Banking: where does the money come from?

“The process by which banks create money is so simple that the mind is repelled. Where something so important is involved a deeper mystery seems only decent.” -  J. K. Galbraith

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In the future, the slow and inefficient banks will be gone, replaced by nimble fintech challengers. 

"Look closely… and it becomes clear fintechs are reliant on the banking system.”

Traditional banks are merely delaying their inevitable demise by relying on flimsy defences like ‘trust’ and ‘scale’.

So goes the debate. Yet, this overlooks what is unique about banks.

It is commonly—but mistakenly—believed that banks essentially re-lend the money they receive on deposit. But the most striking thing about banks, and the one most open to confusion, is that’s not actually true.

In fact, the ‘majority of money in the modern economy is created by commercial banks making loans’.

Think of banking as the swapping and clearing of IOUs. When people or businesses borrow from a bank it takes an IOU from them and deposits newly created money in an account.

A bank IOU has a crucial difference from consumers’ IOU - they can use the bank deposit as money simply by transferring ownership of it to another consumer. For example, if I use my loan to buy a house, the deposit is transferred to the seller of the house.

In time, I must regain possession of a bank deposit to cancel, or repay, my debt.

By recognising bank deposits serve as money and are created as a by-product of lending, we can see how banks differ from their fintech competitors - banks do not first have to raise money to lend money.

Credit cards and revolving loans provide pre-arranged credit lines that can be drawn to create purchasing power, in the form of bank money, instantly. As long as all banks move roughly in lock-step, the banking system can create as much money as is desired.

Yet, for many, the idea banks have the power to create money offends common sense, even to the extent that some argue it should be terminated and only be employed by the government.

What about cash and its own demise? When we withdraw money from a bank, we convert our bank deposit into cash. On a large scale this can turn into a bank run, since banks do not, and cannot, maintain enough cash reserves to cover every bank deposit. Ironically, this fragile position will lessen as the usage of cash diminishes.


How does this all relate to fintechs? It is said fintechs can replace the banking functions of making loans, taking deposits and facilitating payments. Look closely though and it becomes clear fintechs are reliant on the banking system.

Peer-to-peer lenders are money brokers which match those with bank deposits with those without.

They do not create money. P2P lending just transfers existing deposits. It cannot be a replacement for bank lending—there would be nothing to lend!

P2P lenders can simulate a revolving credit line - but only by having a reserve of bank money that exposes their lenders to the risk of uninvested funds. Banks, on the other hand, have the support of a central bank, whose job it is to provide liquid reserves when necessary.

Perhaps the fintechs could challenge the cost of money advantage banks’ low-cost deposit funding provides. One fintech model could offer a deposit-like product that ensured the best interest rate at all times. The idea being that it could capture some of the advantage of cheap deposit funding.

Unfortunately, this fintech would be constantly moving bank deposits in its search for the best rate.

It would be shunned by the banking system as unwanted ‘hot money’ and the consequent low deposit rates would fatally undermine the business model.

Finally, fintech technologies do not represent a new form of payment that threatens to by-pass the banking system. For example, PayPal, ApplePay and WePay all link their services to credit cards or bank accounts because they rely on payments made using bank money. Their services are simply new channels into the existing payment platform provided by the banking system.

Why is the ability for banks to create money important? If banks could only lend pre-existing deposits then lending could only occur after the economy has undergone a slow and deliberate process of saving.

But because bank lending creates deposits, their liquidity provision is dynamic and instantaneous.

This elastic liquidity, that only banks can provide, is essential to keeping the wheels of commerce turning.

Although the emergence of the fintech challengers has serious implications for bank strategy and regulation, ultimately, fintechs can only replace banks by becoming banks.

James Culham is Director, Institutional Portfolio Management at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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