The Financial Intermediation Theory of Banking

Executive Summary

• Private banking interests propose this theory for how banks obtain funds to loan.

Introduction

This theory is widely believed and is asserted by private banking interests, which control what is published in economics textbooks that also propose this theory. Banks are not financial intermediaries. Instead, they are money creation machines or “Mini Feds.”

This is explained in the following quotation.

“Virtually all of the newly developed models are based on the highly misleading ‘intermediation of loanable funds’ theory of banking (Jakab and Kumhof 2015). We argue instead that the correct framework is ‘money creation’ theory. In the intermediation of loanable funds model, bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers; Lending starts with banks collecting deposits of real resources from savers and ends with the lending of those resources to borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and intermediation of loanable funds-type institutions – which really amount to barter intermediaries in this approach – do not exist. This involves the expansion or contraction of gross bookkeeping positions on bank balance sheets, rather than the channeling of real resources through banks. Replacing intermediation of loanable funds models with money creation models is therefore necessary simply in order to correctly represent the macroeconomic function of banks. But it also addresses several of the empirical problems of existing banking models.”

Source: Voxeu

https://voxeu.org/article/banks-are-not-loanable-funds-intermediaries-macroeconomic-implications

Academic Research into Whether the Intermediation Theory of Banking is True or False

Curiously, there is academic research into this question, as it is already determinable by simply reading the documentation of central banks. However, an article titled “Can banks individually create money out of nothing? — The theories and the empirical evidence” was published in 2014. Important quotes from this article include the following.

“According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it ex- tends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories.“

The article admits that there no empirical study to prove which of these theories are correct.

The Confusion Even Within Banks Regarding the Competing Theories

“The three theories are based on a different description of how money and banking work and they differ in their policy implications. Intriguingly, the controversy about which theory is correct has never been settled. As a result, confusion reigns: Today we find central banks – sometimes the very same central bank – supporting different theories; in the case of the Bank of England, central bank staff are on record supporting each one of the three mutually exclusive theories at the same time, as will be seen below.”

One might presume that while the laymen are confused, that those that work in banks, and in fact within one bank (The Bank of England) with staff more knowledgeable on average than the staff of a typical bank would have a consistent understanding of which of the three theories is correct.

Which Theory is Correct Versus and Basel I, II, and III

The following quote points out that for the BIS’s Basel III rules to be effective, one theory has to be operationally in effect in banks.

“It matters which of the three theories is right — not only for understanding and modelling the role of banks correctly within the economy, but also for the design of appropriate bank regulation that aims at sustainable economic growth without crises. The modern approach to bank regulation, as implemented at least since Basel I (1988), is predicated on the understanding that the financial intermediation theory is correct. 5 Capital adequacy-based bank regulation, even of the counter-cyclical type, is less likely to deliver financial stability, if one of the other two banking hypotheses is correct. The capital-adequacy based approach to bank regulation adopted by the BCBS, as seen in Basel I and II, has so far not been successful in preventing major banking crises. If the financial intermediation theory is not an accurate description of reality, it would throw doubt on the suitability of Basel III and similar national approaches to bank regulation, such as in the UK.”

“The implications (of the fractional reserve theory of banking being false) are far-reaching for bank regulation and the design of official policies. As mentioned in the Introduction, modern national and international banking regulation is predicated on the assumption that the financial intermediation theory is correct. Since in fact banks are able to create money out of nothing, imposing higher capital requirements on banks will not necessarily enable the prevention of boom–bust cycles and banking crises, since even with higher capital requirements, banks could still continue to expand the money supply, thereby fueling asset prices, whereby some of this newly created money can be used to increase bank capital. “

This theory is false. It is interrelated with the fractional reserve theory of banking and was introduced by economists, controlled by private banking interests, to cast a layer of obstruction over their enormous free ride off of the government. The Credit Theory of Banking is correct.

Source: Science Direct

https://www.sciencedirect.com/science/article/pii/S1057521914001070