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There are three main theories of banking.
But what are they?
And, more importantly, which one is correct?
1 - FINANCIAL INTERMEDIATION THEORY
First of all, we have the Financial Intermediation Theory.
This is currently the dominant theory of banking, and states that banks are just financial intermediaries (i.e. they gather deposits and lend these out).
OK, pretty basic, makes sense.
It can, and does, however have significant implications.
For example, the Financial Intermediation Theory has had a significant influence on economic policy in the post-war era, specifically the attitude that developing countries could be helped by international banks who could provide missing domestic savings through their lending in order to fund economic growth.
This has resulted in a massive increase in foreign borrowing and indebtedness by developing countries since the second world war. As planned of course.
2 - FRACTIONAL RESERVE THEORY
Next up we have the Fractional Reserve Theory.
This was the dominant theory from around the 1920s to the 1960s.
It also argues that banks are financial intermediaries, but collectively the banking system creates money via the process of 'multiple deposit expansion'.
OK, what does this mean?
Well, it is based on the following idea:
With a reserve of, say 10%, every bank would lend 90% of any deposit, which would increase deposits with other banks, resulting in a multiple creation of deposits in the banking system.
So the Fractional Reserve Theory states that banks create money collectively, but not individually.
According to the American economist Joseph Stiglitz,
"Deposits increase by a factor of 1/reserve requirement."
OK, well at least we know that theory is wrong...
3 - CREDIT CREATION THEORY
Finally, we get to Credit Creation Theory.
This was dominant until around the 1920s, and it is at odds with the other two theories by representing banks not as financial intermediaries - neither in aggregate nor individually.
Instead, each bank is said to create credit and therefore create money out of nothing whenever it loans money or purchases assets.
This means that banks do not need to first gather deposits or reserves to lend money.
According to the Scottish Economist Henry Dunning Macleod:
"Bankers, no doubt, do collect sums from a vast number of persons, but the peculiar essence of their business is, not to lend that money to other persons, but on the basis of this bullion to create a vast superstructure of Credit; to multiply their promises to pay many times: these Credits being payable on demand and performing all the functions of an equal amount of cash.
...the business of banking is not to lend money, but to create Credit"
So the Credit Creation theory differs from the Fractional Reserve Theory, as one bank is able to create deposits.
Now you would expect many empirical tests of these theories, to see which one is correct? Right?
Well, no.
From the mid-19th century until 2014, there were no scientific empirical tests on this issue.
The first empirical test was published in 2014 by Richard Werner.
Only the credit creation theory was consistent with the observed accounting records.
Surprisingly, the Credit Creation Theory does not feature in most contemporary economics, finance or banking textbooks.
Think about this:
Since roughly the 1920s, there has been a movement from the accurate credit creation theory to the misleading, inconsistent and incorrect fractional reserve theory to today's dominant, yet completely implausible and blatantly wrong financial intermediation theory.
The interesting thing...is that the Banking Cartel, and when I say banks I am referring commercial banks here, are under attack from another Cartel.
A Cartel set to become more powerful than ever before...
The Central Banking Cartel...
https://www.youtube.com/watch?v=C4sOWJDDZsI
SOURCES:
Can banks individually create money out of nothing? — The theories and the empirical evidence
https://www.sciencedirect.com/science/article/pii/S1057521914001070
A lost century in economics: Three theories of banking and the conclusive evidence
https://www.sciencedirect.com/science/article/pii/S1057521915001477
Audience Questions for Richard Werner, Larry Kotlikoff, William White and William Dunkelberg
https://www.youtube.com/watch?v=_RWXrQqENvg
CREDIT:
Werner, R.A., A lost century in economics: Three theories of banking and the conclusive evidence, International Review of Financial Analysis (2015)
DISCLAIMER: NOT INVESTMENT ADVICE
