RBA’s Chris Kent explains how banks make money ... literally

Banking is a licence to create money out of thin air, the Reserve Bank’s Chris Kent says in a speech which explodes myths.

Reserve Bank assistant governor (economic) Chris Kent.

Banking is a licence to create money out of thin air, the Reserve Bank says, exploding the myth that banks make loans by “lending out customer deposits”.

In a landmark speech, assistant governor Chris Kent moved in Sydney yesterday to clear up the “degree of confusion” about how money is created, explaining that banks create deposits when they make loans — in contrast to what textbooks say and most people ­believe.

“Concerned citizens might be worried about what they see as the ability of private banks to create money via the extension of credit, seemingly at will,” he said.

Since June 2008, the volume of money in the economy has almost doubled from just over $1.1 trillion, or 100 per cent of GDP, to almost $2.1 trillion, or about 115 per cent this year. “Money can be created when financial intermediaries make loans,” Dr Kent said. “When a bank extends a loan, it makes money available to the borrower, for example, to buy a car, a house or equipment for a business.”

Dr Kent, responsible for financial markets, said the Reserve Bank was responsible for meeting banks’ demand for notes and coins, now worth $75 billion, but not for “broad money”, which ­includes currency plus households and businesses’ deposits at banks, credit unions and building societies.

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“Changes in the stock of broad money are the result of a myriad of decisions, including those of banks, their borrowers, creditors and shareholders.

“When customers withdraw currency from an ATM or a bank branch, the value of their deposit holdings declines as the value of the currency holdings increases. The stock of broad money, however, is unchanged.”

Dr Kent dismissed concern that a lack of deposits would constrain banks’ ability to lend. “Worrying about slower deposit growth impinging on the banking system’s ability to generate credit is putting the cart before the horse,” Dr Kent said. “If some banks really did have insufficient deposit funding, we would expect to see them competing more vigorously for deposits by raising interest rates on those products.”

Average rates on online deposit accounts, less than 0.5 per cent, are at the lowest level they have ever been.

The process of loan and deposit creation, which emerged in its present form in the 1970s and is often called “fractional reserve” banking, is criticised by some for encouraging financial crises and excessive accumulation of debt.

A result of regulation rather than free-market forces, the system has been controversial since the Great Depression, when conservative US economists such as Irving Fisher unsuccessfully proposed requiring banks to keep 100 per cent of the value of their deposits as reserves with the central bank.

Former Bank of England governor Mervyn King also recently backed the idea.

Dr Kent appeared to be at odds with the Bank of England, which said in 2014 that “whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money”.

Dr Kent, however, stressed “the process of money creation is not the result of the actions of any single bank, rather than the banking system as a whole”.

The Bank of England said: “One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them.”

The value of notes and coins in circulation has increased to about 4 per cent of GDP, the highest share in decades.

“This increase, observed in a range of countries, is consistent with the low level of interest rates, which has reduced the opportunity cost of holding money,” Dr Kent said.