Banks and Money Creation ‘Out of Nothing’
Robert W Vivian†
The phrase ‘banks create money’ forms part of popular discourse, but it precipitates an incorrect
understanding of a bank’s role in the money creation process. Additionally the notion that banks
create money ‘out of nothing’ has gained popularity after the recent financial crisis, fueling criticism
of the banking system by the public. We explore the role of banks in the money creation process and
illustrate that bank money is created when banks agree to facilitate intertemporal exchange
transactions between buyers and sellers on the basis of debt-credit contracts. We illustrate that bank
money is not created ‘ex nihilo’ and that reference to banks creating money is a misleading caricature
of a bank’s role in the money creation process.
Keywords: Money creation; Money supply; Financial intermediation
JEL Classification: E51, G20, G21
† Professor of Finance and Insurance, School of Economic and Business Sciences, University of the
Witwatersrand (Wits), Johannesburg, South Africa
‡ Corresponding author. Lecturer in Economics, School of Economic and Business Sciences, New Commerce
Building, West Campus, University of the Witwatersrand (Wits), Johannesburg, South Africa, 2000. Wits
African Microeconomic Research Unit (AMERU). Wits Institutions and Political Economy Group (IPEG).
We are grateful to our colleagues as well as an anonymous referee from Economic Research South Africa
(ERSA) and various other referees for all feedback received. Earlier versions of this and a companion article
were presented at the 4th International Conference on Financial Services, Wild Coast, South Africa, 2–4 October
2013; the staff research seminar series, University of the Witwatersrand, South Africa, 6 May 2014; the ERSA
4th Annual Monetary Economics and Macroeconomic Modelling workshop, University of Pretoria, 15–16 May
2014; and the University of Johannesburg Value 2014 conference, Emperors Palace, South Africa, 26–27 May
2014. All opinions and errors remain our own.
This article concerns the phenomenon of money creation and the role of traditional commercial and
retail banks (hereafter simply referred to as banks)
in this process. There are two issues that this
article addresses: the first is the description of banks as ‘money creators’, and the second is the notion
that ‘bank money’ is created ‘ex nihilo’.
First, we illustrate that banks are an important component of the money creation process, but
phraseology implying the creation of money by banks per se provokes a misleading caricature of a
bank’s role in the money creation process.
A more accurate restatement of a bank’s role in the money
creation process could read: banks facilitate intertemporal exchange transactions between buyers and
sellers by providing liquidity services and managing, on behalf of these agents, the idiosyncratic risks
and costs associated with privately issued debt-credit
contracts. The function described in this
restatement is not reflected in the phrase ‘banks create money’.
Second, the notion that bank money is created ex nihilo is an expression that has gained in
popularity after the recent financial crisis.
This article details the process of bank money creation to
illustrate that, far from being created out of nothing, bank money is the product of a legal and
institutional framework and results from an underlying value-for-value intertemporal exchange
transaction that is facilitated by the intermediation of the bank. Bank money is created by private
debt-credit relationships between economic agents, and reference to this relationship as ‘nothing’
The discussion presented concerns the primary activities of traditional banking practice as opposed to what is
generally considered investment banking. In referring to the early development of banking, Freixas & Rochet
(2008, p. 5) note: “[i]nvestment banking was performed by a different type of institution and was a different
concept from traditional credit activity”.
Examples of well-known contemporary authorities from within the financial sector who have promulgated the
notion that banks create money include: Sir Mervyn King, the former governor of the BoE (King, 2012); Lord
Adair Turner, former chairman of the now defunct Financial Services Authority (FSA) (Turner, 2012; Turner,
2013); and the IMF’s (now BoE) Michael Kumhof (2013).
We use the term debt-credit to refer to what is elsewhere in the literature referred to interchangeably as either
debt or credit and which has the potential for confusion. As Hawtrey Invalid source specified. states “[t]hat
which to the debtor is a debt, is to the creditor a credit” and hence any such agreement has simultaneously both
debt and credit aspects. If we do not intend to emphasise either the debt or the credit aspects of these agreements
we use the term debt-credit instead.
The notion that banks can create money ex nihilo is found in a broad spectrum of academic literature, for
example in relation to the Circuitist Theory (Rochon, 1999b; Gnos, 2006), Post-Keynesian literature (Rochon,
1999a), Modern Money Theory (Wray, 2012), as well as banking literature generally (de Soto, 2009; Benes &
confounds and undermines this relationship. This has important implications when the notion that
banks create money out of nothing frames regulatory and policy debate.
Regulating the banking
system’s ability to create money from nothing is a disparate framing of policy discourse to regulating
the private indebtedness of economic agents.
In proceeding, this article is structured as follows. Section 2 provides the motivation for this
discussion and Section 3 is aimed at clarifying the subject of this article – bank money. In the fourth
and fifth sections we explore the bank’s role in the money creation process in detail. Finally, the sixth
section concludes the article.
Recently the Bank of England (BoE) acknowledged in its Quarterly Bulletin that the money creation
process is not well understood, and published two companion articles on money creation refuting
general contemporary graduate textbook explanations (McLeay, Radia, & Thomas, 2014a; 2014b).
However, the BoE publications do not dispel (but rather reinforce) a common misconception that
banks themselves create money. This misconception underlies the belief that ‘banks create money out
of nothing’, or ‘out of fresh air’ – ‘creatio ex nihilo’.
The need to clarify the relationship between banks and the process of money creation is
pertinent given the increased emphasis on incorporating financial sector mechanics into
macroeconomic models in the wake of the recent financial crisis.
Jakab & Kumhof (2015) illustrate
important macroeconomic stability implications of reconceptualising how a bank’s role in the money
Fuelled by the recent financial crisis in Europe and the United States, organisations, individuals and public
officials have used public media to call for an end to the current practice of money creation by banks and for an
overhaul of the banking system. As examples of the public outcry, Martin Wolf, veteran financial journalist,
calls for an end to the practice of money creation by banks (Wolf, 2014). In the US, long serving former senator
Ron Paul has called for an end to fractional reserve banking and the Federal Reserve System in general (H.R.
1094, 2011). In the UK, the organisation Positive Money continues to campaign against the ability of the current
banking system to create money (Positive Money, 2014). In South Africa, this view underpinned litigation
against the banking system by the organisation The New Economic Rights Alliance (The New Economic Rights
Alliance v Absa Bank Limited and others, 2012).
Benes et al. (2014) and Borio and Disyatat (2011) provide insightful discussions on the theoretical
considerations concerning money creation usually omitted from macroeconomic models.
creation process is understood. Their DSGE model incorporates endogenous money creation ‘out of
nothing’ by banks which thereby generates pro-cyclical bank leverage and, compared to traditional
models, “changes in the size of bank balance sheets … are far larger, happen much faster, and have
much greater effects on the real economy … [and] are much more in line with the stylised facts”
(Jakab & Kumhof, 2015, p. ii). A correct understanding of the bank money creation process is
therefore important for understanding financial instability and for correctly informing both public
debate and regulation discussions centred on the role of banking in the financial system.
Our discussion focuses on the importance of acknowledging the underlying intertemporal
exchange transactions which give rise to the bank money creation process. Detailed expositions of a
bank’s role in the money creation process and the fundamental link between this process and
underlying real economic transactions are common in the early banking theory literature that
accompanied the birth of the modern banking system in the late 19th and early 20th centuries, when
bank demand deposits were emerging as a common and generally accepted means of payment.
the connection between the money creation process and underlying intertemporal exchange
transactions is omitted from contemporary explanations which focus on banks as money creators.
Elaborating on this connection illustrates a bank’s economic role in the money creation process as a
cost and risk mitigating financial intermediary between buyers and sellers. In terms of this process
money is not created ex nihilo nor is it accurate to refer to banks themselves as creating money; rather
money is created as a result of an underlying value-for-value exchange transaction and is the product
of a legal and institutional framework.
3. Money: Cash money and bank money
Money is commonly defined according to its functional roles, traditionally identified as: a measure of
numerical value (also referred to as a unit of account), a medium of exchange, a store of value and a
See for example Macleod (1866) and Wicksell (1936 , Chapter 6). Sissoko (2015a; 2015b) provides a
detailed discussion on the importance of this early literature to understanding the contemporary financial system
See McLeay, Radia, & Thomas (2014b), Werner (2014b) and Jakab & Kumhof (2015) as examples.
standard of deferred payments.
The latter two functions focus on money’s ability to facilitate
intertemporal exchange (the primary function of concern in this article). Modern money consists
chiefly of two types of monetary instrument which fulfil these roles. The first type of monetary
instrument (and that which is most commonly understood by the proverbial man on the Clapham
omnibus to be money) is fiat money the notes and coins issued by central banks – also referred to as
currency, state money or cash money
. The second type of monetary instrument is composed of bank
liabilities, also thought of as a cash money substitute and referred to as deposits, credit money or bank
money. Simply put, a distinction is made between cash money and bank money. A list of authors who
recognise this distinction constitutes a veritable who’s-who of commentators on the subjects of money
and financial stability over the last two centuries including Tooke (1844), Macleod (1866), Bagehot
(1873), Wicksell (1936 ), von Mises (1953 ), Pigou (1917), Keynes (1930), Hayek
(1933), Schumpeter (1961 ), Minsky (2008 ), Gorton (2014) and many others. The
measurement of modern money supply includes numerical measures of both the quantity of cash
money and the quantity of bank money available for circulation in an economy, a fact which is readily
verified by observing the composition of monetary measures M1, M2, etc. An increase in the amount
of bank money (recorded as deposit liabilities on bank balance sheets) therefore constitutes an
increase in the money supply of the modern economy.
The subject of this article is only bank money creation, not cash money or any other
manifestation of money. There are two important points regarding the distinction between cash money
and bank money. The first is that the money that banks are said to create must be understood to be
bank money, as opposed to cash money. Cash money is only issued by central banks.
Schumpeter (1954, p. 1053) refers to these as being the “old four functions” having been discussed in some
way or another as early as the likes of Plato, Aristotle and many others since.
Here we are only referring to the cash money as it is recorded in the official money supply, which is to say
cash money in circulation as opposed to cash money held in the central bank’s vaults, or the central bank’s
accounting entries reflecting bank reserve holdings.
There are specific instances of banks issuing their own currency notes – as was common for Scottish banks in
the 18th century (Dow & Smithin, 1992) or the so called Free Banking Era – but this should not be confused
with cash money issued by central banks.
money is at its roots a record of intertemporal exchange based on a debt-credit relationship.
bank money is created as the result of an inter-temporal exchange transaction based on debt-credit
relations between parties has been understood since early writings dealing with bank money.
notion that ‘banks create money’ undermines the complexity of the debt-credit relationship underlying
the process of bank money creation. As an alternative to this notion, a bank’s role as risk and cost
mitigating facilitator of intertemporal exchanges (of which bank money serves as a record of
underlying debtor-creditor relationships arising through these intertemporal exchange transactions)
can be illustrated by a simple but detailed narrative as follows. This descriptive narrative builds on
that of Spearman & Vivian (2016).
4. Money creation and the underlying transaction
We begin our narrative on bank money creation with the relatively simplistic situation of someone
wishing to purchase immovable residential property without the aid of the banking system. We begin
with this limited institutional framework to emphasise the debt-credit nature of bank money; however,
in Section 4.2 we relax this restriction and proceed to discuss the transaction with the assistance of a
banking institution. We use immovable residential property for our example because residential
mortgage loans are considered to be at the heart of explanations of the recent financial crisis – see for
example the textbook discussion provided by Mankiw (2013, pp. 575-589) – and it is through these
and similar loans that banks are thought to create money out of nothing. We extend the discussion to
consider alternative bank financing arrangements, but leave this until Section 5 to avoid distraction
from the central point of the discussion, which is the role of a bank in the money creation process.
4.1. Bank money creation in the absence of banks
See Hudson (2004) for a thorough historical perspective on this point, and Sissoko (2015b) for a more recent
historical perspective. Sissoko (2015b) also provides an insightful discussion on the importance of the early
banking literature to understanding the contemporary financial system in general.
Examples include Macleod (1866), Wicksell (1936 ), von Mises (1953 ), Innes (1913), and
Schumpeter (1961 ).
Assume there are two individuals, Ms S (the seller) and Mr B (the buyer). Cash money (denoted with
the symbol “$”, issued by a central authority and used as the circulating medium of exchange)
provides a numeraire, enabling debt instruments to be issued in terms of this generalised legally
accepted monetary unit.
S owns a house and wants to sell her house to B, who wants to buy the
house. S and B thus enter into a common exchange transaction. S is willing to transfer her house to B;
B is willing to accept transfer of the house. The price of the transaction is $1m expressed in the
accepted currency unit. B does not have the $1m in cash money available and therefore must come to
some debtor arrangement with S. B offers to pay off the $1m over a 20-year period in monthly
instalments (in the form of cash money). S and B enter into a written contract setting out debt-credit
rights and obligations. This constitutes a debt-credit instrument and a form of promissory note (and in
this specific case it may be accompanied by a Deed of Trust contract). We refer to a debt-credit
instrument (as opposed to the more frequently used term ‘debt instrument’) to reflect that the debt is
matched by a corresponding credit position. Therefore B’s offer in exchange for the house is a debt-
credit contract which specifies that B will make periodical payments to S over some pre-specified
future time period. In the absence of a bank, this is the best that S can expect and thus she accepts this
offer and the two parties enter into this intertemporal exchange, exchanging current goods for the
promise of future goods. Before the transaction took place, S had a property worth $1m; after the
transaction has taken place, S has a claim against B for the future periodical payments – the face value
of which (or the principal sum), is also $1m. It is a value-for-value exchange transaction. After the
transaction, S has exchanged the house for another asset – a claim for periodical payments; B has an
asset in the form of a $1m house and an obligation to make the future periodical payments. Allowing
the purchaser to buy on credit and pay the purchase price over a period of time is not the sole domain
of a bank; individuals may enter into debt-credit arrangements without directly involving a bank as
evidenced by today’s shadow banking systems (Bernanke, 2012) and anthropological evidence shows
While we have chosen some cash money symbol to function as the numeraire in this example, this is not of
importance as any unit of account (commodity based or otherwise) used to denominate the value of the
transaction would suffice. Thus, the first function of money is encountered – the unit in terms of which a value
is assigned to the underlying transaction.
that this system traces back to early civilisation (Graeber, 2011).
This transaction could take place
whether banks existed or not because a need exists for the intertemporal exchange of property
(immovable or otherwise). Furthermore the obligation to make periodical payments and the
corresponding right to these repayments (contained in the form of a debt-credit financial instrument)
are not created out of nothing: the debt-credit instrument arises as a result of and acquires its value
from the underlying exchange transaction.
In summary, both S and B’s net wealth positions remain unchanged by the transaction. S started
off with a $1m house and ended with a $1m claim against B, as evidenced by the debt-credit financial
instrument. B started off with no wealth and ended with a $1m house matched by a $1m obligation.
B’s net wealth is still zero. The debt-credit instrument acquires a $1m face value from the underlying
transaction. The debt-credit instrument did not obtain its value out of nothing, but obtained its value
as a direct consequence of the value of the goods given in exchange for the instrument. Over the 20-
year period, the $1m obligation will be extinguished by payments made by B to S. Although B may
be required to pledge collateral in order to mitigate the risk to S, the $-value of the collateral does not
determine the $-price of the house or the $-amount of the financial instrument created in order to
conduct the transaction.
In our example the debt-credit instrument is the counter exchange to the exchange of the
residential property and is the financial medium of intertemporal exchange used in the absence of a
banking institution: S accepts the $1m debt-credit financial instrument detailing the obligation for
periodical payment in exchange for her $1m house; B accepts the $1m house in exchange for the
obligation to make the periodical payments. The debt-credit instrument was created as a medium of
exchange to facilitate a value-for-value transaction; it was created as a result of the underlying
transaction, it derives its value from the exchange
and its value is underpinned by the obligation of B
to make future payment. The debt-credit instrument is a record of a debtor-creditor relationship and if
Financial columnist Frances Coppola offers a personal contemporary description of this process (Coppola,
This is what we understand von Mises (1953 ) referring to as the “objective exchange-value of money”.
generally accepted as means of payment, constitutes money as described by Pigou (1949).
the rise of modern banking institutions, obligations to make future payments and the counter party
rights to these payments were a common method of facilitating intertemporal transactions. Records of
the use of such debt-credit financial instruments serving as instruments of exchange extend from the
earliest of societies to recent times.
Wicksell (1936 , pp. 62-68), writing in a period that was
witnessing the emergence of modern banking, explains how such privately issued promissory notes –
debt-credit instruments – circulated as monetary instruments and were a forerunner to modern bank
money. Spearman & Vivian (2016) explain that Wicksell’s account illustrates how the simple bill
of exchange was an inadequate substitute for cash money, lacking general acceptability due to the
idiosyncratic risk associated with the individual issuer. However, a system of concurrent
endorsements mitigated this risk and enabled these promissory notes to function as more generally
accepted monetary instruments. Additionally, Wicksell observes the gradual replacement of these
financial instruments by a more convenient instrument: the accounting entries in the books of banks.
Wicksell’s description highlights the importance of the modern banking system in transforming
claims against privately issued debt-credit financial instruments into generally accepted media of
exchange through risk and cost mitigation. The important role played by the intermediation of banks
is the provision of liquidity through the mitigation of the idiosyncratic risks and costs associated with
the privately issued debt-credit financial instruments used to finance intertemporal exchange. This is
discussed further in the following subsections. This connection to underlying real economic
transactions is absent from contemporary explanations which lead to the notion that money is created
out of nothing – see the explanations given in McLeay, Radia, & Thomas (2014a; 2014b), Werner
(2014a; 2014b), and Jakab & Kumhof (2015) as examples.
4.2. Banking institutions
“[Money is] anything … accepted fairly widely as an instrument of exchange” (Pigou, 1949, p. 5).
Innes (1913) provides an early account of debt-credit instruments serving as mediums of exchange while
Gillet Bros. Discount Co. Ltd (1964) provides a thorough description of the workings of the bill of exchange (a
generally accepted debt-credit instrument serving as medium of exchange) well into the second half of the 20th
century. Graeber (2011) also provides a fascinating account of the history of the debt-credit institution.
The exchange transaction we have been following holds a number of disadvantages for S. First is the
liquidity disadvantage. S may not want to wait 20 years to receive her cash money (even if she is
enticed by interest payments, although we do not engage in discussion concerning the role and
purpose of interest in this article). Second, S is exposed to solvency and default risk. S could mitigate
these risks by carrying out a due diligence exercise and by insisting on a mortgage bond (every seller
would thus need the skills and acquire information necessary to conduct the due diligence and have
knowledge about mortgage bonds). Third, S faces an administrative burden. S would have to spend 20
years collecting outstanding amounts and keeping a record to this effect. S thus faces potentially
considerable risks, inconveniences and other associated transaction costs by entering into such a
transaction in the absence of a bank. S would benefit if these problematic disadvantages could be
reduced or avoided. An opportunity therefore exists for an institution able to reduce S’s
disadvantages. Hence, if institutions with the characteristics of modern banks did not exist, the space
for them (or similar institutions) to spontaneously evolve is present; S’s disadvantages can be resolved
by inserting a traditional banking institution into the transaction.
Such a theory for the existence of
banks is common in financial intermediation theory generally (Allen & Santomero, 1998; Gorton &
Winton, 2003; Scholtens & van Wensveen, 2003; Freixas & Rochet, 2008; Greenbaum, Thakor, &
Boot, 2016), is consistent with the transactions theory of the firm (Coase, 1937) and evidence of this
emergent evolution has been documented (Wicksell, 1936 ). Thus, banks can be expected to
emerge if, as intermediaries, they reduce a broad spectrum of associated risks and transaction costs.
Assume now instead that Ms S and Mr B are fortuitously both customers of the same bank (this
simplifies matters although this restriction is by no means necessary). If Customer S sells her house to
Customer B, S could cede her claim, the debt-credit instrument against B, to the bank in return for the
promise of immediate access to cash money or payment of cash money on demand. S may not need
the cash money, or all of it, and the bank could merely make it clear to S that she can make
withdrawals from the bank’s coffers to the value of the transaction at any time. Being a claim for cash
money on demand, S’s asset is no longer a claim for periodical payments from B, but a claim for cash
In this regard, the bank is an institution that accepts deposits from the public (bank liabilities) and advances
loans (bank assets) to the public.
money on demand from the bank. This obligation is recorded by the bank as a liability accounting
entry called a ‘call deposit’, which is to say, as bank money. In the contemporary banking system, this
call deposit, being a claim to cash money on demand functions as a cash money substitute (to use
Wicksell’s terminology) by being both generally accepted in payment and circulating without
requiring conversion to cash. This increase in bank money therefore reflects an increase in the money
supply. This increase in bank money reflects the value of an underlying transaction, which had taken
place externally from the bank and the value of which has subsequently been recorded by the bank.
The ceded claim against B is the bank’s matching asset. With this arrangement, S has solved her
liquidity, default and administrative problems. It is correct to note that S is now exposed to the risk of
the bank’s liquidity and solvency, but it is enough for the purposes of this narrative to simply assume
that the reputation of the bank and bank regulation is such that S, and indeed others, have faith that the
bank will provide cash money on demand when requested, as is the case in contemporary banking
4.3. Cession no longer necessary
If it is accepted that some form of banking institution can be called upon to assist, then the process of
first drawing up a promissory note, effecting mortgage bond security and then ceding these to a
banking institution will fall away – if the bank was to accept the cession, it would still have to carry
out a due diligence exercise, and having taken cession, register a mortgage bond. If both S and the
bank did this, this would double the transactions costs as the seller and the bank replicate the process.
Instead, the system has evolved, as would be expected according to the transactions theory of the firm,
to minimise these costs. The seller, Ms S, now agrees to sell to the buyer, Mr B, on condition that B
negotiates the services of a bank to act as intermediary to the transaction between seller and buyer.
Having entered into a suspensive contract of purchase (the offer to purchase), B approaches the bank,
which carries out the due diligence exercise, and if satisfied that B can make periodical payments,
issues B with a guarantee to make a cash money facility available on demand to S for an amount of
$1m. On transfer of the property, the guarantee is presented to S (or more likely her legal
representative), who returns it to the bank (or more likely the bank’s legal representative) whereby S
acquires the right to make withdrawals up to $1m on demand from the bank. The outcome is precisely
the same as if the promissory note and mortgage bond had been entered into and ceded to the bank. In
this evolved state, the process is more efficient as the transactions theory of the firm predicts. No
formal cession is carried out between the parties. The bank simply (i) indicates its willingness to make
available cash money on demand in favour of S by issuing a guarantee of payment on behalf of B, and
(ii) the bank honours the guarantee by recording a ‘deposit’ in favour of S once the sale is concluded
and S returns the guarantee to the bank. Thereafter S’s claim for cash money on demand appears as a
liability from the bank’s perspective. The bank acquires the claim against B for the periodical
repayments, which is an asset from the bank’s perspective (and a liability from B’s perspective). The
accepted position of the bank after the transactions is indicated in Table 1.
[Insert table 1 approximately here]
4.4. The illusion of money creation by banks
A number of observations can now be made concerning what has transpired. First, bank money (the
aggregate of bank deposits) has increased despite the fact that nothing has been ‘deposited’ with the
Second, the $1m of recorded bank money was not simply created by the bank, nor was it
created out of nothing. A financial instrument (a bank deposit) with a face value of $1m was created
as a result of an intertemporal value-for-value exchange: the sale of a $1m house sold by S and
purchased by B. The $1m represents the value of S’s initial claim against B arising out of the
exchange transaction. The bank acquired a claim against B for $1m and a liability towards S for the
same $1m. The bank’s liability to S provides S with liquidity and the reduction of the various risks
and costs associated with the transaction and faced by S. The rationale for the existence of the bank is
the reduction of the various risks and costs associated with this transaction. In the process, the bank
has become exposed to both the default and solvency risks of the buyer, and the liquidity risks
associated with the potential cash money demands of the seller.
This is a crucial aspect of modern
banking. It is the bank’s ability and skill to manage these risks and to take over the 20-year
administration of the debt-credit agreement which justify its existence. For its risk and cost mitigating
services provided to the seller, the bank will benefit and be paid from an interest cost (or fees charged)
built into the repayments made by B. This service is of value to B if the sale would not have been
conducted without the risk mitigating services offered by the bank. B therefore agrees to pay these
costs when he agrees to the bank acting as intermediary. B may also potentially benefit from the
reduced transactions costs (in the face of competition among banks) by paying a lower interest rate
than he would otherwise be afforded without the services of a bank.
Third, from an accounting perspective, although the buyer is guaranteed a credit facility prior
to the sale as a necessary condition for the sale to take place, no credit or debit accounting entries take
place when the guarantee is made. The guarantee is simply an endorsement by the bank of the buyer’s
perceived ability to honour his debt-credit agreement. Prior to the transaction taking place, the credit
facility will only appear as a note on the bank’s balance sheet for prudential purposes.
It is only on
conclusion of the sale of the property that the deposit value is recorded as a liability credit entry in
favour of the seller, and the buyer is recorded as an asset debit entry. It is only on conclusion of the
sale of the property that the buyer is held liable for payment and that relevant credit and debit
accounting entries are made by the bank recording the value of bank money created as a result of the
exchange transaction. The record of a bank asset (the debt of the buyer) and a corresponding deposit
in the name of the seller takes place only on conclusion of the sale.
A record of the increase in the
economy’s money supply only occurs when the bank makes the accounting entry crediting the
Should the seller wish to convert the promise of cash money offered by the bank (i.e. the seller’s bank money)
into cash money, it is the obligation of the bank to provide the cash money. But discussing this aspect of
banking is not necessary for explaining the process of bank money creation (the topic with which this article is
immediately concerned). It is therefore not dealt with further in this paper.
This can be readily verified by reviewing any listed banking entity’s financial statements issued in terms of
GAAP or IFRS standards.
There is an obvious reason for the bank to conclude the financing agreement with B only on transfer of the
property, because the property will in most instances act as collateral against the bank’s loan asset to B, and
until transfer has taken place, the property cannot form collateral against the asset as B does not own the
property until transfer takes place.
account of the seller. This entry records the amount of bank money created as a result of the
underlying exchange and determined by the price of the goods provided in exchange.
5. Modern banking
In modern day-to-day banking, the seller of the property, as in our example, does not need to seek out
a buyer, request a promissory note and a Deed of Trust contract and then cede the contracts to a bank.
As predicted by the transactions theory of the firm, buyers and sellers deal directly with the firm (the
bank). The seller will put the property on the market subject to the suspensive condition that the
prospective buyer will obtain financing from a bank (assuming the buyer requires this financing), that
is, on condition that a bank will accept the offer of periodical payments from the buyer. To an outsider
simply viewing the books of the bank, it appears as if by recording an asset account entry connected
to the buyer and by recording a corresponding deposit entry, the bank has created money out of
nothing; this is the illusion of the bank having created money out of nothing. But this is only the
prima facie appearance and not the truth of the matter because the outside observer has neglected to
acknowledge that the deposit value records the value-for-value exchange conducted through an
underlying transaction. In reality, the seller no longer has a house and the buyer now has a house.
At this point, an objection may be raised concerning the generalisability of the discussion.
How does the discussion pertain to alternative forms of bank funding such as cheques drawn against
overdrafts or unsecured personal loans? We briefly consider each of these in turn.
Consider an entrepreneur starting a new business, needing to purchase equipment and financing the
purchase through the use of an overdraft facility. It is important to note that no accounting entries are
made at the time that the entrepreneur is granted the overdraft facility.
The accounting entries
recording bank money creation (which is to say a credit entry in the name of the equipment seller and
a debit entry in the name of the entrepreneur) only occur at the moment in time after a cheque has
been drawn against the facility and the cheque is then returned to the banking system to be
‘deposited’. The case of the cheque drawn against an overdraft illustrates the fact that the moment in
time when the overdraft facility is used to facilitate a transaction (this is the moment that money is
created and functions as the medium of exchange) may not correspond to the moment in time when
the overdraft facility is approved or when bank money creation is ultimately recorded in the books of
the bank. The bank money recorded at the point in time when the cheque is deposited corresponds to a
transaction that occurred earlier in time.
Prior to this transaction the overdraft does not appear in the
books of the bank: it is a conditional commitment and thus an off-balance-sheet operation which does
not appear on the balance sheet until after the cheque is returned. This highlights the fact that the
recording of bank money creation and the actual act of exchange wherein bank money functions as
the medium of exchange (the point in time where the buyer purchases on the basis of a debt-credit
agreement) do not necessarily occur at the same moment in time. The cheque itself may even circulate
widely, financing additional purchases before being deposited.
Although the bank endorses the entrepreneur’s credit worthiness when approving an overdraft
facility, the unused overdraft will not be reflected in the books of the bank or in the economy’s money
supply. Even though an overdraft is granted, until the overdraft is used, no money is created and the
money supply does not change, the entrepreneur has not made an exchange requiring the use of a
debt-credit instrument and hence there has been no need for bank money to be created.
5.2. Personal loans
As noted by Cencini (2002, p. 69), “[a]s rightly pointed out by Keynes, unused overdrafts do not ‘appear
anywhere at all in a bank’s statement of its assets and liabilities’ ”.
This situation corresponds to the early descriptions of bank money creation found for example in Wicksell
(1935 , p. 85): “payments will be made by successive drawings by the borrower upon his credit in the
bank, and every such cheque must naturally lead to a credit with another person's (seller's) account”.
If a personal loan is approved in the form of an overdraft facility then the description above carries. If
the bank instead chooses to credit a customer’s current account with the value of the loan at the
moment in time when the loan is approved, then the money supply will have seemingly increased
without a corresponding transaction. In this case, the argument goes, should it not be said that in the
absence of a transaction the bank itself has created the money and that it did so out of nothing? This is
the basis of the argument presented in Werner (2014a; 2014b). Addressing this point requires
reflecting upon the role of a bank in guaranteeing credit worthiness. There are three points to note.
First, an endorsement of credit worthiness does not itself amount to the creation of money as
illustrated by the examples of the bank guarantee issued in the property transaction or the unused
overdraft. Simply endorsing credit worthiness does not in itself create bank money; a position of
indebtedness must also have been incurred by the buyer for bank money to have been created.
Second, note that for the bank to credit the current account of a customer to the value of a personal
loan it must at the same time debit an asset loan account in the name of the same customer to the same
value. The net debt position of the customer will remain zero: the customer can simply transfer the
balance of the current account to the loan account offsetting the loan value. To do so, however, would
be a pointless exercise as the arrangement would have been of no use to the customer. Third, the
granting of a personal loan in the form of an overdraft would serve the same function for the customer
(and without any change in the official money supply); the only material difference would be to the
bank’s revenue as the bank would only be able to charge interest once the overdraft had actually been
used. The sooner the facility is used, the sooner the bank will earn interest revenue, if the bank credits
the customer’s account as soon as the facility is approved it will begin earning interest immediately
(at an expense to the presumably annoyed customer who will be paying interest on an as yet unused
credit facility). It is therefore understandable from the perspective of the profit maximising firm that a
bank might directly credit a customer’s current account as the bank can at that point immediately
begin earning interest on a corresponding loan account. Considering these three points, from the
customer’s point of view, the current account credit entry would only be necessary if the customer
We believe this point to be self-evident for it is not the potential indebtedness of credit worthy economic
agents that is reflected in money supply measures but rather the actual indebtedness.
plans to immediately use the credit balance, for as noted by Tobin (1963, p. 8) “[b]orrowers do not
incur debt in order to hold idle deposits”. If the customer does not make immediate use of the deposit
then s/he will be incurring an unnecessary interest cost and would benefit from an overdraft facility
instead. In essence then, the credit of the customer’s current account is a reflection of the bank’s
endorsement of the customer’s credit worthiness which will be followed shortly by an actual
exchange transaction (for this was surely the reason the customer applied for the personal loan)
is an example of money creation being recorded before the actual act of exchange.
5.3. The timing of money creation and its recording by the banking system
The examples discussed illustrate the following: the mortgage loan is an example of the simultaneous
recording of both bank money creation and the exchange transaction which gives rise to the bank
money; the cheque is an example of the recording of bank money creation taking place only after the
exchange transaction which gives rise to the creation of the bank money; and the personal loan is an
example of the recording of bank money creation taking place before the exchange transaction which
gives rise to the creation of the bank money.
5.4. Bank money as a social institution
The intertemporal exchange creates an obligation on the buyer (of current goods and services) that is
expected to be repaid by future income (itself derived from future goods and services). The buyer’s
indebtedness does not arise out of nothing, but in exchange for goods received in the present and for
which payment is expected to be received (and now collected and administered by the bank) in the
On this point, Werner’s (2014a) field study to demonstrate that banks create money out of nothing is not an
accurate reflection of the actual process of granting a personal loan as revealed in the appendix to Werner’s
discussion. In terms of “Appendix 1. Sequence of steps for the extension of a loan: Raiffeisenbank Wildenberg
e.G.”, the final step – “17. Payment of loan at the value date, in exchange for evidence of use of the loan in line
with the declared use in the loan application” (p. 18) – does not take place as Werner’s experiment does not
involve any intended expenditure. The standard loan process therefore remains incomplete. Werner simply
becomes simultaneously both creditor and debtor to the bank (see the section “Supplementary material 2. The
account statement of the borrower”) and at the same time “the bank waived the actual interest proceeds, in
support of the scientific research project” (p.14). The granting of Werner’s loan and deposit are therefore far
from the bank’s standard practise.
future. Thus, the nature of bank money as a social construct (Zelizer, 1989) and the product of a legal
and/or institutional framework – a broadly cartalist position (Cesarano, 2014) – is evident. It therefore
seems misleading to state that “banks create money” when the process is far more complex.
Bank money (a liability entry in the books of the bank) derives its nominal value from the
value of the goods given in exchange for a portfolio of debt-credit instruments held within the bank’s
The quality of bank money is underwritten by this asset portfolio of private debt
obligations. The salient features of the discussion extend to all manner of intertemporal exchange
transactions for which the buyer cannot immediately exchange cash money and which are thus
facilitated by means of a bank, and the complexities of which are undermined by the simplistic
statement “banks create money ex nihilo”.
6. Concluding remarks
The notion that banks create money out of nothing is both misleading and at face value erroneous. We
have explained that banks arise to facilitate intertemporal exchange transactions conducted on the
basis of debt-credit arrangements through risk and transaction cost mitigation. We have focused on
money creation and the role of banks therein and tried to prevent obfuscation of the discussion by
avoiding numerous attendant issues such as debates concerning macro-prudential regulation, the
scope of central bank mandates, questions of fractional reserves and general questions concerning
The phrase “banks create money” does little to convey the fact that a bank’s role in terms of the
money creation process is primarily as a risk and cost mitigating financial intermediary and leads
How the creation of bank money affects general price levels or the value of the bank money itself is an
important issue, but is beyond the scope of this particular discussion.
Our discussion should also not be confused with the Real Bills Doctrine, which is not part of our discussion at
all. On at least two occasions where we presented our discussion we received questions concerning the Real
Bills Doctrine. Our discussion is concerned with the process of bank money creation, and although our
discussion deals with issues central to the Real Bills Doctrine debate, the theories related to the doctrine and the
debate surrounding those theories are of no relevance to our discussion.
Jakab & Kumhof (2015) to reject the idea of banks as intermediaries altogether.
A more accurate
recasting of the phrase would therefore be to say that banks facilitate intertemporal exchange
transactions between buyers and sellers by providing liquidity services and managing, on behalf of
these agents, the idiosyncratic risks and costs associated with privately issued debt-credit contracts.
Our restatement emphasises the specific economic role provided by banks and carries different policy
implications to those associated with creating money out of nothing. There are moves towards
rethinking monetary policy generally (Blanchard et al., 2010) and we believe our discussion can
inform that process by clarifying the bank money creation process. But in this regard we echo the
words of Tobin (1963, p. 16) whose discussion ends, “I draw no policy morals from these
observations. That is quite another story, to which analysis of the type presented here is only the
Allen, F., & Santomero, A. (1998). The theory of financial intermediation. Journal of
Banking & Finance, 21, 1461-1485.
Bagehot, W. (1873). Lombard Street: A Description of the Money Market (3rd ed.). London:
Henry S. King & Co.
Benes, J., & Kumhof, M. (2012). The Chicago Plan Revisited. IMF Working Paper
Benes, J., Kumhof, M., & Laxton, D. (2014). Financial Crises in DSGE Models: A Prototype
Model. IMF Working Paper WP/14/57, 58.
Bernanke, B. S. (2012). Some Reflections on the Crisis and the Policy Response. Rethinking
Finance: Perspectives on the Crisis. New York: Board of Governors of the Federal
Reserve System. Retrieved from
“Specifically, whenever a bank makes a new loan to a non-bank customer X, it creates a new loan entry in the
name of customer X on the asset side of its balance sheet, and it simultaneously creates a new and equal-sized
deposit entry, also in the name of customer X, on the liability side of its balance sheet. The bank therefore
creates its own funding, deposits, in the act of lending. And because both entries are in the name of customer X,
there is no intermediation whatsoever at the moment when a new loan is made” (Jakab & Kumhof, 2015, p. 3).
Borio, C., & Disyatat, P. (2011). Global imbalances and the financial crisis: Link or no link?
BIS Working Papers No 346, 37.
Cencini, A. (2002). Monetary Macroeconomics: A New Approach. London: Routledge.
Cesarano, F. (2014). The Puzzle of Metallism: Searching for the Nature of Money. History of
Political Economy, 46(2), 177-210.
Coase, R. (1937). The Nature of the Firm. Economica, 386-405. doi:10.1111/j.1468-
Coppola, F. (2012, July 6). I am a bank. Retrieved from Coppola comment:
de Soto, J. H. (2009). Money, Bank Credit, and Economic Cycles (2nd ed.). Auburn,
Alabama: Ludwig von Mises Institute.
Dow, S. C., & Smithin, J. (1992). Free Banking in Scotland, 1695-1845. Scottish Journal of
Political Economy, 39(4), 374-390. Retrieved from
Freixas, X., & Rochet, J.-C. (2008). Microeconomics of Banking (2nd ed.). Cambridge,
Massachusetts: MIT Press.
Gillet Bros. Discount Co. Ltd. (1964). The Bill on London: or the Finance of Trade by Bills
of Exchange. London: Chapman & Hall.
Gnos, C. (2006). French circuit theory. In P. Arestis, & M. Sawyer (Eds.), A Handbook of
Alternative Monetary Economics. Cheltenham: Edward Elgar Publishing Limited.
Gorton, G. (2014). Chapter11: Some Reflections on the Recent Financial Crisis. In R.
Acharyya, & S. Marjit (Eds.), Trade, Globalization and Development: Essays in
Honor of Kalyan K. Sanyal (pp. 161-184). New Delhi: Springer.
Gorton, G., & Winton, A. (2003). Financial Intermediation. In G. M. Constantinides, M.
Harris, & R. Stulz (Eds.), Handbook of the Economics of Finance (pp. 431-552).
Graeber, D. (2011). Debt: The first 5000 years. New York: Melville House.
Greenbaum, S. I., Thakor, A. V., & Boot, A. W. (2016). Contemporary Financial
Intermediation. Amsterdam: Elsevier Acamdemic Press.
Hayek, F. A. (1933). Monetary Theory and the Trade Cycle. (N. Kaldor, & H. M. Croome,
Trans.) Augustus M Kelley Pubs.
Hudson, M. (2004). Chapter 5: The Archaeology of Money: Debt versus Barter Theories of
Money's Origin. In L. R. Wray (Ed.), Credit and State Theories of Money: The
Contributions of A. Mitchell Innes.pdf (p. 281). Cheltenham, UK: Edward Elgar.
Innes, A. M. (1913). What is Money. Banking Law Journal, 30(5), 377-408. Retrieved from
Jakab, Z., & Kumhof, M. (2015). Banks are not intermediaries of loanable funds — and why
this matters. Bank of England Working Paper No. 529.
Keynes, J. M. (1930). A Treatise on Money Volumes I & II. London: Macmillan.
King, M. (2012, October 23rd). Speech given to the South Wales Chamber of the Bank of
England. Bank of England Publications. Retrieved from
Kumhof, M. (2013, November 22). The Chicago Plan Revisited. Retrieved from Youtube
London School of Economics and Political Science (LSE) Channel:
Macleod, H. D. (1866). The Theory and Practise of Banking (2nd ed.). London: Longmans,
Green, Reader and Dyer. Retrieved from
Mankiw, N. G. (2013). Macroeconomics (8th ed.). New York: Worth Publishers.
McLeay, M., Radia, A., & Thomas, R. (2014a). Money in the modern economy: an
introduction. Bank of England Quarterly Bulletin(Q1), 4-13. Retrieved from
McLeay, M., Radia, A., & Thomas, R. (2014b). Money creation in the modern economy.
Bank of England Quarterly Bulletin(Q1), 14-22. Retrieved from
Minsky, H. P. (2008 ). Stabilizing and Unstable Economy. New York: McGrawHill.
Pigou, A. C. (1917). The Value of Money. The Quarterly Journal of Economics, 32(1), 38-
Pigou, A. C. (1949). The Veil of Money. London: Macmillan.
Positive Money. (2014, April). About Us. Retrieved from Positive Money:
Rochon, L.-P. (1999a). Credit, Money and Production: An Alternative Post-Keynesian
Approach. Cheltenham: Edward Elgar.
Rochon, L.-P. (1999b). The Creation and Circulation of Endogenous Money: A Circuit
Dynamique Approach. Journal of Economic Issues, 33(1), 1-21.
Scholtens, B., & van Wensveen, D. (2003). The Theory of Financial Intermediation: An
Essay On What It Does (Not) Explain. SUERF Studies: 2003/1.
Schumpeter, J. A. (1954). History of economic analysis. London: G. Allen & Unwin.
Retrieved from http://digamo.free.fr/schumphea.pdf
Schumpeter, J. A. (1961 ). The Theory of Economic Development: An Inquiry into
Profits, Capital, Credit, Interest and the Business Cycle. New York: Oxford
Sissoko, C. (2015a). The Bank-Centered View of the Money Market Part I: Why Banks Are
Different. USC Gould School of Law Center for Law and Social Science Research
Papers Series No. CLASS15-4.
Sissoko, C. (2015b). The Bank-Centered View of the Money Market, Part II: Re-evaluating
the Real Bills Approach to Macro-prudential Regulation. University of Southern
California Law School Legal Studies Working Paper Series No.158.
Spearman, N., & Vivian, R. W. (2016). The Financial Intermediation of Intertemporal
Exchange. Researcha gate working paper. doi:DOI: 10.13140/RG.2.2.27313.38243
The New Economic Rights Alliance v Absa Bank Limited and others, 27478/2012 (South
Gauteng High Court 2012). Retrieved from
Tobin, J. (1963). Commercial Banks as Creators of Money. Cowles Foundation Discussion
Paper No. 159. Retrieved from http://cowles.econ.yale.edu/P/cd/d01b/d0159.pdf
Tooke, T. (1844). An Inquiry into the Currency Principle the Connection of the Currency
with Prices, and the Expediency of a Separation of Issue from Banking. London:
Longman, Brown, Green, and Longmans. Retrieved from
Turner, A. (2012, September 2). Monetary and Financial Stability: lessons from the crisis and
from classic economics texts. Speech delivered at the South African Reserve Bank.
Retrieved from http://www.fsa.gov.uk/static/pubs/speeches/1102-at.pdf
Turner, A. (2013, September 12). Credit, Money and Leverage: What Wicksell, Hayek and
Fisher know and modern macroeconomics forgot. Speech read on his behalf at the
Stockholm School of Economics. Stockholm. Retrieved from
von Mises, L. (1953 ). The Theory of Money and Credit. (H. E. Batson, Trans.) New
Haven: Yale University Press. Retrieved from https://mises.org/books/tmc.pdf
Werner, R. A. (2014a, December). Can banks individually create money out of nothing? —
The theories and the empirical evidence. International Review of Financial Analysis,
36, 1-19. doi:10.1016/j.irfa.2014.07.015
Werner, R. A. (2014b). How do banks create money, and why can other firms not do the
same? An explanation for the coexistence of lending and deposit-taking. International
Review of Financial Analysis, 36, 71–77.
Wicksell, K. (1935 ). Lectures on Political Economy. London: George Routledge &
Wicksell, K. (1936 ). Interest and prices: a study of the causes and regulating the
value of money. London: Macmillan. Retrieved from
Wolf, M. (2014, April 24). Strip private banks of their power to create money. Retrieved
from Financial Times: http://www.ft.com/intl/cms/s/0/7f000b18-ca44-11e3-bb92-
Wray, R. (2012). Modern Money Theory: A Primer on Macroeconomics for Sovereign
Monetary Systems. Basingstoke, Hampshire: Palgrave Macmillan.
Zelizer, V. A. (1989, September). The Social Meaning of Money: "Special Monies".
American Journal of Sociology, 95(2), 342-377. Retrieved from
Table 1: Bank balance sheet post cession
Mr B (buyer)
Obligation to make re-payment of the loan
Ms S (seller)
Right to make cash money withdrawal