Money, Bubbles and Bailout : Part I

I always assumed a bank worked the way a moneylender works, just at a bigger scale. Someone deposits money, the bank holds it safely, and then lends that same money out to someone else, keeping a small cut for itself. That is what I was taught in my very first economics class, and it is what almost every bank advertisement quietly implies when it shows a vault full of your money. After listening to Richard Werner walk through how banking actually works down to the level of individual accounting entries I realized that story is not just simplified. It is wrong. And the way it is wrong matters enormously for anyone trying to understand inflation, recessions, and financial crises.

The Three Stories Economicst Tells About Banks

An economist, explains that there have historically been three competing theories about what a bank actually does.

Story One - Financial Intermediation Theory: This is the version taught in almost every textbook and used by almost every journalist. A bank collects deposits from savers, does credit analysis, and lends those exact funds to borrowers. The bank is a middleman. It never creates anything; it only moves money that already exists from one pocket to another.

Story Two - Fractional Reserve Theory: This was the dominant academic view until the 1960s. It admits that something more is going on that as banks interact with each other, the banking system as a whole can expand the money supply beyond what was originally deposited, through what economists call the "money multiplier." But each individual bank is still just an intermediary; the multiplication happens somewhere in the aggregate interaction between banks, not inside any single bank's own accounting.

Story Three - Credit Creation Theory: This is the oldest of the three, widely accepted until about a hundred years ago, then dismissed for decades as a fringe idea. It says something much more direct: an individual bank, by itself, has the power to create brand new money out of nothing the moment it issues a loan. No transfer from anyone. No multiplier effect building up gradually across the system. Just one bank, one loan, and new money that did not exist a second earlier.

Werner did something almost nobody else had done in over a hundred years of this debate: he actually tested it. He took out a real loan from a cooperating bank and had observers including a BBC film crew watch the bank's own internal accounting system while the loan was processed, transaction by transaction. His conclusion: Story One is false. Story Two is false. Story Three is correct. Individual banks, including ordinary commercial banks not just central banks create money out of nothing every time they issue a loan.

What Actually Happens on the Balance Sheet

This is the part that changed how I read every bank's financial statements. Let's walk through it the way an accountant would, using a simple example.

Imagine Rima takes out a loan of 500,000 taka from her bank to buy equipment for her small business. Under the old "intermediary" story, we would expect the bank to hand her money that came from somewhere else which means another customer's deposit, or the bank's own reserves. Under Werner's credit creation theory, here is what the bank's books actually do:

Before the loan, the bank's simplified balance sheet has some existing assets and liabilities, but nothing related to Rima.

The moment the loan is approved, two new entries appear simultaneously:

Now notice what did not happen. No money left any other customer's account. No cash moved out of a vault. The bank did not draw down its reserves at the central bank to fund this. It simply wrote a new asset (the loan) on one side of its books and a matching new liability on the other side.

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In double-entry accounting terms, the bank debited "Loans Receivable" and credited a liability account and that liability account is where the trick lives.

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The Trick: Why It's Called a "Deposit" At All

Legally speaking, what the bank owes Rima after granting her loan is an accounts payable liability. The same kind of obligation that arises whenever you sign a contract promising to pay someone. Werner points out that in English courts, and under the legal frameworks of most countries, a "bank deposit" is not actually a special, protected thing. It is simply a loan that you, the customer, have extended to the bank. When you "deposit" your salary, you are technically lending your bank money and trusting it to pay you back on demand.

Here is why this relabeling is only possible for banks and nobody else. Every other institution that holds money on behalf of a client — a lawyer holding funds in escrow, a broker holding client funds, an accountant managing a client account is bound by something called the client money rule. This rule forces them to keep client funds completely separate from their own books, held in custody, not counted as their own asset or liability. If a lawyer tried to "get creative" with how client money is recorded, that would be fraud, potentially a criminal offense.

Banks are exempt from this rule. When you place money with a bank, it does not sit in a separate custodial account with your name on it. It goes straight onto the bank's own balance sheet, as a liability the bank owes you. And because the bank is the keeper of its own records, it can take what is legally just an accounts-payable liability arising from a loan contract like the one Rima signed and record it under a friendlier label: "customer deposit." That single relabeling is what allows the entire system to feel, to an ordinary person, like the bank is safeguarding money that already existed, when in fact new money was created at the exact moment the loan was signed.

Why This Distinction Actually Matters

If banks were genuinely just intermediaries, then lending would be close to a zero-sum activity. One person's gain would be roughly matched by another person's opportunity cost of not having that money themselves. The overall effect on the economy would be modest maybe a small efficiency gain from getting money to better uses, nothing more.

But if banks create new purchasing power every time they lend which is what the empirical test showed then every single lending decision made by every bank in a country has a direct impact on the total money supply. That means the direction bank credit flows (toward productive business investment, toward consumption, or toward asset purchases like real estate) is not a side detail. It is the single most important variable in determining whether an economy gets healthy growth, unproductive inflation, or a dangerous asset bubble. That question is where does new bank money actually go, and what happens when it goes to the wrong place is exactly what the next article covers.