Office Hours with Drew University’s Raphaele Chappe

Most bank deposits are created by banks themselves

June 2021 – This summer, we’re spending time in office hours with some of Drew University’s amazing faculty to learn about what interests and inspires them and their research.

Today, we’re talking with Raphaele Chappe, Assistant Professor of Economics.

What about your field interests you most?

In the modern economy, most money takes the form of bank deposits. But there is a real misconception around how these deposits are created, and the role of banks in this regard. The great majority of deposits are actually created by banks when they make loans.

Why does it fascinate you?

The reality of how money is created differs from the description offered in the majority of textbooks. Banks do not act simply as financial intermediaries, lending out deposits that savers place with them. Nor do banks “multiply” central bank money through successive rounds of loans and deposits. Instead, there is a real alchemy of banking in which banks create money out of thin air—or the proverbial stroke of the banker’s pen. The way banks make money is simple yet mysterious and completely counterintuitive. Common sense would suggest that banks need to have pre-existing deposits before they can lend them. Yet in the modern economy, bank deposits are mostly created by banks. In other words, it’s the lending that creates money!

Break that down for us.

When a bank makes a loan to someone taking out a mortgage to buy a house, for example, it doesn’t need to come up with actual cash, but simply credits the borrower’s bank account with a deposit of the size of the mortgage. Deposits are legally nothing more than the bank’s promise to pay cash on demand.

The mortgage is created through a simple accounting double entry on the bank’s balance sheet: on the asset side, a new loan is booked, reflecting the fact that the borrower owes money (to the bank) on their mortgage; on the liability side, the borrower’s deposit account increases by an equal amount. The bank’s balance sheet expands, reflecting the fact that new money came into existence.

How do you bring the topic into the Drew classroom?

In my course on Money and Banking, I rely on a memo by the Bank of England that outlines how the majority of money in the modern economy is created by commercial banks. Banks substitute their own debt (deposits) for a borrower’s debt. What makes banks so unique is that their promise to pay cash—deposits—counts as money. It is part of the money supply.

Today, there is talk of Central Bank Digital Currencies, which could completely change this story, and the face of modern banking. Stay tuned!

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