus, the deposit that is created needs a certain amount of reserves to be held against it, which is supplied by the Federal Reserve (the U.S.'s central bank).
How can banks lend money they don't have? ›Banks use fractional reserves to create loans for businesses and consumers. Without the ability to do this, an economy's growth is stunted, leaving it to flounder while those that need money for large purchases and investments rely on a bank's substantial holdings.
What is a predatory financial service? ›What is predatory lending? Lending and mortgage origination practices become "predatory" when the borrower is led into a transaction that is not what they expected. Predatory lending practices may involve lenders, mortgage brokers, real estate brokers, attorneys, and home improvement contractors.
What is the self liquidating paper theory? ›Self-liquidating theory - This hypothesis/theory keeps up that a Commercial Bank's liquidity would be guaranteed as long as resources were held in short term credits that would be sold in the ordinary course of business.
How do banks fund themselves? ›Banks must pay interest on the funds that they collect from savers, which is one of their main funding costs. On the other hand, banks receive interest from loans that they make to borrowers and this is a large part of their revenue. From the perspective of a bank: funding costs are the interest rates paid to savers.
How do banks create money without printing it? ›Banks can create money through the accounting they use when they make loans. The numbers that you see when you check your account balance are just accounting entries in the banks' computers. These numbers are a 'liability' or IOU from your bank to you.
Who has the right to create money? ›
Article I, Section 8, Clause 5: [The Congress shall have Power . . . ] To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures; . . .
How do banks create money without printing any currency? ›Banks create money by lending excess reserves to consumers and businesses. This, in turn, ultimately adds more to money in circulation as funds are deposited and loaned again. The Fed does not actually print money.
What are 3 ways banks make money? ›They earn fees for customer services, such as checking accounts, financial counseling, loan servicing and the sales of other financial products (e.g., insurance and mutual funds).
What are the theories of money supply? ›There are two theories of the determination of the money supply. According to the first view, the money supply is exogenously by the central bank. The second view holds that the money supply is determined endogenously by changes in the economic activity which affect people's desire to deposits the rate of interest etc.
What does a bank do if there are no excess reserves? ›Excess reserves plus required reserves equal total reserves. Because banks earn relatively little interest on their reserves held on deposit with the Federal Reserve, we shall assume that they seek to hold no excess reserves. When a bank's excess reserves equal zero, it is loaned up.
How commercial banks create money out of nothing? ›When banks create money, they do so not out of thin air, they create money out of assets – and assets are far from nothing. A simple parable helps clarify how banks create money and what the role of asset-backing is in that process.
What happens if banks run out of money? ›A systemic banking crisis is one where all or almost all of the banking capital in a country is wiped out. The resulting chain of bankruptcies can cause a long economic recession as domestic businesses and consumers are starved of capital as the domestic banking system shuts down.
Who pays when a bank fails? ›Federal law requires the FDIC to make payments of insured deposits "as soon as possible" upon the failure of an insured institution. While every bank failure is unique, there are standard policies and procedures that the FDIC follows in making deposit insurance payments.
How do banks create money from a $1000 deposit? ›To use a classic example: If you deposit $1,000 into a savings account and the bank keeps 10% in reserves, your bank holds onto $100 and lends out $900 to another customer. That customer spends $900 on a car repair and the auto shop deposits the money. The shop's bank keeps $90 and lends out $810, and so on.