Banking: Intermediation or Money Creation
Roundtable 1 Prompt

Contributors: Morgan Ricks, Marc Lavoie, Robert Hockett, Saule Omarova, Michael Kumhof, Zoltan Jakab, Paul Tucker, Charles Kahn, Daniel Tarullo, Stephen Marglin, Howell Jackson and Christine Desan

Prompt for Discussion

Commercial banks are, indisputably, at the center of credit allocation in virtually all modern economies. Astonishingly, however, it remains controversial exactly how banks expand the money supply.

According to one view, banks operate as intermediaries who move money from savers to borrowers. The basic idea is that banks extend the monetary base by lending out of accumulated funds in a reiterative way. In round 1: a bank takes a deposit, sets aside a reserve, lends on the money; round 2 – the money lands in another bank, that bank sets aside a reserve, lends on the money; round 3 – the process repeats. Money’s operation is effectively multiplied in the economy because banks transmit funds constantly from (passive) savers to (active) borrowers, thus distributing money across those hands. The system works because savers, who are content to leave their funds alone, are unlikely to demand more than the (respective) reserve amounts back from any round. Banks balance their flow of funds over time as borrowers repay their loans.

Banking: Intermediation or Money Creation
C. Kahn, Are Banks Special? A Fintech Perspective

January 15, 2020

Charles M. Kahn, University of Illinois

The issue is whether the “money creation” view of banking or the “financial intermediation” view of banking is the correct one. I’ll use Andolfatto’s summary of the views: “The heterodox view [i.e. the money creation view] is that banks are critically different from other financial market participants. In particular, while non-bank agencies wanting to finance investments first need to acquire the requisite funding, this is not the case for banks. In contrast to the non-bank sector, banks can create the money they lend.” The financial intermediation view (he calls it the orthodox or mainstream view) is that for the purposes of business cycle analysis, “it makes little sense to draw a sharp distinction between which … liabilities constitute ‘money’ and which do not … The fact that bank lending creates money—i.e., that bank liabilities are more liquid than those of other financial agencies—is not a critical consideration.” (Andolfatto, 2018, pp. 1-2)