In most textbook economics I came across the financial intermediation theory of banking and the fractional reserve theory of banking are presented as theories as how money is created.

However there is evidence that these theories are wrong. See for example

Economist A. Werner writes in his empirical case study:

An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".

The study even includes a letter signed by the manager of the bank in which Werner did his experiments:

Dear Prof. Dr. Werner,

Confirmation of Facts

In connection with the extension of credit to you in August 2014 I am pleased to confirm that neither I as director of Raiffeisenbank Wildenberg eG, nor our staff checked either before or during the granting of the loan to you, whether we keep sufficient funds with our central bank, DZ Bank AG, or the Bundesbank. We also did not engage in any such related transaction, nor did we undertake any transfers or account bookings in order to finance the credit balance in your account. Therefore we did not engage in any checks or transactions in order to provide liquidity.

Yours sincerely,

M. Rebl,

Director, Raiffeisenbank Wildenberg e.G.

Similar claims are made by Kumhof and Jakab published by the IMF (International Monetary Fund):

Specifically, virtually all recent mainstream neoclassical economic research is based on the highly misleading “intermediation of loanable funds” description of banking, which dates to the 1950s and 1960s and back to the 19th century.We argue instead for the “financing through money creation” description, which is consistent with the 1930s view of economists associated with the Chicago School. These two views have radically different implications for a country’s macroeconomic response to financial and other shocks. This in turn has obvious relevance for key policy choices today.­

Lending, in this narrative, starts with banks collecting deposits of previously saved real resources (perishable consumer goods, consumer durables, machines and equipment, etc.) from savers and ends with the lending of those same real resources to borrowers. But such institutions simply do not exist in the real world.

  • $\begingroup$ I suppose that textbooks take decades to change $\endgroup$
    – dm63
    May 23, 2021 at 12:32
  • $\begingroup$ shame that the study did not included signed letter of M Rebi stating that Goldbach's conjecture is true, proof by signed letter could be the key to answering any unsolved science problem $\endgroup$
    – csilvia
    May 24, 2021 at 0:30
  • $\begingroup$ I took Money and Banking in night school decades ago. The professor, a bank manger, said most bank managers will deny that banks can create money. I asked a bank manager this question once and he said, "No. The books must balance." I had no interest in arguing the point with an "expert" who thought he knew better because he made money as one of many managers of his bank. Each bank has a credit department (loan officers) and treasury department (officers that actively manage bank liabilities and reserve levels). Credit officers create M1/M2 money and it must exist to "borrow back" at interest. $\endgroup$ May 24, 2021 at 1:28
  • $\begingroup$ @csilvia Obviously not. It's just that in this case the credit creation by banks is often explicitly denied as pointed out in the previous comment... $\endgroup$ May 24, 2021 at 8:07
  • 1
    $\begingroup$ Not the 1st Q here about Werner (2014) economics.stackexchange.com/questions/26991/… $\endgroup$ Sep 11, 2021 at 9:02

3 Answers 3


There are several reason for it. Please note the reasons are not necessarily listed in order of importance, the last point is actually most relevant answer to your question.

  1. The 'Evidence' You Cite is Controversial

First, in fact the work you cite itself states that this issue is matter of ongoing controversy (Werner, 2014). So it is far from settled.

However, what even more the empirical 'test' of Werner (2014) is itself actually quite controversial and has been criticized heavily for confusing accounting with economics (e.g. see Rendahl & Freund 2019 or Spearman 2016). Accounting and economics are completely distinct disciplines so it is often not possible to conclusively test economic theory just by accounting arguments.

For example, a theory of perfect competition predicts that in equilibrium there will be no economic profit. However, you can't test whether firm has zero economic profit by looking at the firm's profit and loss statements because accounting does not capture economic reality and does not include things like opportunity cost which could make profit zero. Depreciation in accounting is also treated in a way that economically has almost no sense etc. As a result even if in real life there would be some perfectly competitive industry you cannot test for that just by looking at firm's profit and loss statement but you need better more nuanced test.

In a similar way the paper by Werner is criticized for making essentially the same error of assuming that just because on the balance sheet money seemingly appear out of nothing that means that banks actually can create them out of nothing, and as explained in greater detail in Rendahl & Freund (2019), that is to a degree just accounting fiction and does not really prove that banks do not create money against some assets as understood in economics (as opposed to what accounting understands them to be - which again is completely separate discipline with its own terminology and very little relation to economics).

Next, when it comes to financial intermediation, it would again be quite controversial to state that banks do not engage in some financial intermediation. Even McLeay et. al. (2014) argue financial intermediation plays some role in money creation. Now this is not the same as claiming the authors endorse financial intermediation theory the point is that stating that banks do not engage in financial intermediation at all would be controversial.

Textbooks are generally not being rewritten if one controversial paper is published. It takes time for literature to settle. Even if the new controversial paper is entirely correct it can take few years before that is reflected in textbooks (especially undergraduate ones graduate textbooks are much more up to date).

  1. All Models are Wrong but Some are Useful (George Box)

As the title of this section says all models are wrong, you can imagine model as being a map. Any map that is not 1:1 replica of landscape will be wrong in some way, however having 1:1 replica of landscape as a map ceases to be model and quite frankly it is completely useless even though it is 100% correct. Both 'fractional reserve theory' and 'financial intermediation theory' have their utility.

Starting with 'fractional reserve theory'. For example, before 2009 when central banks started engaging in 'unconventional' monetary policy, the 'fractional reserve theory' was quite useful for back of the envelope calculations. This is because pre-2008 commercial banks held virtually no excess reserves as you can see from the data provided by FRED below:

enter image description here

In such situation, the 'fractional reserve theory' can be actually quite useful and reasonable approximation. As you can see from graphs below, the $M_2/M_1$ ratio and amount of reserves before 2008 tended to move in same direction.

enter image description here

enter image description here

In fact if you remove observations post 2007 and calculate correlation between $M_2/M_1$ and required reserves you would find the correlation to be significant with point estimate approximately $0.55$ (with $95\%$ conf. interval (rounded to 2 significant digits) $[0.49, 0.60]$)*. Sure simple correlation is no rigorous test, but with such high correlation it is difficult to claim that there is no relationship between reserves and ratio of $M_2/M_1$ meaning that at least in past money were created in a way that looks like a situation where banks just multiplied reserves (again I am not saying this is necessary rigorous test, one can invoke reverse causality and so on, point is that its not an unreasonable model for a first approximation).

Now for sure utility of the 'fractional reserve theory' diminishes greatly under the new unconventional monetary policy, and especially now that many central banks around the world (but not all) completely abolished reserve requirement altogether (see Fed explainer on its abolishment of reserve requirements here). However, it is not clear if this is new normal. These policies are still referred to in the literature as 'unconventional' and it is not clear if they will last. In fact before the Covid-19 hit world economy, Fed was already contemplating of returning to normal policies (e.g. see news articles pre-Covid such as this one). Consequently, an argument can be made that this model is useful for students to understand because it described banking relatively (relative to its simplicity) well in the past, and it is not so clear if the current unconventional monetary policies that make the model give very wrong predictions will last. You should also note, that it is not like this is the only model textbooks discuss. For example, Blanchard et al Macroeconomics: A European Perspective pp 71 described failures of simple multiplier model and alternative endogenous money supply theories already in 2013.

When it comes to 'financial intermediation of banking' theory this one has still its uses even contemporary empirical research (See discussion in Freixas & Rochet Microeconomics of Banking). Consequently, when it comes to this theory it is even more useful for students to know, even if you can of course criticize it and competing theories exist.

  1. Both Theories are Important for Didactic Reason

Since we are discussing textbooks and not applied research it is important to realize that textbooks, beyond anything else, serve didactic purpose. They are intended to be used as teaching tool, and especially undergraduate textbooks (which is where you will see 'fractional reserve theory' and 'financial intermediation theory' given most space) have to build foundations for future study.

For example, every single intro physics textbook in existence will teach Newtonian physics, even though we now know that Newtonian physics is wrong and at best special case of general relativity. Yet learning incorrect Newtonian physics is still useful as it can be used for back of the envelope calculation in many situations and it will still give reasonably good answers. As shown under point 2 even simple 'fractional reserve theory' provides quite reasonable predictions (although it is definitely not as close as Newtonian theory to general relativity so please do not take this analogy too far).

This is like asking why textbooks typically include linear demand and supply when in reality demand and supply is almost never linear. Well answer is that solving models with simple linear demand and supply is easy for students and facilitates learning, as it serves as a stepping stone to understanding more complex models. For example, in typical graduate microeconomic textbook you will virtually never see linear demand or supply save for some rare exceptions, yet if you would try to teach 101 econ students from graduate textbooks such as MWG Microeconomic Theory or Varian Microeconomic Analysis, all but the top $5\%$ of class would fail miserably. Again you would end up in analogous situation if you would start physics 101 with Einstein's field equations. Anyone except for top students would not be able to follow. As a result you will fail in your task to educate students, since even students that might become excellent physicist when they learn physics in small steps instead of trying to directly tackle graduate level physics, would never be able to achieve their full potential if you would just stress teaching more realistic but infinitely more complex models. Again this does not mean such models should not be taught but there is plenty of room for that in graduate courses.

Even McLeay et al (2014) who very harshly criticize 'fractional reserve theory' argue it can be a

useful way of introducing money and banking in economic textbooks,

Next, it is also important to understand that both 'fractional reserve theory' and 'financial intermediation theory' are part of exogenous money supply theory (a theory where private banks are passive agents that just expand/contract money supply in a way that is exogenously dictated by central bank), and regardless whether you consider exogenous money supply theory right or wrong (I personally think exogenous money supply theory is far from completely correct), learning exogenous money supply theory is important part in learning endogenous moneys supply theory (which is theory where private banks have active role in money supply creation).

This is because as discussed earlier, even authors who are proponents of endogenous money supply theory such as McLeavy et al (2014), do not deny that banks are constrained by central bank's policy and that some financial intermediation is taking place.

The difference between exogenous money supply theory and endogenous money supply theory is that under exogenous money supply theory the chain of causality goes just from central bank policy to money supply, whereas under endogenous money supply theory there is relationship that goes both ways (see more details on this in above mentioned Blanchard et al). Consequently, endogenous money supply models will still feature central banks policy be it via reserves or more often other ways that affect money supply like bank regulation/interest rates etc, and will still often have banks that still take in deposits. Rather under endogenous money supply theory there will be additional relationships where money demand will cause banks to lend more and in turn banks will then create more reserves at the central bank (like described in McLeavy et al).

Consequently, even if you think exogenous money supply theory is completely wrong, it is didactically better to first teach exogenous money supply theory, and then explain to students that this is wrong because there are additional channels that lead to simultaneity/reverse causality and build your explanation of endogenous money supply theory based on exogenous money supply theory. Jumping directly to endogenous money supply theory would likely just facilitate less learning and create more confusion even if your goal is to teach only endogenous money supply theory.

The above alone is the most important reason why these models heavily feature and will likely continue to feature in most 101 macro textbooks in foreseeable future. However, you should note that the space most mainstream macro textbooks devote to exogenous money supply models has shirked substantially, you can verify that by comparing the latest editions of Mankiw Macroeconomics or Blanchard et al Macroeconomics to their earlier editions. Nowadays, you will get quite more space devoted to endogenous money supply theories (however, do not confuse endogenous money supply theory with controversial assertions of Werner (2014) of money being created completely ex-Nihilo by private banks - that is very controversial compared to just general endogenous money supply theory).

* Code for the correlation calculation in the spoiler:

#data are obtained from fred data linked above, data after 2007 are deleted, data were merged in excel before runing the code (with raw output below):
cor(fred$M2SL_M1SL, fred$REQRESNS, method = c("pearson"))
> [1] 0.54867
cor.test(fred$M2SL_M1SL, fred$REQRESNS, method=c("pearson"))
> Parson's product-moment correlation
data: fred$M2SL_M1SL and fred$REQRESNS
t = 15.887, df = 586, p-value < 2.2e-16
alternative hypothesis: true correlation is not equal to 0
95 percent confidence interval:
0.4895299 0.6027855

  • $\begingroup$ I fail to see how the critic by Rendahl & Freund invalidates the money creation theory put forward by Werner. They basically say that banks are constrained by the reserve requirements, which is hardly a big limitation, plus has been abolished in some parts of the world. They also state that the funds granted to the customer need to be paid back in the future, plus that there is a regulatory requirement in as such that not everyone can get a loan. However this does not explain where the money comes from in the first place. $\endgroup$ May 23, 2021 at 22:25
  • $\begingroup$ @Rubus 1. Even if reserve requirements were abolished they were also replaced by capital requirements - hence banks can’t create as much money as they want. These are not that different from reserve requirements on fundamental level. 2. Even if the above would be abolished as explained by R&F private banks are limited by solvency constraint. 3. The money is created from assets of their customers and liquidity transformation. The main point is that money can’t be created ex-nihilo, indeed as authors point out of that would be possible no bank would ever go insolvent and need bailout $\endgroup$
    – 1muflon1
    May 23, 2021 at 23:04
  • $\begingroup$ M1/M2 money supply does grow ex-nihilo (from nothing). Consider the custom of barn raising where the community uses what I call "labor credit" to raise an asset (barn) without using other forms of money or credit instruments. No M1/M2 money is created or destroyed under the custom of barn raising using labor credit in a small community where people donate labor to create an asset for their neighbor. However if the bank extends a loan to build the barn it creates new M1/M2 money when the contractor secures a construction loan. The contractor is often paid when another bank provides a mortgage. $\endgroup$ May 24, 2021 at 1:18
  • $\begingroup$ @SystemTheory no that doesn’t count as ex nihilo money creation have a look at the sources especially R&F (2019) $\endgroup$
    – 1muflon1
    May 24, 2021 at 8:13
  • $\begingroup$ @1muflon1 How is money created from assets of their customers and liquidity transformation? Does the bank buy goods from the customer? Banks can create demand deposit (non-confdential money) but they can't create hard cash. Yes the reserve/capital requirements have to be met with hard cash, however its only a very small fraction of the actual debt they create $\endgroup$ May 24, 2021 at 8:15

Professor Werner sets up a "strawman" argument, by defining banking as either the credit theory or the financial intermediation theory, when in fact banks can both create money by the expansion of bank credit and banks must operate as financial intermediaries. This is a matter of logical reasoning about banking customs which include both the legal meaning of credit/debt deals and the accounting customs based on the legal deals.

See this 10 page paper The Money Creation Paradox:


where the basic idea is that the bank sector creates money (bank liabilities) via the expansion of bank credit (financial assets) but each bank must manage its liabilities to keep payments flowing in the interbank payment system. This tends to validate both the credit theory, where banks create money via the expansion of bank credit, and the intermediary theory, where banks must borrow funds to sustain the ability to clear interbank payments.

Finance customs are ex-nihilo (from nothing). A promise to repay the bank sector with bank sector liabilities arises from nothing but the promise or intention of a human agent and the acceptance of this promise by the banker. The debtor repays the bank with M1/M2 money that must be created by the bank sector when it accepts the promise of someone in the community. This is all ex-nihilo since the economic profession concedes that economic value exists independent of the finance customs that create and destroy money. So if one can imagine an economy without money then one must concede that money is created from nothing even if the finance relations are taken to be economic goods or goods with economic value. In any event let bank credit go to zero the money supply also goes to zero in the limit. So the repayment of bank credit destroys the economic value associated with the M1/M2 money supply.

This article argues that banks create money by lending against assets which have economic value:


however the article does not make a distinction between the economic value of non-financial assets versus financial assets. A house, for example, is a non-financial tangible asset which has the same economic value, the value of actual economic income in the form of shelter, privacy, use and enjoyment of its property characteristics, and this economic value is independent of its sale price in a market transaction or rental price changing over time. When banks validate the rising prices of existing houses via mortgage lending operations they add no economic value to those existing houses. This is applying economic logic where the loans are financial assets, the promises to repay the loans are liabilities that evidence the financial assets, and the economic value of promises to repay is created from thin air when such promises are made. This is how credit fuels asset price inflation (bubble or price overshoot) and lack of credit fuels asset price deflation (collapse of the bubble).

Lastly, suppose that, for some reason, Barclays’ customers suspected that it held unhealthy assets – that is, there was doubt regarding the repayment capacity of Barclays’ debtors – or that it did not have sufficient reserves to settle transactions on their behalf. This would undermine the pegged exchange rate between Barclays-pounds and British pounds on which the banks edifice stands. Eventually, this would lead to a run on the bank, and it would quickly find itself illiquid, or even insolvent. This is indeed what happened to several banks during the Global Crisis, including Countrywide Financial in the US and Northern Rock in the UK. If banks were indeed able to create money out of nothing, why would we need to bail them out?

The logic of this conclusion, taken from the article above, is incorrect. If there is a run on the whole bank sector, for example during the Great Depression the bank sector financial assets and liabilities were down significantly compared to prior levels during 1929, then this type of case study shows that the bank sector must be able to expand credit, to issue liabilities, and to borrow back money already created via expansion of bank credit, in order to sustain levels that we recognize and measure as the "elastic money supply". The proper conclusion is that the bank sector can create money when bank credit is expanding and the bank sector must destroy money (and any associated economic value of these financial instruments) when the bank sector is voluntarily or involuntarily making a reduction of its financial assets. A mechanical device that allows the flow of fluid in one direction, but not the other direction, is called a check valve. An electrical device with this function is called a diode. The bank sector can create money when the credit psychology of society allows expansion of financial assets and it must destroy money when the psychology reverses as during a financial panic.

This reference describes the failing bank sector and the decline of the money supply in the context of the Great Depression:


One explanation that has stood the test of time focuses on the collapse of the U.S. banking system and resulting contraction of the nation’s money stock. Economists Milton Friedman and Anna Schwartz make a strong case that a falling money stock caused the sharp decline in output and prices in the economy.2As the money stock fell, spending on goods and services declined, which in turn caused firms to cut prices and output and to lay off workers. The resulting decline in incomes made it harder for borrowers to repay loans. Defaults and bankruptcies soared, creating a vicious spiral in which more banks failed, the money stock contracted further, and output, prices and employment continued to decline.

Network banking would be the term I use to describe how banks actually operate to (1) create money; and (2) operate balance sheets as financial intermediaries. Professor Werner argues that a bank does not have to increase reserves before making a loan, which is true, however a bank cannot keep making new loans without having to spend reserves to another bank eventually. This means the bank must pay interest on its liabilities to manage reserve levels in the interbank payment clearing system. Therefore in the long run the banking sector creates money and each bank resembles the business model for a financial intermediary.

I regard each bank in a banking system as a node in a network. Each bank makes credit deals on both sides of its balance sheet. This makes each bank have the business model of a financial intermediary. A bank can expand its balance sheet by extending more bank credit, and increasing deposits due to customers, and would not have to pay out reserves to any other bank as long as customers do not spend funds to customers of some other bank. If the central bank imposes a reserve requirement to limit the expansion of deposits it would have to create a scarcity of reserves to slow down deposit expansion or else provide the required reserves to validate aggregate bank sector balance sheet expansion. If the central bank controls the interest rate this means it supplies the required reserves and only enforces a slight shortage to keep control of the monetary policy rate of interest (overnight rate on borrowing reserves).

In the network banking model there are stochastic flows in the banking network, based on credit deals, money market deals, and payment clearing of transactions, which force each individual bank to manage the level of reserve balances via the management of liabilities in money and credit markets.


If you consider bank balances to be "money", then the fractional reserve theory makes sense. If you consider bank balances to be "not money", then the financial intermediation theory makes sense. They are two equivalent ways of looking at the same system from different perspectives.

If bank deposits are "money", then of course, when you take out a loan and the bank increments your balance, they are creating money out of thin air. This is only a surprise to people who haven't thought about how banks work. Did you expect that when you got a loan, someone else's account balance would go down? Fractional-reserve banking is well-understood and I won't explain it further here.

Note that non-bank financial institutions are also subject to this effect, such as stock brokers. If you consider stocks as "money", then the stock market creates and deletes money all the time. If you count derivatives as money, then whenever you open a derivative position, you create money (because one person has the cash and the other has the derivative), and whenever you close a derivative position, you delete money (because now there is just the cash again).

If bank deposits are not "money", then banks cannot create money, but only act as intermediaries. When you get a loan and the bank increments your balance, they are not creating money - they are only updating an internal record of your relationship with them. When you withdraw the money you just borrowed, they give it to you - but they do not create it. It came from other depositors, from the central bank, or other such sources.

Under this view, when someone deposits money in a bank, they are not storing it in their account, but rather exchanging it for "bank credits" which are recorded in their account. The bank is free to do what it likes with the money - such as giving it to people who withdraw their loans - because it now belongs to the bank, not the depositor. The bank only promises that you will be able to convert bank credits back to money at any time.

Under this view, the bank doesn't create or destroy any money. Depositors give their spare money to the bank, so that the bank may find somewhere to invest it. The bank has an economy of scale on investing; because it has the money from many depositors, it can afford to make large investments that its individual depositors could not, and because it makes many investments, it can afford to hire specialists to decide which investments to make. The bank is acting as a financial intermediary, not a money creator.

As you can see, there is no conflict. Both theories are compatible with the same reality, viewed under different lenses. The difference between them is what you include or exclude in the definition of "money", rather than about the underlying reality.

  • $\begingroup$ Even if you consider bank deposits to be money, the fractional reserve theory still has the problem that there is no reserve requirement $\endgroup$ Jul 16, 2021 at 2:49
  • $\begingroup$ @Timkinsella There is a reserve requirement, though. They probably just don't track it for each individual transaction - rather, they check their total balance at end-of-day and borrow reserves from other banks if needed. (Hence LIBOR) If they can't do that, they'll tell their loan officers to issue less loans... $\endgroup$ Jul 16, 2021 at 9:21
  • $\begingroup$ I mean, their reserves have to be in the black and they do overnight borrowing to make sure of that, but afaik that's not the common meaning of "reserve requirement." I think "reserve requirement" usually means that the amount of reserves has to be equal to or greater than some fraction of total deposits. And afaik that fraction was set to zero for the US sometime in the last few years. And it seems like reserve requirements are a key assumption in the fractional reserve model $\endgroup$ Jul 16, 2021 at 9:37
  • $\begingroup$ @Timkinsella Yes, that's what reserve requirement means. Of course it has to be in the black because it's physically impossible to have less than zero reserves. Of course if the reserve requirement is zero then the system breaks down... although notice that's just the legal requirement. The bank still has to have enough reserves to avoid a bank run causing bankruptcy! $\endgroup$ Jul 16, 2021 at 9:38
  • $\begingroup$ It would seem prudent to keep enough reserves to survive/avoid a bank run. That doesn't mean banks do that. I mean certainly banks don't keep enough reserves to honor all their deposits simultaneously. Anything much short of that is just a highly subjective risk assessment. $\endgroup$ Jul 16, 2021 at 9:44

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