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How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking

How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking
How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking
Thanks to the recent banking crises interest has grown in banks and how they operate. In the past, the empirical and institutional market micro-structure of the operation of banks had not been a primary focus for investigations by researchers, which is why they are not well covered in the literature. One neglected detail is the banks' function as the creators and allocators of about 97% of the money supply (Werner, 1997 and Werner, 2005), which has recently attracted attention (Bank of England, 2014a, Bank of England, 2014b, Werner, 2014b and Werner, 2014c). It is the purpose of this paper to investigate precisely how banks create money, and why or whether companies cannot do the same. Since the implementation of banking operations takes place within a corporate accounting framework, this paper is based upon a comparative accounting analysis perspective. By breaking the accounting treatment of lending into two steps, the difference in the accounting operation by bank and non-bank corporations can be isolated. As a result, it can be established precisely why banks are different and what it is that makes them different: They are exempted from the Client Money Rules and thus, unlike other firms, do not have to segregate client money. This enables banks to classify their accounts payable liabilities arising from bank loan contracts as a different type of liability called ‘customer deposits’. The finding is important for many reasons, including for modelling the banking sector accurately in economic models, bank regulation and also for monetary reform proposals that aim at taking away the privilege of money creation from banks. The paper thus adds to the growing literature on the institutional details and market micro-structure of our financial and monetary system, and in particular offers a new contribution to the literature on ‘what makes banks different’, from an accounting and regulatory perspective, solving the puzzle of why banks combine lending and deposit-taking operations under one roof.
bank accounting, bank lending, client money rules, credit creation, loans, monetary reform
1057-5219
71-77
Werner, Richard A.
dc217378-eb19-4592-9be4-ab5f847b74a1
Werner, Richard A.
dc217378-eb19-4592-9be4-ab5f847b74a1

Werner, Richard A. (2014) 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. (doi:10.1016/j.irfa.2014.10.013).

Record type: Article

Abstract

Thanks to the recent banking crises interest has grown in banks and how they operate. In the past, the empirical and institutional market micro-structure of the operation of banks had not been a primary focus for investigations by researchers, which is why they are not well covered in the literature. One neglected detail is the banks' function as the creators and allocators of about 97% of the money supply (Werner, 1997 and Werner, 2005), which has recently attracted attention (Bank of England, 2014a, Bank of England, 2014b, Werner, 2014b and Werner, 2014c). It is the purpose of this paper to investigate precisely how banks create money, and why or whether companies cannot do the same. Since the implementation of banking operations takes place within a corporate accounting framework, this paper is based upon a comparative accounting analysis perspective. By breaking the accounting treatment of lending into two steps, the difference in the accounting operation by bank and non-bank corporations can be isolated. As a result, it can be established precisely why banks are different and what it is that makes them different: They are exempted from the Client Money Rules and thus, unlike other firms, do not have to segregate client money. This enables banks to classify their accounts payable liabilities arising from bank loan contracts as a different type of liability called ‘customer deposits’. The finding is important for many reasons, including for modelling the banking sector accurately in economic models, bank regulation and also for monetary reform proposals that aim at taking away the privilege of money creation from banks. The paper thus adds to the growing literature on the institutional details and market micro-structure of our financial and monetary system, and in particular offers a new contribution to the literature on ‘what makes banks different’, from an accounting and regulatory perspective, solving the puzzle of why banks combine lending and deposit-taking operations under one roof.

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e-pub ahead of print date: 29 October 2014
Published date: December 2014
Keywords: bank accounting, bank lending, client money rules, credit creation, loans, monetary reform
Organisations: Centre of Excellence for International Banking, Finance & Accounting

Identifiers

Local EPrints ID: 372868
URI: https://eprints.soton.ac.uk/id/eprint/372868
ISSN: 1057-5219
PURE UUID: 1b3b6dd7-7222-4e7c-a1ee-6aed6987e641

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Date deposited: 24 Dec 2014 12:14
Last modified: 19 Jul 2019 20:55

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Author: Richard A. Werner

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