Review of the paper:

Can banks individually create money out of nothing? - The theories and the empirical evidence

By Richard A. Werner* / July 2014

Reviewed by
Edward J. Dodson / July 2015

In the abstract to his paper, Richard Werner states that his paper:

"… presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing."

My own experience in the banking sector as head of the residential mortgage lending program for a commercial bank causes me to question the basis for the assertion by almost all critics of the banking sector that banks do, in fact, create money out of nothing. The basis for this assertion is that a bank "does so when it extends credit (the credit creation theory of banking)." Richard Werner accepts the challenge of investigating whether this is actually the case. And, in the end, he agrees:

"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'."

A sound understanding of how money is created and enters into an economy is essential to the task of constructing useful models of the economy. Richard Werner points to a number of research efforts underway to achieve this end.

There is little disagreement that "banks, unlike other financial intermediaries, can collectively create money, based on the fractional reserve or 'money multiplier' model of banking." How much money can be created is a function of how much money is held in reserve and how much is spent into circulation. The issue I am compelled to raise relates to what is held in reserve. Holding gold or silver coinage as reserves is no longer required. Circulating coins have very low intrinsic value. What a bank must hold in reserve is a currency balance based on a formula adopted by the Board of Governors of the Federal Reserve System, and other regulatory agencies created by state and federal law.

If, in fact, individual banks are creating money when they extend credit, this implies that a huge fraud is being perpetrated, a fraud that in effect transfers purchasing power to the banks without any exchange of goods or services. However, the very fact that during each and every economic downturn some banks fail is a signal that even the ability to create money out of nothing is not a protection against insolvency. An important point of clarification is raised by Richard Werner by reminding readers that in most countries only one bank, the central bank, is authorized to issue bank notes that circulate as currency. However, what economists such as Joseph Schumpeter and Herbert Davenport were arguing early in the twentieth century is that any currency reserve requirement is but a minor obstacle the ability of banks to extend credit. In 1931 John Maynard Keynes explained how this was possible:

"It is not unnatural to think of the deposits of a bank as being created by the public through the deposit of cash representing either savings or amounts which are not for the time being required to meet expenditure. But the bulk of the deposits arise out of the action of the banks themselves, for by granting loans, allowing money to be drawn on an overdraft or purchasing securities a bank creates a credit in its books, which is the equivalent of a deposit."

This is an appropriate point in the story to intervene, to describe how banks are established, how they raise funds, and how they record these activities according to standard accounting rules. What Richard Werner will endeavor to explain is how bankers are able to circumvent these accounting rules with impunity.

A century ago, when individuals wanted to start a bank, they had to pool their money together. By money was meant coins with a standard weight and measure of gold and or silver. The importance of gold is evidenced by the fact that during the last half of the nineteenth century twice as much gold was mined as in all previous history. An international gold standard developed to serve commerce between all major trading nations. For reasons of regional benefit (silver was far more plentiful in parts of the country), United States politicians argued the case for bimetallism until 1900.

Gold provided the coinage that provided the initial capital of banks chartered by the U.S. government until the establishment of the Federal Reserve System. Then, as gold coins came into the banks, they were withdrawn from circulation. This process was accelerated when the United States entered the First World War. The exportation of gold was curtailed and the minting of gold coinage significantly reduced.

While gold supplies were expanding, banks held gold coinage as reserves. They were also required to purchase government securities as reserves. The banks would then advertise -- to attract depositors (who would bring in privately-held coinage) and customers seeking loans for various purposes. Receipt of cash was debited as an increase to the bank's assets, with a corresponding liability created in the name of the depositor. At this point there was no increase in the capital of the bank's owners. If the depositor opened only a checking account, the bank paid the depositor no interest. A savings account paid interest because there were certain restrictions on when and how much could be withdrawn without penalty. When an individual came to the bank requesting a loan, the bank now had its capital plus deposited cash to draw on, subject to whatever regulatory requirements for reserves were imposed. The bank officer evaluated the creditworthiness of the potential borrower and offered credit for some period of time at a stated rate of interest based on the time value of money as well as the risk of potential default. The rate of interest could be negotiated based on the borrower's ability to provide collateral (e.g., a property against which a mortgage lien could be recorded).

One result of the First World War was the movement of gold reserves from Old World banks to the United States Treasury and the Federal Reserve Banks. By 1925 around 45 percent of the world's gold stocks were held in the United States. Commercial banks were able to expand their lending volume by selling their reserves of coinage to the Federal Reserve Banks. Very quickly, money with any real intrinsic value was replaced by Federal Reserve Notes that were neither redeemable for any specific quantity of precious metal nor stable in the amount of goods or services they would purchase in exchange.

Banks could also raise additional cash by issuing debt - bonds. On the books, the banks assets were increased, offset by a liability to the bond holders. Banks could also divert profits into other forms of investment, although banks are not permitted to invest in the stock market but are permitted to invest in asset-backed securities. In this respect, a bank is much more than a financial intermediary; the banker must exhibit a high level of investment and risk management expertise in a world where the exchange value of money changes daily.

Richard Werner reminds readers that no less an authority on economics than Paul Samuelson argued that individual banks cannot create new money. He quotes Samuelson as follows:

"According to these false explanations, the managers of an ordinary bank are able, by some use of their fountain pens, to lend several dollars for each dollar left on deposit with them. No wonder practical bankers see red when such behavior is attributed to them. They only wish they could do so. As every banker well knows, he cannot invest money that he does not have; and any money that he does invest in buying a security or making a loan will soon leave his bank"

Take, for example, what occurs when an individual purchases a residential property, obtaining a mortgage loan from a bank to complete the financial transaction. The proceeds of the sale are paid to the seller -- less fees taken by the bank, by a title insurance issuer, by a closing attorney, by local government, by a property appraiser and the realtor. The likelihood that all or even any of these participants will deposit their share of the proceeds with the funding bank is small. The bank issues a check which is deposited to an escrow account with the closing attorney, which then issues multiple checks as necessary to each party. The bank credits its cash account and creates a new asset, a mortgage loan receivable. With the introduction of electronic transfers, the deduction of cash may be almost immediate (i.e., there is no delay between the time the bank enters the transaction on its books and the funds are transferred elsewhere).

Of course, some portion of the cash removed from the lending bank will end up in being deposited by individuals in other banks. And, a portion of these funds will be turned into loans to new customers or otherwise invested. Therein is the story of the money multiplier. However, some amount of cash is simply held by individuals for a short period of time for use in daily purchases of goods and services. This cash circulates and circulates and may never find its way to a bank until the note is nearly worn out from use and must be replaced with a new Federal Reserve Note.

The executives of every commercial bank, savings bank or credit union must be able to manage all of the risks associated with their business activity. As history has proven, some do a far better job than others. Moreover, the absence of geographical diversity of assets and customers adds to the vulnerability of some institutions in the event of a regional economic downturn. For this reason, banks have either sold most of the mortgage loans their originate to investors, or pooled the loans together as collateral for a mortgage-backed security that is held as a liquid asset, reducing the amount of reserves required when the loans were held in portfolio. When in need of cash, the bank can sell the security. Depending on the circumstances of the moment, the security will sell at its stated value (i.e., the total of the outstanding principal balances of the underlying loans), at a discount because the weighted average yield is less than current market interest rates for assets with the same expected life and other risk factors, or at some amount above the outstanding principal balances.

At the heart of the issue raised by Richard Werner is one of how a bank could book a loan receivable without a corresponding credit against its available cash. The only answer I can come up with is that funds are somehow acquired the receipt of which is booked as an addition to capital. The sale of stock would be the only such transaction I can think of. This could be done under provision of a commitment to repurchase the stock at a stated future date at a stated price. In effect, the transaction looks like an increase in net worth but is, in effect, a loan.

Richard Werner attempts to demonstrate that this bit of creative accounting is not necessary, that the mere granting of a loan to someone creates money out of nothing. He asks whether the bank "actually withdraws this amount from another account, resulting in a reduction of equal value in the balance of another entity - either drawing down reserves (as the fractional reserve theory maintains) or other funds (as the financial intermediation theory maintains)." If so, "this would constitute prima facie evidence that the bank was able to create the loan principal out of nothing."

His empirical evidence involved the tracking of a loan transaction initiated with a small German bank. A loan was approved, and, as one possible outcome, "the loan amount was immediately credited to the borrower's account with the bank." Thus, logic indicates that one form of ban asset (cash) was replaced by another form of asset (a loan receivable). The following day, the total was withdrawn by the borrower to complete the purchase of something. What he found is that the bank personnel involved made no effort to determine whether the bank actually held sufficient surplus reserves from which the loan amount could be drawn. In the case of this bank, this calculation is made each day after the close of business. The implication is that this or any bank with similar practices could find itself technically insolvent from one day to the next.

The conclusion reached by Richard Werner is that "the bank newly 'invented' the funds by crediting the borrower's account with a deposit, although no such deposit had taken place. This is in line with the claims of the credit creation theory." What he does not examine in this paper is whether the bank subsequently is required by its own controller or internal auditors to take steps to bring the asset-liability ratios back into proper alignment. Absent the measures I described above, a bank has strong demands on its cash balances that must be tightly managed in order to remain in compliance with risk-based capital requirements. When Richard Werner writes:

"Thus it can now be said with confidence for the first time - possibly in the 5000 years' history of banking - that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a 'bank loan'. The bank does not loan any existing money, but instead creates new money. The money supply is created as 'fairy dust' produced by the banks out of thin air.32 The implications are far-reaching."

I find it difficult to understand how this flow of funds analysis validates an assertion of general principle. What is described is a special case where a highly leveraged bank could find itself temporarily insolvent, with a very limited window of exposure before the bank would be found guilty of criminal fraud.


* Richard A. Werner is Chair in International Banking, Director, Centre for Banking, Finance and Sustainable Development; Director of Int'l Development, at the University of Southhampton