BANKS CREATE MONEY FROM LEVERAGE, NOT THIN AIR

What is money?

Money is frequently defined in terms of its functions. Money is a unit of account (also known as a measure of value), a means of trade, a store of value, and a standard of deferred payments.
There are two types of monetary devices that make up modern money. The first is the currency issued by central banks in the form of notes and coins (fiat money). Money is the most prevalent interpretation by the proverbial man on the Clapham omnibus.

Bank liabilities, often known as deposits, credit money, or bank money, are the second type. In modern economies, the amount of cash money and bank money is therefore measured as part of the money supply.
A record of debt-credit relationships is kept in a bank. Since the earliest prominent discussions on modern bank money, the formation of this type of money has been believed to be the consequence of an inter-temporal exchange transaction between parties.

No Noney, No Problem (If You’re a Bank, Allegedly)

Professor Werner (supposedly) demonstrates how banks manufacture money out of thin air in a 2015 article. He expertly explains this approach using a Credit Suisse transaction from 2008. Credit Suisse was on the verge of going bankrupt due to sour subprime mortgage transactions. To stay afloat, the bank required more funds. It was, however, difficult to raise it. Investors are wary about lending to insolvent institutions.
Credit Suisse, on the other hand, did not have to be concerned. It was a financial institution. It could just conjure up some cash. According to Professor Werner, any bank can do it, and Credit Suisse did just that. After a few keystrokes, the result is: Voila! Credit Suisse had made a £7 billion profit and was now debt-free.

The acts of the Swiss bank Loan Suisse in 2008 best highlighted the relationship between bank credit creation and bank capital. This episode has resulted in a case study that highlights how banks, as money generators, can effectively conjure any quantity of capital, whether directly or indirectly, rendering capital adequacy-based bank regulation obsolete… [I’ve used italics to emphasize my point.]

Professor Werner demonstrates this approach with the following simplified balance sheet transactions. Credit Suisse first makes a £7 billion loan to a new investor (Gulf Investor), which it deposits in a newly established account. This is demonstrated in Step 1. To reflect the loan, a credit is given to Credit Suisse’s “Loans and investments” assets (i.e. an investment). A “Deposits” liability item is also created to account for the new monies that Gulf Investor can now withdraw at its leisure. Credit Suisse makes and holds the loan, therefore it’s a win-win situation.

No money exchanges hands as a result of the proceeds. The bankers at Credit Suisse do not transfer £7 billion from their vault to a new account deposit box for Gulf Investors. Rather, the bank keeps track of these contractual fund movements via accounting entries. Despite Professor Werner’s “fictitious” claim, everything appears to be in order thus far.

Then the true magic begins. Gulf Investor withdraws £7 billion and invests it in newly issued Credit Suisse preference shares, as represented in Step 2 as Capital. Because the transactions are limited to Credit Suisse, no money changes hands; just the proper balance sheet entries are made. That’s all there is to it! Credit Suisse converted a £7 billion deposit obligation into much-needed capital without having to raise any fresh funds. The bank was able to conjure up £7 billion out of thin air. With just a few keystrokes, it was able to save itself!

Thinking it Through in the Real World

You’re right if you think this is miraculously impossible. It does, however, take an understanding of corporate finance to notice. If you stop the study where Professor Werner does, it appears like Credit Suisse conjured up money to rescue itself. However, we are unable to conclude our investigation at this point. We need to look into it more thoroughly.

Credit Suisse was saved thanks to a £7 billion investment from Gulf Investor. However, because the transactions took place within a closed system, this “trick” worked. Within Credit Suisse, they were self-contained. The bank merely had to establish that it was solvent. It was not required to make a payment to a third party. As a result, no money had to be physically exchanged, as Professor Werner properly points out. Credit Suisse would not be able to transfer these monies to a third party if it needed to. Gulf Investor, likewise, was unable to withdraw the loan money. Credit Suisse would have had to come up with the cash in either case. The recipient would have wanted something more concrete than “air” as a manner of payment settlement.

Even still, the £7 billion lifeline comes from a legitimate source. Existing Credit Suisse shareholders foot the bill in the form of reduced future stock prices. They will collectively lose (more than) £7 billion in value in the future. All dividends and/or repurchase payments paid to Gulf Investor’s preference shares would have gone to common shareholders instead. As a result, the stock will be worth (much) less than it would be if the transaction had not occurred (and had Credit Suisse found another way to remain solvent). Credit Suisse, in other terms, borrowed £7 billion from the future.

However, suppose Gulf Investor’s investment proved insufficient to save Credit Suisse, and the bank declared bankruptcy. Existing shareholders would be wiped out, including Gulf Investor. The story, however, does not end there. Creditors (bondholders, suppliers, etc.) acquire control of the bank, and Gulf Investor still owes them £7 billion.

The preference shares of Gulf Investor are wiped away in bankruptcy, but the loan from Credit Suisse is not. It still has to pay it back. There are two alternatives available to Gulf Investor. It has the option of repaying the loan through other methods or defaulting. In the first scenario, Gulf Investor becomes the bank’s final source of previously created funds. Credit Suisse’s new owners (creditors) receive £7 billion less for their claims in the latter case (i.e. they lose even more money). In any case, someone has to pay the £7 billion cost that Credit Suisse racked up. It isn’t made up.

Leverage Not Magic Nor Privilege

Professor Werner’s “money from thin air” theory asserts that banks’ privileged accounting position, notably their exclusion from “Client Money Rules,” gives them this money production authority. Client Money Rules compel financial organizations to hold client funds in separate, off-balance-sheet accounts. Customers’ assets are kept separate from the company’s by stockbrokers, for example. Banks, on the other hand, keep them on their balance sheets as deposits, mixed up with their own. Professor Werner contends that without this tiny distinction, banks and non-banks would be the same. Otherwise, banks would be unable to issue fresh money.

What distinguishes banks from non-banks is their ability to create credit and money through lending, which is accomplished by booking what are actually accounts payable liabilities as fictitious customer deposits, which is enabled by a regulation that makes banks unique: their exemption from the Client Money Rules.

However, nothing unusual or malicious is taking place. Professor Werner, on the other hand, overlooks a fundamental distinction between banks and non-banks (like stockbrokers). When banks offer loans, they do not lend their customers’ assets. They take them! When you make a deposit, unlike when you invest with a stockbroker, you are literally lending your money to your bank. This is why you pay your bank for deposits and your stockbroker for asset management. Professor Werner points out that while modern “bail-in” policies have blurred the distinctions between bank shareholder, creditor, and depositor, they have not fundamentally transformed the borrow-to-lend business model.

Thus, in our case, Credit Suisse’s fresh money is simply leverage. Credit Suisse is borrowing it now and in the future from others before handing it on to Gulf Investor. Depending on how circumstances unfold, the new money is finally accounted for in real life in some manner, shape, or form. Don’t get me wrong: the piper gets paid.

Professor Werner is true in that banks produce money, but it isn’t out of thin air. They accomplish this by promoting intertemporal communication. Banks offer borrowed future worth to those that need it right now. Privilege has no bearing. “Everyone can manufacture money,” as Hyman Minsky put it, “the challenge is getting it acknowledged.” We take bank money in exchange for their critical financial intermediation service… we demonstrate that banks are a key part of the money generation process… Bank money, far from being generated out of thin air, is the consequence of an underlying value-for-value intertemporal exchange transaction facilitated by the bank’s intermediation. [I’ve used italics to emphasize my point.]

Financial accounting is treated as a game in the “money from thin air” argument. It’s not the case. All of those figures represent a real-world value exchange. Nobody, not even banks, can just make things up. Money is incorrectly confined to bank operations in this view. While popular, Minsky is correct; anyone, not only banks, may (and can) generate money. All economic production is monetary production since money is just a unit of account. Banks create money through the use of productive leverage.

Banks Create Money From Leverage, Not Thin Air

The common belief is that banks create money out of thin air. This viewpoint pervades conversations in academia, markets, and monetary policy. The “money from thin air” argument is based on a concrete understanding of money that is limited to bank activity and the belief that banks have a special accounting status that gives them this power. Professor Werner, in my opinion, delivers one of the most compelling demonstrations of this point of view.

The “money from thin air” argument, on the other hand, is fallacious. It concentrates too narrowly on banks’ immediate actions and overlooks the bigger picture of corporate finance. Banks borrow money in order to lend it out. They act as a “value-for-value intertemporal exchange intermediary.” Banks make value generation easier by using leverage. Professor Werner observes the following economic production as money creation. However, “thin air” is a form of leverage, not magic.
Money has a far larger definition than banks. It’s a monetary unit used to measure worth across a culture. Similarly, financial accounting is not a game that only the wealthy can play. It’s a tool for keeping track of crucial real-world transactions, such as money production. Despite popular belief, there is no such thing as a free lunch or free money.