The Three Theories of Banking: An Overview

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I have already published a few posts regarding the Federal Reserve and the credit facilities it has developed in an attempt to mitigate the financial crisis resulting from the COVID-19 pandemic. However, I thought it would be beneficial to take a step back and explore a more fundamental topic – how does banking work? This is a topic that I’ve been interested in discussing for a while and I think now is a great time to explore it. The answer to the question of how banking works is more complicated than many realize. Moreover, it is still a topic that remains open to debate within the realm of economics.

One of the most compelling arguments that I’ve come across stems from the work of German economist Richard Werner. He provides three mutually exclusive theories of banking, ultimately making the case that one in particular is the empirically correct way to understand how banking works in practice. The three theories put forward by Dr. Werner are the financial intermediation theory, the fractional reserve theory and the credit creation theory.  It is important to grapple with these theories because the way banking is conceived of and carried out in practice will ultimately have profound implications for how banking policies, monetary policies, and bank regulations are implemented. For the purposes of this post, I will be focusing on the three theories of banking presented above and how they are unique from each other.

Financial Intermediation Theory

This is the presently dominant theory of banking. It holds that banks are merely financial intermediaries, undiscernible from other non-bank financial institutions: they gather deposits from clients and use them to make loans. Put another way, banks are “borrowing” money from their depositors in the short term and using that money to make long term loans to borrowers. This theory of banking is publicized by highly ranked economics journal and has also been lauded by well known economists such as Keynes and Mises, with Mises being one of its earliest proponents. The more recent views of this theory, as put forth by the likes of Ben Bernanke, double down on the notion that banks are simply financial intermediaries, one among many, with the power to create credit or money. The key distinction here is that banks and other financial intermediaries do not create money, they can only repurpose existing funds – effectively swapping one asset for another.

Fractional Reserve Theory of Banking

This theory of banking also makes the case that each bank serves as a financial intermediary, but it takes a more nuanced approach than the former. For example, this theory disagrees with the collective notion that banks are solely financial intermediaries, indistinguishable from others, incapable of creating money. Rather, it argues that “together” the banking system does create money through the process of depository expansion. This process is also referred to as the “money multiplier” process. While each bank serves as a financial intermediary, the banking system as a whole is capable of creating new money. Fractional reserve banking effectively means that banks can lend in excess of their reserves, while the total amount outstanding must remain equal to total deposits. Typically, banks are only required to hold 8-10% of their outstanding loan balances in reserves. An important caveat here is that, just like in the financial intermediation theory, banks cannot make loans without having depositors. The nuanced part of this is that banks are only required to allocate a small percentage of their deposits to reserves, while lending out the rest. These new loans become inevitably create multiple new deposits throughout the financial system, which has the aggregate effect of creating new money.

Credit Creation Theory

The third theory of banking is at odds with the other two theories presented above. Unlike financial intermediation and fractional reserve approaches, the credit creation theory asserts that banks are not financial intermediaries in any sense. Rather, each bank is said to be capable of creating credit and money out of nothing whenever it executes a bank loan contract or purchases an asset. From this perspective, banks are not required to gather deposits or allocate reserves in order to lend. This theory posits the opposite – that banks create deposits whenever they originate a loan. The argument being made here actually has less to do with finance and more to do with the law. When a bank originates a loan, what takes place legally is the execution of a legal document. This legal document is a “debt instrument” that the bank is technically purchasing from the borrower under a particular set of conditions (i.e. the sum being purchased by the bank now, will be repaid in the future with interest). Through this purchase, the bank creates a deposit and records it as such on its books. Therefore, at the end of the transaction, money has been created that did not exist prior.

Conclusion

This concludes my brief overview of the theories of banking. Most are probably familiar with the financial intermediation and fractional reserve theories, especially if they have taken contemporary courses in finance, economics, or business. What I found the most interesting in Werner’s work was the notion of credit creation, as it was, for me, a novel concept with some interesting implications. In future blogs I will focus more on this topic and expand on more on the credit creation theory. As always, if you found this information valuable please like, share, and subscribe to my content.

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