AbstractThis chapter describes how money is created. Many people mistakenly believe that money can only be created by governments or central banks. But money today is mostly – but not exclusively – created by commercial banks. This chapter describes the ways in which this is done, it outlines the forces that drive and constrain this means of money creation, and it discusses the role of monetary policy. Show
This chapter describes how money is created. Many people mistakenly believe that money can only be created by governments or central banks.Footnote 1 But this is not the case: money today is mostly – but not exclusively – created by commercial banks. Section 2.1 describes the ways in which this is done. Section 2.2 outlines the forces that drive and constrain this means of money creation. Section 2.3 discusses the role of monetary policy. Section 2.4 closes the chapter with a brief conclusion. 2.1 Banks and Money CreationThe bulk of today’s money supply consists of bank deposits (money in payment and savings accounts); only a small proportion consists of cash.Footnote 2 Understanding how money is created thus entails focusing on the creation of bank deposits. To understand how this works, we first examine the concept of the bank balance sheet (Box 2.1). Box 2.1 The Bank Balance SheetA bank’s operations are best illustrated through its balance sheet. To keep it simple, imagine the balance sheet as a balanced pair of scales. On the left side are the bank’s assets; on the right are its liabilities (see Fig. 2.1). The assets generate income for the bank and are funded by its liabilities. The simplified balance sheet below shows only the bank’s main assets and liabilities. Fig. 2.1  A simplified bank balance sheet Full size image On the left side are the bank’s assets. These consist of loans granted by the bank including mortgages and corporate loans. These loans are an important source of income but may also lead to losses. The bank also holds marketable financial assets such as government bonds. These assets usually generate less income than loans but are easier to sell to other parties. Finally, the bank holds central bank reserves, used as a means of payment between banks and between banks and the central bank. This includes cash, which for a bank is interchangeable with central bank reserves. On the right side of the balance sheet are the bank’s liabilities, consisting of debts and equity. The debts include the balances of customers’ payment and savings accounts. Banks are thus indebted to their account holders. Although savings accounts are similar to payment accounts, there are some differences. In normal times, the bank pays higher interest on savings accounts, but balances on these accounts cannot be used to make direct payments.Footnote 3 The bank also has debts to other banks and the central bank and issues bonds. Finally, there is the bank’s equity. Equity can be calculated by subtracting debts from assets. It is the money that the shareholders have invested in the bank, plus retained profits and minus any losses. Equity is important because it can absorb losses. The two sides of the balance sheet are by definition always equal. If someone sells a €100 government bond to the bank, the bank’s financial assets increase by €100 on the left side of the balance sheet and the seller’s payment account balance rises by €100 on the right side. If a financial asset held by the bank (such as a government bond) falls in value and all other things remain equal, the bank’s equity decreases by the same amount. If a bank suffers losses on its assets (left side) to the extent that equity disappears (right side), it is technically bankrupt. So how is money created? While many people believe banks first raise money and then lend it to others, this is not how it works in the current system.Footnote 4 When a borrower obtains a loan from a bank, the bank simultaneously grants the loan and creates a bank deposit (the money). Banks thus create new money when granting loans. We can explain this by using a simplified bank balance sheet (see Fig. 2.2) and an example. Suppose Anne wants to borrow €5,000 from the bank to buy a car. Before the bank grants a loan, it first checks her creditworthiness. If the bank grants the loan, it increases Anne’s payment account balance by €5,000, thereby creating money. This new money is a debt that the bank owes Anne. At the same time, Anne incurs a debt of the same amount to the bank. This debt is added to the bank’s assets on the left side of the balance sheet, while the amount on the payment account is added to the liabilities on the right side. The balance sheet remains in balance, but both sides are now longer. We say that the bank’s balance sheet has increased. Fig. 2.2 Creation of deposit money by bank lending (This is a simplified bank balance sheet. It contains the same elements as the balance sheet in Fig. 2.1). Full size image In this type of money creation, new deposit money and a new loan are always created at the same time. Conversely, deposit money is destroyed when someone repays a debt to the bank. When Anne repays €500 to the bank, her bank deposit decreases by €500 (right side) and the bank’s asset (the loan) also decreases by €500. Once again the balance sheet remains in balance (see Fig. 2.3). The repayment decreases the balance sheet. Fig. 2.3 Destruction of deposit money by debt repayment Full size image In addition to this form of money creation, money is also created or destroyed when banks buy or sell financial assets – for example government bonds, corporate bonds or shares – to or from non-banks. When Thomas sells the bank a government bond, the bank credits his payment account. The bank now has a new asset on the left side (the government bond) and a new liability on the right side (Thomas’s higher bank balance). This increases the money supply. In the reverse case – when Thomas buys a government bond from the bank – a sum is debited from his account and an amount of deposit money is destroyed. But this way in which money is created and destroyed accounts for much less than the granting and repayment of loans.Footnote 5 2.1.1 Electronic Payments and Cash WithdrawalsTo understand how money is created, we also need to examine payments between account holders of different banks. In our example, Anne borrowed €5,000 from Bank A to buy a car. When she buys this car and pays for it using a debit card, she instructs her bank to debit €5,000 from her payment account and credit €5,000 to the car dealer’s payment account. But suppose the car dealer’s account is at Bank B. How is this transaction processed? The reserves that a bank holds with the central bank play a key role in the processing of transactions. These reserves serve as interbank money. They are not accessible to consumers and businesses and do not form part of the money supply. When deposits are transferred between banks, banks use these reserves to pay each other. In the example, Bank A reduces Anne’s balance by €5,000 and asks Bank B to increase the car dealer’s balance by €5,000. This means that Bank A’s debt to Anne (the bank deposit) decreases by €5,000, while Bank B’s debt to the car dealer increases by €5,000. Bank B will not want to assume this debt without having assets transferred to it by Bank A. Bank A therefore transfers €5,000 of its central bank reserves to Bank B. Both banks’ balance sheets are now back in balance. The result is that Bank A has both lower liabilities (Anne’s balance has declined by €5,000) and lower assets (its central bank reserves have also declined by €5,000). Precisely the opposite happens for Bank B (see Fig. 2.4). Fig. 2.4 Transfers between banks Full size image Millions of transactions take place between customers of different banks each day, the net result of which is settled by banks using their central bank reserves. When a bank’s central bank reserves fall below the required level, it must supplement them by borrowing reserves from other banks through an interbank loan or from the central bank. Such a loan increases the bank’s liabilities (debt owed to other banks or to the central bank) and assets (central bank reserves). Since banks must normally pay higher interest on such loans than on payment accounts, banks seek to retain customers (account holders) and limit high outflows from payment accounts. In short, banks need to keep their finances in order, attracting payment and savings account deposits and maintaining appropriate mixes of funding. But as the description above makes clear, banks do not have to raise money before they can grant new loans. When a customer withdraws cash from a bank, deposit money is converted into cash. This changes the composition but not the size of the money supply. If Anne, in our example, had withdrawn the money she borrowed in cash from an ATM, we would again see changes on both sides of the bank’s balance sheet: both the bank’s central bank reserves (which include cash) and Anne’s payment account balance would have decreased. When someone converts cash into deposit money, this does not affect the size of the total money supply.Footnote 6 2.1.2 Free Money?Banks create money through simple administrative acts when granting loans. This tends to cause confusion, because it suggests that banks can just create money and spend it; put differently, that banks get free money. That is not the case. The created money is a debt owed by the bank to the customer (the bank deposit) and is the customer’s money. But the customer has also incurred a debt to the bank. The creation of deposit money thus involves the simultaneous creation of a debt owed by the customer to the bank and a debt owed by the bank to the customer, a phenomenon known as ‘mutual debt acceptance’.Footnote 7 Although ‘mutual debt acceptance’ may suggest that the two debts mirror one another, the debts have different characteristics. The customer’s debt to the bank, for example a mortgage, often has a longer maturity and must be repaid (with interest, the bank’s income) at regular intervals. The bank’s debt to the customer (the payment account balance) has no fixed repayment term – it may in fact never be repaid. It serves as money: it can be used to make payments and can be withdrawn at any time. The customer can convert it into cash or transfer it to another bank. A point of discussion is whether banks earn ‘seigniorage’ profits – profits generated through the creation of money. Traditionally, seigniorage represents the difference between the cost of producing money and its purchasing power. If the government mints a euro coin incurring material and production costs of 10 cents and then spends this euro, the government realizes 90 cents of seigniorage.Footnote 8 But because banks cannot spend the new money they create, they do not earn this type of seigniorage. Rather, bank profits largely derive from the difference between the interest received on loans and the interest paid on bank deposits, known as the interest margin. This does not mean that banks do not financially benefit from their ability to create new money. That they can create bank deposits when granting loans gives them a funding advantage over ‘ordinary’ businesses, although they do have to bear the costs of maintaining the payments system (seigniorage and bank profits are discussed in more detail in Box 4.3). 2.2 Driving and Constraining ForcesAlthough commercial banks today create the bulk of the money supply when they grant loans, this does not mean that there are no constraints on creating money. The financial sector, households, businesses and governments all play driving or constraining roles, with the central bank occupying a pivotal position.Footnote 9 The creation of money is influenced by three key factors: the behaviour of households and businesses; banks’ balance sheet risks and associated regulations; and the influence of monetary policy and the role of the central bank. These factors are interrelated and influence one another. The first two are discussed in this section. Monetary policy is discussed in Sect. 2.3. 2.2.1 The Role of Households and BusinessesBanks create money when they grant loans. This highlights an important prerequisite: there must be demand for credit. In the creation of money as elsewhere, it takes two to tango. Demand for credit largely depends on the plans, wishes and expectations of borrowers. Moreover, not all lending requires the bank’s explicit consent. Take for example businesses making use of credit lines. The bank gives businesses a margin within which they can borrow money; the bank cannot determine precisely how much will be lent (and therefore how much money will be created). The number of transactions is so vast that it is impossible to control or approve every transaction in which money is created. Overdrafts usually occur on the initiative of the borrower. Another factor is what borrowers do with their payment account balances. Suppose Peter borrows money to buy a house from William, who moves into a rented apartment. Since William still has a mortgage, he uses the proceeds from the sale to repay it. The newly created money is then (at least in part) destroyed. Creating money can also lead to increased spending on goods and services. If William has already repaid his mortgage, he can use his newly obtained money for other purposes. The money may thereby find its way to businesses that use it to finance expenditures, etc. In that way the newly created money facilitates more spending in the economy. If the money is used to import goods, deposit money will flow abroad (to the exporter’s bank account) and the money supply shrinks. In short, the behaviour of borrowers and account holders affects the size of the money supply. Whether there is net money creation at the national level therefore largely depends on people’s willingness to incur debt, their desire to repay debt, and the extent to which they wish to hold funds in payment or savings accounts at domestic banks. All of this in turn largely depends on people’s beliefs about what the future has in store for their incomes and assets. Uncertainty about the future is a major source of instability. In good times, with rising house prices, people may become overly optimistic and take on high levels of debt. This is encouraged by banks, which in good times are usually generous in granting credit (encouraged by the rising value of collateral, e.g. housing prices). Overall, this leads to strong credit growth and money creation. But when future prospects appear ominous, parties often hit the brakes at the same time: businesses and households become reluctant to take on more debt and focus on repaying existing debts. Banks cut credit lines because collateral values collapse and the future appears dire. Contractions in credit and the money supply then go hand in hand. Banks themselves of course play a role in shaping the demand for bank credit. They pursue particular credit policies, deciding who they will or will not lend to, and on what terms (interest rates, fees, repayment periods, amount of collateral, etc.). Because banks earn income from lending, they seek to attract borrowers; they monitor their competitors, basing their loan conditions and interest rates partly on what other banks are offering. Future prospects, assessments of risk, and the central bank interest rate – which affects funding costs for banks – all heavily influence their actions. All this in turn affects the demand for loans. 2.2.2 Banks’ Balance Sheet RisksThe second major factor that influences contemporary money creation concerns balance sheet risks for banks. When banks create money by granting loans, they must consider two types of risk. First, there is the risk that the bank’s equity will be unable to absorb falling asset values (outstanding loans and other financial products). This is known as ‘solvency risk’. Second, there is the risk that the bank will be unable to meet cash withdrawals and transfers to other banks, or that short-term funding will dry up. This is called ‘liquidity risk’. Since bank failures generally have far-reaching social consequences, governments have introduced legal requirements for bank solvency and liquidity. 2.2.2.1 Absorbing Losses – Leverage and Capital RatiosLike other businesses, banks fund themselves through a combination of debt and equity (the money invested by shareholders, plus retained profits, less losses) (see Fig. 2.5). Fig. 2.5 Bank equity and debt Full size image Banks are unique in that much of their debt consists of account holders’ deposits – debts that are used as money in society. As explained earlier, the bank creates these debts when it grants loans, but it must ensure that these do not rise excessively relative to equity. After all, it is the equity that absorbs the bank’s losses when assets fall in value. Sufficient equity ensures that the bank’s debts can be repaid and that losses or declining asset values do not lead to bank failure. Bank failures can threaten the stability of the financial system, with far-reaching consequences for society as a whole. At the same time, the bank’s shareholders prefer the bank to fund itself largely through debt, which is generally cheaper than funding through equity. Like other businesses, banks’ interest expenses are tax-deductible. Furthermore, the bank’s debts largely consist of bank deposits. As customers use bank deposits to make payments, they are prepared to accept lower remuneration than other creditors. This means that while the bank’s shareholders have an interest in ensuring that the bank can absorb losses, they also prefer a high proportion of debt so as to increase return on equity.Footnote 10 Banks therefore need to strike the right balance between debt and equity; the right balance will not necessarily be the same for all stakeholders. The ratio of equity to total assets is also referred to as the ‘leverage ratio’ – an important metric for banks, shareholders and regulators. Consider two banks, both with a balance sheet of €100 million (see Fig. 2.6). The difference is that Bank A has a leverage ratio of 4% (€4 million of equity) and Bank B has a leverage ratio of 20% (€20 million of equity). If the value of these banks’ assets rises by 4% (€4 million), the value of the equity also rises by €4 million. For the shareholders of Bank A, this means the value of the equity doubles (from €4 million to €8 million). For the shareholders of Bank B, it means the value rises by only 20% (from €20 million to €24 million). With the same increase in the value of a bank’s assets, the equity of Bank A has risen relatively more than that of Bank B. This is the leverage effect: a relatively small rise in the value of assets generates a large rise in the value of the bank to its shareholders. But this cuts both ways. If the value of the bank’s assets falls by 4%, Bank A’s equity evaporates and the bank is on the verge of bankruptcy, whereas Bank B faces no problems. Fig. 2.6 How leverage works Full size image When banks have little equity, a minor shock can cause immediate problems, for them and for the financial sector as a whole.Footnote 11 This is why there are legal requirements governing banks’ equity levels. In technical terms, this is called capital regulation (see Box 2.2). Since the 1980s, policy in this area has been developed by the Basel Committee on Banking Supervision (BCBS). Box 2.2 Equity and CapitalEquity consists of the money shareholders have invested in a firm. Over time, equity grows through retained profits (profits that have not been distributed to shareholders or other capital providers) and shrinks through any losses. When discussing banks, we often use the terms ‘capital’ or ‘capital buffers’ instead of equity. Particularly the term ‘buffers’ generates confusion as it suggests money held by a bank in a physical or virtual safe. A bank’s capital is also sometimes confused with the reserves that a bank holds at the central bank. But central bank reserves are assets of the bank, on the left side of its balance sheet. Capital is the means by which the bank is financed (on the right side of the balance sheet). Capital is the perhaps unfortunately chosen term referring to the bank’s equity. But there is a difference. In its definition of capital, the Basel Committee includes components that are technically not part of the bank’s equity. This is referred to as Tier II capital (Tier I is approximately equal to equity). Tier II capital includes, for example, debts that can be converted into equity when a bank faces financial difficulties. A contemporary example is a contingent convertible (CoCo) bond – a loan to the bank that is converted into a share (equity) if the bank’s capital falls below a certain minimum. The creditor then becomes a shareholder. This reduces the bank’s debt and increases its equity.Footnote 12 If a bank’s leverage becomes excessive, the risk of failure increases. The leverage ratio expresses equity as a percentage of total assets (see Fig. 2.7).Footnote 13 The Basel III Accord prescribes a minimum leverage ratio of 3%, but this requirement is not yet binding in European regulations.Footnote 14 A binding leverage ratio is part of a recent package of measures recently adopted in EU legislation.Footnote 15 Anticipating these agreements, Dutch policymakers have specified that from 2018 Dutch systemic banks must meet the minimum requirement of 4%.Footnote 16 The current government plans to abolish this requirement when the new European capital ratio rules (see below) come into force.Footnote 17 Fig. 2.7 The leverage ratio Full size image Regulators believe that a leverage ratio (that only expresses equity as a proportion of total assets) encourages banks to hold riskier, higher-yielding assets with the same amount of equity. Regulations and supervision therefore focus primarily on the ratio by which assets are risk-weighted, known as the capital ratio. The capital ratio expresses capital as a percentage of a bank’s total risk-weighted assets (see Fig. 2.8). This means that a bank must hold more capital to cover risky assets than to cover safe assets. If a bank invests primarily in safe government bonds, it does not need as much equity as a bank that grants risky loans. Fig. 2.8 The capital ratio Full size image Banks must maintain a minimum capital ratio of 8%, although in practice additional requirements lead to higher buffers. Capital requirements have changed over time, both above the line (items that count as capital) and below the line (the weighting of asset risks). Since the Basel II Accord, the major banks enjoy a great deal of freedom in calculating their risks.Footnote 18 Banks can use a standardized approach (used by smaller banks) or the so-called ‘internal rating based’ approach (used by the major banks). In this latter approach, banks calculate their capital requirements using their own risk-models, although these models require regulatory approval.Footnote 19 This risk-based approach has drawn criticism in the wake of the crisis, with experts calling for requirements that also consider the size of a bank’s balance sheet. The Basel III Accord thus included a minimum leverage ratio (see above).Footnote 20 Research by the Bank of England revealed the leverage ratio to be a better predictor (than the capital ratio) of which banks would encounter trouble during the crisis.Footnote 21 It was also found that risk assessments for similar asset portfolios varied significantly between banks.Footnote 22 What does all this have to do with the creation of money? When a bank grants a loan and thereby creates a new bank deposit, the bank’s balance sheet increases. A loan is added on the left side of the balance sheet, and a bank deposit on the right. As a bank grants more loans, its equity will make up a smaller proportion of the balance sheet, lowering both the leverage and capital ratio.Footnote 23 The result is that the bank is now less able to absorb losses. When granting loans, banks thus carry out risk assessments to determine the likelihood of losses that could cause financial difficulty. If the bank’s equity is too low relative to total assets, lending may be constrained. The bank may decide to grant fewer loans or to strengthen its equity by retaining earnings or, if possible, by attracting new equity. How a bank’s equity position will affect its lending is based on a combination of its own risk assessments and legal requirements, i.e. the minimum capital and leverage requirements. The amount of equity can thus limit a bank’s ability to create money. To what extent does a bank’s equity position limit the creation of money? Risk-weighted capital requirements do not constitute an absolute limit. Asset risks are often underestimated in good times and overestimated in bad. In good times, a relatively low level of equity is deemed sufficient, allowing for more lending. In bad times, assets are considered much riskier and the balance sheet must be shortened. Risk weighting can therefore have procyclical effects. Furthermore, balance sheet ratios are never an absolute brake on lending and money creation, for so long as a bank can maintain its level of equity by retaining profits or attracting new equity, it can continue to grow without any decline in its ratios. Another reason why capital requirements are not an absolute limit on money creation and lending is that banks have found innovative ways to remove assets from the balance sheet. The mortgage packages that were so popular in the years preceding the crisis were largely motivated by the desire of banks to shorten their balance sheets so that they could continue to meet statutory capital requirements. Banks set up special institutions (part of the ‘shadow banking system’, further discussed in Chap. 4) to buy up bundles of mortgages which they financed by issuing special bonds (mortgage-backed securities), which proved popular among pension funds and insurance companies. The mortgages were no longer on the banks’ balance sheets and the banks had scope to grant new loans. 2.2.2.2 Meeting Withdrawals: Liquidity Ratios and Reserve RequirementsThe second risk a bank must consider is liquidity risk. If a large number of households and firms simultaneously wish to turn their deposits into cash or transfer money to other banks, a bank can only meet their requests if it has sufficient cash or central bank reserves.Footnote 24 If it does not, it must have assets such as government bonds that can be readily sold and converted into cash or central bank reserves, i.e. liquid assets. The most familiar type of liquidity problem is the bank run of the kind that hit the British bank Northern Rock in 2007, when account holders queued en masse to withdraw their balances in cash. Although this is the classic image, most bank runs today are electronic and thus less visible. Nevertheless, when many account holders transfer their deposits electronically to other banks, such bank runs are just as problematic for individual banks.Footnote 25 Another potential cause of liquidity problems is banks’ reliance on short-term debt funding. Although these loans are readily rolled over in good times, this can stop suddenly when lenders begin to doubt the bank’s creditworthiness. In the 2007–2008 financial crisis, it was this type of bank run that caused the biggest problems.Footnote 26 Liquidity problems are inherent to banking due to the differences in maturity between a bank’s assets and liabilities. On average, a bank’s assets have longer maturities than its liabilities: mortgages, for example, may have a maturity of 30 years and corporate loans of five years, whereas bank deposits can be withdrawn on a daily basis. If deposit money is withdrawn in cash, the same amount is deducted from both sides of the bank’s balance sheet, with reductions on the left side in cash (the bank’s asset) and right side in account holders’ deposits (the bank’s liability). If deposit money is transferred to another bank, the balance sheet also contracts on both sides: central bank reserves on the left and bank deposits on the right. If the bank lacks sufficient central bank reserves, it can sell liquid assets (such as highly rated government bonds) to other banks in order to supplement its central bank reserves. A bank can also borrow reserves from other banks, thereby adding new liabilities to the right side of the balance sheet.Footnote 27 Finally, a bank can borrow reserves from the central bank, against specified collateral. In the event of a liquidity crunch, the central bank may decide to provide emergency funding, unless it considers the bank no longer viable. It is therefore crucial for banks to have sufficient stable funding (right side of the balance sheet) to prevent liquidity problems. They must also have sufficient central bank reserves and readily saleable assets (left side of the balance sheet) to cope with spiking withdrawals or when loans to the bank are not rolled over. The 2007–2009 financial crisis revealed liquidity risks to be much more severe than previously thought. Banks had assumed that they would be able to sell assets such as mortgage-backed securities under all circumstances. They also expected that in case of difficulty, they would always have access to short-term funding from other financial institutions. Both assumptions proved incorrect. In response, the Basel Committee on Banking Supervision introduced liquidity rules in the new Basel III Accord.Footnote 28 The Accord specifies two ratios that banks must adhere to: (1) the liquidity coverage ratio (LCR); and (2) the net stable funding ratio (NSFR). The LCR has already been implemented in the European Union. The NSFR has only been recently adopted, and will only enter into force in 2021.Footnote 29 The liquidity coverage ratio requires banks to have sufficient liquid assets to survive a period of liquidity stress lasting 30 days. The bank is required to hold a stock of high-quality liquid assets at least as large as the total expected net outflows during the stress period (see Fig. 2.9). Fig. 2.9 Liquidity coverage ratio (LCR) Full size image If a bank expects €100 million to flow out over a period of 30 days, it must have at least €100 million of high-quality liquid assets (see Box 2.3 for the definition of liquid assets). The liquidity coverage ratio is designed to ensure that problems in the financial sector do not disrupt payments in the real economy.Footnote 30 Box 2.3 High-Quality Liquid AssetsA crucial question when assessing a bank’s liquidity is what can be considered a high-quality liquid asset. The Bank for International Settlements states that the criteria are, first, the fundamental characteristics of the financial asset: its riskiness, ease of valuation, correlation with other risky assets, and whether the asset is listed on a developed and recognized exchange. Second, regulators look at market-related characteristics. An asset is deemed liquid when there is a sizable, active market for it, with limited volatility in its trading price, and when investors consider it a ‘safe haven’ in times of crisis. It is particularly important that the asset meets these criteria in times of crisis, when liquidity in many markets dries up.Footnote 31 Supervisors use these criteria to calculate banks’ liquidity coverage ratio. Assets that are considered liquid in almost all circumstances, such as highly rated government bonds, count as 100% in this calculation. Assets that are likely to be harder to sell without a loss during a crisis are given a ‘haircut’ and are only partially included in the LCR. Individual corporate loans or mortgages do not count as they are barely marketable. Since the liquidity of assets largely depends on market conditions, there is a degree of circularity in its regulation: liquidity rules affect those very conditions – and hence the liquidity of assets. This can lead to unintended consequences. The very fact of designating certain assets as ‘liquid’ increases their liquidity, while other assets become less liquid. Imposing minimum liquidity requirements can also make banks less willing to sell their liquid assets in emergencies, as they fear breaching the requirements. Paradoxically, this can make the assets less liquid, because in bad times everyone wants to adhere to the requirements. To limit this problem, the Basel standard includes an explicit provision allowing banks to (temporarily) breach the minimum requirement in an emergency. Whether they will dare to do so in practice – also given the associated reputational risks – remains to be seen.Footnote 32 The second standard for liquidity is the net stable funding ratio (NSFR) which aims to ensure that banks rely on sufficiently stable sources of funding. The NSFR requires longer-term loans to be funded by long-term liabilities (see Fig. 2.10). The stability of both the assets and liabilities is weighted. The weighted stability of liabilities, or ‘available stable funding’, must exceed that of assets (‘required stable funding’). The NSFR is designed to ensure balance between the maturity of a bank’s assets and its sources of funding, known as maturity matching.Footnote 33 Fig. 2.10 Net Stable Funding Ratio Full size image On the assets side, all loans outstanding for longer than one year fall into a category requiring 100% stable funding. Many other assets require less stable funding and are therefore weighted (between 5% and 85%). Only cash, central bank reserves, claims on the central bank with residual maturities of less than six months, and so-called “trade date” receivables arising from sales of financial instruments, foreign currencies and commodities require 0% stable funding. On the other side of the balance sheet, different types of funding variously count as stable forms of funding. Equity capital and bank deposits, for example, are considered 90–100% stable; other forms of funding are considered less stable.Footnote 34 How do liquidity ratios affect the creation of money? If a bank grants a five-year loan to Farid, his debt to the bank has a maturity of five years whereas he can withdraw the newly created deposit at any time. Since the created asset and liability have different maturities, every new loan results in an additional maturity difference on the bank’s balance sheet, thereby in principle increasing liquidity risks. But in practice, bank deposits are considered a very stable source of funding. For the net stable funding ratio, consumers’ and small businesses’ bank deposits are deemed 90–95% stable.Footnote 35 Although customers do transfer money between banks, the overall volume of bank deposits, in the short run, remains roughly the same. It is only when borrowers withdraw deposits en masse in cash, or transfer them to other banks or abroad, that individual banks face liquidity problems. In addition to these liquidity requirements there are also other policies for limiting or absorbing banks’ liquidity risks. We have already mentioned the possibility for banks to borrow from the central bank. Deposit insurance also plays a role: as customers know that deposits up to certain amount (in the EU: €100,000) are guaranteed, they are less likely to withdraw their money if they suspect problems at their bank. The deposit insurance scheme does not apply to professional financial market participants; other providers of bank funding (such as bondholders or providers of short-term loans) also have no repayment guarantee if a bank fails. Liquidity problems are therefore more likely to come from this side. Liquidity is moreover affected by market sentiment. When optimism prevails, assets have higher valuations and appear highly liquid, while constraints on credit and money creation arising from liquidity requirements are less effective. But optimism can evaporate in a crisis: “[when] liquidity dries up, it disappears altogether rather than being re-allocated elsewhere”.Footnote 36 Alongside requirements for liquidity, central banks also impose minimum reserve requirements. These include maintaining a certain minimum percentage of reserves relative to bank deposits at the central bank (see Fig. 2.11). Reserve requirements, however, currently play a limited role in many developed countries and are not used to control bank liquidity. The United Kingdom, for example, has no requirements at all. In the euro area, the requirements are fairly lenient: central bank reserves must average at least 1% of total payment and savings account deposits, debt securities issued with a maturity of up to two years and money market funding.Footnote 37 Fig. 2.11 Minimum reserve requirements Full size image Confusion surrounds minimum reserve requirements because they can serve three different objectives.Footnote 38 They may have a prudential aim, ensuring that banks have sufficient liquid assets to meet any sudden outflows of funds. The central bank can also use reserve requirements to directly influence the money supply: if it strictly limits available reserves, lending is constrained. Finally, the central bank can use reserve requirements to facilitate interest rate policy; the mandatory holding of reserves means banks must accept the interest rate that the central bank sets for these reserves. In developed economies reserve requirements are currently used solely for this last objective. To what extent do reserve requirements constrain the creation of money? In our current monetary policy framework, there is no cap on central bank reserves: commercial banks are free to borrow reserves from the central bank so long as they can provide high-quality collateral. This means that reserve requirements do not directly constrain the creation of money. Although central banks in developed economies no longer apply reserve requirements to constrain or cap credit growth as they did in the past, reserves continue to function as an indirect brake on money creation through central bank interest rates. 2.3 Monetary PolicyA final important factor that affects money creation is monetary policy. We have outlined how the interest charged on loans and the interest paid on payment and savings accounts impacts money creation. These interest rates are influenced by the central bank’s monetary policy. In this section we first discuss the objectives and instruments of monetary policy (Sect. 2.3.1), followed by the effects of monetary policy (Sect. 2.3.2) and quantitative easing (Sect. 2.3.3). 2.3.1 Objectives and InstrumentsThe goals, focus and instruments of monetary policy have changed over time, as has the line between monetary policy and other policy domains. While the currency’s internal and external stability has always been a core aim, the means of achieving this have changed over time. Moreover, central banks have also had other objectives such as contributing to economic development, employment and financial stability.Footnote 39 Particularly since the 1980s, however, keeping inflation in check has been the holy grail in many countries. The principal aim of current European monetary policy is price stability (Article 127(1) TFEU). The ECB defines this as low and stable inflation below, but close to, 2% (see Box 2.4). Box 2.4 The 2 Percent TargetThe centrality of the objective of price stability is set out in the Treaty on the Functioning of the European Union (Article 127(1) TFEU). In 1998 the ECB’s Governing Council defined price stability as “a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability must be maintained over the medium term.” In 2003 the Governing Council specified that the aim was to achieve inflation close to, but below, 2%. Price stability was thus operationalized in several ways. The aim is not absolute currency stability but low inflation (close to, but below, 2%). The ECB gives a number of reasons for this.Footnote 40 Low inflation provides scope to tackle the risks of deflation (decreasing prices). Since interest rates cannot fall far below zero, it is easier for the central bank to combat inflation than it is to combat deflation. The ECB also wants a margin to deal with differences in inflation across euro area countries, thereby insulating some countries from the effects of very low inflation or even deflation.Footnote 41 The margin also allows for the possibility that the method for inflation measurement (HICP) overstates actual inflation. The definition further clarifies that inflation is measured by the rise in consumer prices, the Harmonized Index of Consumer Prices. ‘Harmonized’ means that all countries in the European Union use the same methodology to measure inflation.Footnote 42 Importantly, this measurement approach excludes price rises in other areas, particularly real estate, shares and other financial assets. Finally, the definition makes clear that the ECB focuses on the medium term, accepting short term deviations from its target. In case of a deviation the ECB aims to achieve a predictable and gradual return to the desired level. The ECB aims to ensure price stability by influencing the interest rates at which financial institutions do business with each other (money market rates). The main monetary policy instruments are: (1) standing facilities; (2) open market transactions; and (3) reserve requirements.Footnote 43 In the past central banks also used more direct instruments to limit credit growth (see Chap. 3); instruments that are nowadays generally labelled as ‘macroprudential’ policy tools. Standing facilities allow banks to borrow central bank reserves overnight against accepted collateral (the marginal lending facility) or deposit their reserves with the central bank (the deposit facility). The interest rates that banks pay or receive are usually the upper and lower limits of money market interest rates.Footnote 44 The second central bank instrument consists of the open market transactions. In contrast to standing facilities, these transactions take place at the central bank’s initiative. These are generally one-week loans (against accepted collateral) for which banks can ‘bid’. The aim is to bring the money market interest rates to the desired level. The central bank can purchase financial instruments using central bank reserves – a particular form of open market transaction now used as part of ‘quantitative easing’ (see below). The third instrument comprises minimum reserve requirements (discussed above). This is the average amount of central bank reserves commercial banks are required to hold, currently set at 1% of total payment and savings account deposits, debt securities with a maturity of up to two years, and money market funding. As stated above, in the current system reserve requirements are not used to directly limit the creation of money and debt. This is because the ECB is always prepared to create new central bank reserves and lend these to banks (against collateral and at specified interest rates). 2.3.2 How Monetary Policy Works in PracticePrice stability – or actually stable inflation – is the main aim of monetary policy. Here the central bank wields three important instruments. But how does this work in practice? Figure 2.1 showed that banks hold reserves at the central bank. These reserves are part of a bank’s assets and thus enter on the left side of the balance sheet. Banks need these reserves when customers transfer money from Bank A to Bank B (Bank A must transfer an equivalent amount of central bank reserves to Bank B) and when customers withdraw cash. The central bank sets the interest rate at which banks can deposit their excess reserves and the rate at which banks can borrow additional reserves (these rates serve as the floor and ceiling of the so-called interest rate corridor). These interest rates influence the rates that banks charge each other (money market interest rates) and ultimately also other interest rates. It is important to note that a credible central bank generally has to do little to influence these rates; it often suffices to express a particular preference. Banks after all know that the central bank will ultimately intervene to enforce the desired interest rate. For example, in the ECB’s early years it could announce a specific target while waiting several days before taking specific actions to bring it about. But in the intervening period, interest rates had already moved in the desired direction. Market participants’ knowledge and expectations of central bank objectives are often just as important as the central bank’s actions to achieve its objectives.Footnote 45 Particularly since the introduction of unconventional monetary policies, central banks have followed a strategy known as forward guidance, whereby they deliberately influence future expectations by communicating their longer term aims. The central bank discloses not only what it is doing now, but also what it expects to do in the future. But for this mechanism to work, central banks must back their words with action. In the UK, forward guidance has become less effective, as the Bank of England has on multiple occasions backtracked on earlier promises in the face of unexpected economic developments.Footnote 46 The central bank’s ultimate objective is price stability, and it uses its influence on the money market interest rate to achieve this. The ways in which the money market interest rate is translated into price stability is known as the ‘transmission mechanism’. It is less mechanical than the word suggests and by no means clear-cut as inflation is influenced by numerous factors. A great deal also depends on market participants’ expectations about the future. As the ECB states: “central banks typically see themselves confronted with long, variable and uncertain lags in the conduct of monetary policy.”Footnote 47 A full account of all aspects of this transmission mechanism is beyond the scope of this report.Footnote 48 One crucial element, however, bears directly on money creation. Suppose the central bank expects inflation to exceed the target over the medium term. It then aims for a higher money market interest rate and uses its own instruments to achieve this. If the interest rate for borrowing central bank reserves and interbank loans rises, this influences banks’ behaviour. To maintain profitability, banks will raise the interest charged on loans. If every bank does so, the demand for credit will fall. On the liabilities side, banks will try to be less dependent on the more expensive money market and increase the share of saving deposits in their funding. Competition then causes interest rates on savings accounts to rise as well. Households and businesses will then find saving more attractive and spend less of their income. Both have the same overall effect: businesses will invest less and households will spend less on products and services. The idea is that this will help keep inflation under control over the medium to long term.Footnote 49 This highly simplified description of how monetary policy works differs from how many introductory economics textbooks continue to describe it. Textbooks often suggest that central banks focus on the amount of central bank reserves as increasing or reducing them would – by means of a ‘money multiplier’ – lead to a higher or lower money supply. Although some countries followed this policy in the past, it is not how monetary policy works today. As the ECB states, this is an example in which “academic economists developed theories detached from reality, without resenting or even admitting this detachment”.Footnote 50 Indeed, the mechanism operates in reverse. Instead of the ‘monetary base’ being created at the initiative of the central bank and being translated by banks into the total money supply, the central bank sets the interest rate and supplies the appropriate central bank reserves.Footnote 51 We consider this issue further in Box 2.5. Box 2.5 The Money MultiplierThe term ‘money multiplier’ suggests that central banks increase central bank reserves and that banks then automatically grant more credit, thereby multiplying the central bank’s money. But numerous factors influence bank lending and money creation, including the demand for loans, whether banks expect these loans to be repaid, bank liquidity and equity, what other banks are doing, etc. We thus cannot assume that banks will automatically increase their balance sheets when central banks issue more reserves. The relationship is actually the reverse: the dynamics of private money creation lead to changes in payment and savings account balances at banks, which affect banks’ demand for central bank reserves and the amount of central bank reserves. Rather than a ‘money multiplier’, it would be more accurate to speak of a ‘money divisor’.Footnote 52 The amount of reserves is not fixed in our current system. Central banks seek to control inflation through the interest rate charged on central bank reserves. Since this interest rate is set by the central bank, the amount of central bank reserves must then adapt to commercial banks’ demand for these reserves. Central bank reserves play a key role in influencing this interest rate. Banks can borrow central bank reserves (or deposit excess reserves) at interest rates set by the ECB. If central bank reserves were fixed and central banks provided no facilities, they would be unable to influence the interest rate in this way, as it would lead to wild fluctuations in the money market interest rate. After all, individual banks cannot easily predict what will happen to these reserves on a day-to-day basis and how much reserves they will need. It largely depends on the extent to which account holders need cash or transfer money to other banks. It is therefore not the case that the central bank first determines the amount of reserves and that this – by means of a fixed multiplier – leads to a certain volume of money being created by banks. Nevertheless, the volume of central bank reserves can indirectly affect bank lending. Banks generally try to hold an amount of reserves that is stable relative to their balance sheets. The amount of reserves can also influence money market interest rates, particularly when the central bank does not intervene.Footnote 53 2.3.3 Quantitative EasingSince the 1970s, the dominant objective of monetary policymakers has been to curb inflation. But the latest financial crisis revealed another danger: deflation. This was due to the debt hangover from the 2007–2009 crisis. Households and businesses took a much gloomier view of the future and repaid debt rather than taking out new loans. Banks’ balance sheet problems and their pessimism about the future also led to more restrained credit policy. To absorb this shock, central banks cut interest rates sharply in the hope that (through different transmission channels) this would contribute to price stability.Footnote 54 The policy interest rate, however, rapidly approached the lower limit of 0%. This is known as the zero lower bound problem.Footnote 55 Credit was extremely cheap but money creation and inflation fell short of the target. The interest rate policy could not provide a solution. In response, many central banks – including the US Federal Reserve, the Bank of England and in 2014 the ECB – switched to a policy known as quantitative easing, with the aim of influencing long-term interest rates. Quantitative easing means that the central bank purchases financial assets (such as government and corporate bonds) from pension funds, banks or large companies. When the central bank buys a government bond from a pension fund, money is credited to the pension fund’s payment account at a commercial bank. The commercial bank’s new liability to the pension fund (the bank deposit) is offset by the simultaneous increase in the commercial bank’s central bank reserves. The bank balance sheet thus remains balanced. The purchase of a government bond from the pension fund thus increases the money supply (see Fig. 2.12). But when the central bank buys bonds from a commercial bank, the money supply does not increase directly, although central bank reserves do. This only changes the left side of the bank balance sheet (assets): bonds decrease and central bank reserves increase. Fig. 2.12 Schematic representation of quantitative easing Full size image The intended transmission mechanism involves influencing interest rates in order to reduce funding costs for households, businesses and governments and to increase spending in order to achieve the 2% inflation target. The idea is that as a result of selling their bonds to the central bank, pension funds will have higher payment account balances than they want. Payment accounts yield little or no interest while pension funds risk losing their money if banks get into financial difficulties. Central banks expect that pension funds will use these newly created bank deposits to purchase financial instruments that generate higher returns, such as corporate bonds and shares. Greater demand for these financial instruments will drive up their value and reduce funding costs for businesses (because interest rates move in the opposite direction to the bond price). Central banks hope that this will stimulate businesses to increase spending, which should ultimately result in inflation of around 2%.Footnote 56 The rising value of financial assets could also make owners feel wealthier and encourage them to spend more. Another possible effect is that increased central bank reserves give banks additional scope to grant loans. Whether monetary policymakers saw this as an important part of the transmission mechanism is not entirely clear.Footnote 57 The Bank of England explicitly states that this is not an important part of the intended transmission mechanism.Footnote 58 2.4 ConclusionThis chapter showed that money creation works rather differently than is commonly assumed. Normally it is not the central bank but commercial banks that create the bulk of the money supply. They do so mainly by granting loans, which consists of the simultaneous creation of an asset (the loan) and a debt for the bank (deposit money on the borrower’s account). When the borrower repays the loan, the money is destroyed. The new money does not belong to the bank but to the borrower. Bank deposits function as money and can be exchanged for cash. By far the largest part of our current money supply (over 90%) consists of bank deposits. Banknotes are printed on behalf of the ECB and coins are struck on behalf of national governments, but because they are put into circulation against bank deposits, this does not increase the total money supply. The fact that banks can create deposit money when granting loans does not mean there are no constraints on money creation. The growth and contraction of the money supply are influenced by the interaction of many factors.Footnote 59 This chapter discussed the three most important ones: the behaviour of households and businesses, banks’ balance sheet risks, and monetary policy. We have seen how monetary policy operates primarily through interest rates, and why this policy is difficult to pursue when interest rates approach zero. Money creation and monetary policy have not always operated in this way. The next chapter discusses how our monetary system has evolved over time. Notes
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Rights and permissionsOpen Access This chapter is licensed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits use, sharing, adaptation, distribution and reproduction in any medium or format, as long as you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license and indicate if changes were made. The images or other third party material in this chapter are included in the chapter's Creative Commons license, unless indicated otherwise in a credit line to the material. If material is not included in the chapter's Creative Commons license and your intended use is not permitted by statutory regulation or exceeds the permitted use, you will need to obtain permission directly from the copyright holder. Reprints and Permissions Copyright information© 2021 The Author(s) About this chapterCite this chapterStellinga, B., de Hoog, J., van Riel, A., de Vries, C. (2021). How Is Money Created?. In: Money and Debt: The Public Role of Banks. Research for Policy. Springer, Cham. https://doi.org/10.1007/978-3-030-70250-2_2 Download citation
What happens to the money supply when customers pay back loans?Repaying loans reduces the amount of money in the economy
Because the money supply in the hands of the public is made up of bank-created numbers in people's bank accounts, repaying loans in this way actually reduces the amount of money in the economy.
What would cause a bank to increase a deposit account?10 strategies for driving bank deposits. Analyze your best customers. ... . Raise your deposit rate. ... . Invest in your community. ... . Make sure your local SEO is up-to-date. ... . Use online advertising. ... . Make sure your website is responsive. ... . Tie in other services. ... . Partner with reputable businesses.. What happens to the money supply when the bank loans out money?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.
Is demand deposit repayable on demand?Demand deposits are repayable on demand by the customers. Current account deposits, Savings bank deposits and Call deposits are the examples of demand deposits. These deposits are repayable on demand by the customers. The amount deposited on these accounts to be released upon the request of customer without any delay.
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