20.7 Commercial banks and private money creation

Most money is commercial-bank money

Most money used by households and businesses in modern economies is not physical currency or money held at the central bank. It consists of balances in commercial-bank accounts. These deposits function as money because they can be transferred to make payments and are generally accepted at their nominal value, but legally and economically they are liabilities of private financial institutions.

The proportion varies by country, date, and definition. In the United Kingdom, commercial-bank deposits made up 97 percent of broad money in December 2013. The Bank of England describes them as IOUs from commercial banks and explains that most are created by the banks themselves (see Money creation in the modern economy). The Reserve Bank of Australia similarly states that the vast bulk of Australian broad money consists of deposits and other liabilities issued by financial institutions (see Money – Born of Credit?).

Lending creates deposits

Banks are commonly described as intermediaries that collect money from savers and lend it to borrowers. That is not an adequate description of modern commercial-bank lending. When a bank approves a loan, it normally records two entries on its balance sheet:

1. a loan asset representing the borrower's obligation to repay the bank; and
2. a deposit liability representing the bank's obligation to make payments for the borrower.

The newly credited deposit did not previously exist. The loan has created new deposit money together with a corresponding debt. When the borrower spends it, the deposit moves through the banking system. When principal is repaid, the corresponding deposit money is extinguished. Banks can also create deposits when they purchase assets, and government and central-bank transactions can alter deposits, so the quantities of bank credit and broad money do not move exactly together. Nevertheless, bank lending is the principal way in which new deposit money is created (see the Bank of England's explanation of money creation and the Deutsche Bundesbank's explanation).

Banks earn interest on the corresponding debt

The borrower pays interest on the loan asset held by the bank. This does not mean that interest is costless profit. Banks must cover defaults, administration, deposit interest, wholesale funding, liquidity, regulatory capital, and returns to shareholders. A bank that creates a deposit may also lose that deposit to another bank when the borrower spends it, requiring the lending bank to obtain settlement funds or other funding.

The institutional privilege remains extraordinary. Commercial banks collectively create most of the medium of exchange by selecting interest-bearing debts. Their income and balance sheets grow through a process that also changes the quantity and initial destination of society's spendable money.

Money creation is constrained but powerful

An individual bank cannot create unlimited money without consequence. It needs willing and creditworthy borrowers, must remain profitable, must settle payments made to other banks, and is constrained by capital, liquidity, lending standards, regulation, and monetary policy. The banking system's creation of money is therefore the combined result of decisions by banks, borrowers, regulators, funding markets, and the central bank.

These constraints do not remove the banks' allocative power. A bank's decision to approve a loan does more than transfer existing purchasing power from one person to another. It creates new purchasing power and determines where that purchasing power first enters the economy. Collectively, banks strongly influence whether new money is directed toward productive businesses, existing houses and land, commercial property, consumer debt, or financial speculation.

Governments and central banks influence the framework through regulation, guarantees, asset purchases, and interest-rate policy. They do not ordinarily choose most individual loans. Commercial banks make the decentralised credit decisions through which most new broad money is created, giving the banking system more immediate control over the direction of money creation than government budget decisions alone would suggest.

Property credit and asset prices

Bank lending is especially consequential when it finances the purchase of existing assets rather than new production. A mortgage used to purchase an existing house creates additional bidding power for an asset whose supply may respond slowly. More mortgage credit can raise property prices; higher prices increase collateral values; larger collateral values support larger loans; and those loans provide still more purchasing power.

The causation can also run in the other direction. Rising property prices encourage borrowers and make property appear safer to lenders, producing additional credit growth. Credit and property prices can therefore form a self-reinforcing cycle rather than a simple one-way relationship. Research published by the Bank for International Settlements finds strong dynamic links between bank credit, commercial-property prices, and banking crises (see Bank lending and commercial property cycles).

This process makes housing less affordable without necessarily constructing more houses. The newly created money raises claims on existing land and buildings, while banks acquire larger interest-bearing loan assets secured by the higher prices. The apparent increase in wealth is partly a rise in the monetary valuation of scarce assets supported by an expansion of private debt.

Private money creates systemic dependence

Under the existing system, a person's everyday money is generally a debt owed by a commercial bank. The safety of transaction balances therefore depends on bank solvency, deposit guarantees, liquidity facilities, prudential regulation, and the expectation that governments and central banks will prevent systemically important banks from failing. Private money creation produces a public obligation to stabilise the institutions whose liabilities the public must use as money.

Credit contraction creates the opposite danger. When loan creation slows or repayment and default shrink bank balance sheets, deposit money can contract. Falling asset prices weaken collateral and lending, which can further reduce credit and spending. The same institutional structure that amplifies a boom can therefore amplify its bust.

Commercial banks under VoTa

VoTa separates financial intermediation from money creation. People and businesses hold currency directly in Central Bank accounts. That currency is not a commercial bank's debt and remains available if a bank fails. The Central Bank Payment System transfers this currency between accounts but never creates or destroys it.

A commercial bank may still assess investments, pool funds voluntarily placed at risk, issue its own bonds or shares, make loans, monitor borrowers, and earn a return for bearing risk. It may finance a loan by crediting an account with a newly created liability against itself. Such an entry is a private promise by the bank, not Central Bank currency, and does not increase the supply of Central Bank currency.

A borrower who wants to make a payment for which the Constitution requires a B-account or R-account needs Central Bank currency in the relevant Central Bank account. A lender wishing to fund that payment must transfer existing Central Bank currency to the borrower or directly to the person being paid. A private bank liability may instead circulate where parties voluntarily accept it, but it remains subject to the bank's redemption terms and solvency.

Why private bank money cannot compete

VoTa does not require people to exchange Central Bank currency at par with a commercial-bank liability. A bank may promise to pay 100,000 currency units and record that promise in an account, but the balance is only an IOU from a potentially insolvent private institution. It is not itself 100,000 units of Central Bank currency.

Central Bank currency is the final settlement asset used by Citizens for domestic commerce, taxation, and public services. Accounts are free to create and use, balances are held directly rather than through a financial intermediary, and the failure of a commercial bank cannot affect them. The Constitution requires the currency to:

• exist only as non-negative balances in Central Bank accounts;
• be transferable with the authority of the sender;
• be available through accounts that any person may hold free of charge;
• remain independent of any commercial bank's solvency;
• never be created, destroyed, duplicated, or lost through rounding;
• be protected by redundant and recoverable transaction records;
• protect the privacy and autonomy of account holders, subject to warranted criminal investigation;
• remain outside discretionary lending, asset purchases, and monetary policy; and
• float freely against foreign currencies.

These properties are guaranteed by the Constitution rather than by a bank's balance sheet or a changing monetary policy. They do not guarantee that purchasing power or foreign-exchange value can never change, and the transfer rules required to enforce consumption tax mean that payments are not wholly unconstrained. They do guarantee that the unit cannot be debased by increasing its supply and that a valid balance is final money rather than a promise to provide money later.

If a seller is offered either Central Bank currency or a private promise denominated in the same unit, the private promise introduces counterparty risk, redemption conditions, and inconvenience. It may offer compensating benefits and may be traded voluntarily at a price reflecting its characteristics, but there is no reason for the State to treat it as equivalent to currency. It has no government deposit guarantee, compulsory acceptance, guaranteed conversion rate, lender-of-last-resort support, or taxpayer bailout. A commercial bank must transfer existing Central Bank currency only when it promises to pay or lend Central Bank currency; it remains free to issue a clearly identified liability of its own.

This gives every loan an opportunity cost. Currency committed to one borrower cannot simultaneously finance another project or remain available for consumption. Investors must choose which uses justify placing their existing purchasing power at risk. Interest is then payment for time, risk, expertise, and the use of scarce funds, not income attached to the creation of society's medium of exchange.

The power VoTa removes

VoTa does not abolish banks. It abolishes their power to issue private liabilities that the public must treat as money. Banks retain useful functions as financial intermediaries but lose the combined ability to:

• create widely accepted money by extending credit;
• select the debts through which new purchasing power enters the economy;
• expand credit and money into asset markets;
• contract the payment medium through repayment, default, or failure; and
• make the monetary system dependent on their continued solvency.

The result is a clear division. The Central Bank supplies a fixed, safe, and neutral payment medium without making investment decisions. Banks and other investors allocate existing savings without creating money. Neither institution possesses both monetary power and discretionary control over the projects that receive it.