Approaches

Ⓒ The European Central Bank should stop banks creating too much debt

Reader's digest

• Private banks are powerful because they can create money. As a consequence, there is no money without debt.
• The way banks allocate that money, for example funneling a lot of money into the housing market, is prone to create financial crises and instability.
• Central banks back private banks by functioning as their “lender-of-last-resort” and exchanging with them an extremely safe form of money, central bank money, to which citizens do not have access.  
• There have been debates on how the power of commercial banks could be reigned in, such as reducing their role to simply acting as intermediaries between savers and borrowers, or getting the ECB to issue money that citizens can access. 
• Alternatively, public authorities could better control who banks lend money to.

Full explanation

Why are banks so powerful? and how does it relate to the issue of increasing levels of debt? The answers to these questions are short but surprising: private banks are powerful because they can create money. While it is true that only the central bank is responsible for printing physical cash and maintaining the value of a local currency, it is the commercial banks that actually create most of the digital money that is in circulation.

How do banks create money? As Former European Central Bank's (ECB) Vice-President Vitor Constancio once explained: “...banks create money by extending credit ex nihilo within the limits [of banking regulation]. A loan, with its inherent risk, creates a deposit which is money. In fact, not all deposits originate from previous savings that the system only intermediates.”

In other words, with each new loan that the banks give out, they create new money by crediting the customer’s account. 

The implications of private commercial banks creating money are wide and systemic. The most obvious one is that most of the money that exists in our bank accounts today is in fact generated in the form of debt. Without commercial-bank-created debt, there would be very little money as physical banknotes and coins represent less than 5% of the total quantity of money in circulation today.

Not only do banks create money out of thin air, they also have the power to decide where it goes and at what price (through interest rates). For example, over the last 15 years, banks have pumped hundreds of billions of euros into the real estate market. The surge in borrowing for real estate investments has pushed the price of housing out of reach for many people and has contributed to aggravating the gap between the rich and poor. Lending to the finance sector has also increased greatly over the past 15 years; this sector includes the companies that were involved in the speculative activities which contributed to the great financial crisis in 2008.

Meanwhile, lending to non-financial businesses has stagnated. In the ten years up to the financial crisis, just 8% of all additional bank lending (i.e. 8% of all newly created money) was lent to businesses outside the financial sector. This harmed the real economy and reduced employment and growth.

By lending to certain sectors disproportionately more than others, banks tend to make the financial system fragile and unstable. By creating too much debt, they end up creating financial bubbles, which eventually burst and damage the whole economy, destroying jobs and companies in the process.

Moreover, banks who are responsible for creating too much debt are not held responsible for their actions. They are most often bailed out, and in the rare case where a bank would be closed down, governments would have to foot the bill because of their promise to reimburse people’s deposits up to 100k euros (under so-called deposit guarantee schemes).

How does the ECB fit into this picture? It is right at the heart of the financial system. The ECB exchanges its own, extremely safe form of money, central bank money, with commercial banks. It also functions as the commercial banks’ “lender of last resort”, that is, it provides the banks with cash — or liquidity — when they get into trouble.

The ECB has been more lenient in supporting commercial eurozone banks than supporting eurozone countries, and has given preferential treatment to supposedly too-big-to-fail banks for fear of them collapsing. Hence, the ECB is often seen as reinforcing the power of big banks and financial institutions which exercise significant control over how money is created and distributed in our economies.

Economists have debated for years whether and how the power of banks to create money could be removed. Under some proposals (sometimes called narrow banking or full reserve banking) banks would become real intermediaries between savers and borrowers, and would not create money in the process. Instead of delegating money creation to commercial banks, the ECB could create real money (in the form of “digital euro”) and allow everyone to use it.

Alternatively, public authorities could better control who banks lend money to, by changing the governance of banks, or by “guiding” bank credit towards projects that are aligned with society’s interests.

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Start the debate

Surprisingly, money is actually created by commercial banks in the form of debt. This means that the economy cannot grow if we don’t accept higher levels of debts, which also means that the financial system is always fragile and at risk of collapsing. The ECB must change the system so less debt is needed.

Want to dig even deeper in this debate? Click on any of the links to discover concrete ideas for the future of the ECB, or join the debate and contribute your own ideas.

→ #5 Support green investment by public banks via quantitative easing

→ #4 Promote fair and sustainable lending by banks

→ #7 Introduce a digital euro and allow every citizen to hold central bank money

→ #9 Restrict money creation by banks