Still On The "Accounting View" Of Money:What Is Commercial Bank Money?

After long being a tenet of Post-Keynesian theories, even mainstream economics has recently recognized that...

...commercial banks are not simple financial intermediaries of already existing money, but do create their own money trough lending (McLeay et al., 2014) - and more generally any time they issue liabilities in the form of sight deposits.

We discussed this issue recently in our contribution to the "Accounting View" of money (Bossone and Costa 2018). Here, we purport to further elaborate on the implications of the new approach with specific reference to commercial bank money.

By Biagio Bossone & Massimo Costa

Bank deposits and central bank reserves

If banks create money, they do not need to raise deposits in order to lend or sell deposits (Werner, 2014). Still, they must avail themselves of the cash and reserves necessary to guarantee cash withdrawals from their clients and to settle obligations to other banks emanating from client instructions to mobilize deposits (i.e., payments and transfers).

In this regard, it should be noted that relevant payment orders are only those between clients of different banks, since settlement of payments between clients of the same bank ("on us" payments) do not require use of reserves and takes place simply by the debiting and crediting of the accounts held on the books of the same bank.

For cash withdrawals and payments to other banks' clients, every bank must determine the optimal amount of, respectively, cash and reserves needed to cover deposits. More specifically, the availability of cash and reserves to support cash withdrawals and payment settlement consists of:

i. Cash reserves and reserves deposited with the central bank;
ii. Reserves from settlement of incoming payments from other banks;
iii. Borrowings from the interbank market;
iv. Borrowings from the central bank;
v. Immediate liquidation of unencumbered assets in the balance sheet, and
vi. New deposits of cash from old and new clients.

Debt or what?

Commercial bank money constitutes a debt liability for deposit issuing banks, since these are under obligations to convert deposits into cash on demand from their clients and to settle payments in central bank reserves at the time required by payment system settlement rules.

However, in a fractional reserve regime banks hold only a fraction of reserves against their total deposit liabilities (even independently of regulatory reserve requirements). Also, the amounts of reserves they actually use for settling interbank obligations are only a fraction of the total transactions settled. This is true not just for netting settlement systems but for gross settlement systems as well, since every unit of reserves is used to settle multiple units of transactions[3].

The more limited the use of cash in the economy, and the larger the economies of scale in the use of reserves allowed by payment system rules and by clients' non-simultaneous and deferred mobilization of deposits, the lower is the volume of reserves that banks need to back the issuance of new deposits [4]. In particular, payment system rules affect the use of reserves via two channels: the settlement modality (i.e., netting or gross settlement) and the technology adopted. Modern technologies, such as hybrid systems, (re-)introduce elements of netting into gross settlement processes and increase the velocity of circulation of reserves, thereby allowing banks to economize on their use for any given volume and value of payments settled.

In the hypothetical, extreme case of a fully consolidated banking system in a cashless economy where all agents' accounts were held with only one bank, all payments and transfers would be "on us" for the bank. This implies that the bank would need no reserves for settling transactions and would be under no debt obligation towards its clients. In such circumstances, the bank might in principle create all the money that the economy could absorb without holding reserves, and its money would (de facto, if not de jure) become legal money for all purposes, having the same power as legal money to settle all debts.

What is then bank money?
In real-world economies, however, there are multiple banks whose payment activities necessarily generate interbank settlement obligations. Yet, the fractional reserve regime and the economies of scale allowed by the payment system and depositors' behavior reduce the reserves needed by the banks to back their debts: with growing scale economies, banks can create more debt (by lending or selling deposits ) with decreasing reserve margins needed to cover their debt liabilities. From the hypothetical case above, and from this discussion, follows that, all else equal, a more consolidated banking system can afford a lower coverage for its debt (and at lower cost) vis-à-vis a less concentrated system.

More generally, it follows that, in normal circumstances - that is, absent adverse economic or market contingencies that would induce depositors to convert deposits into cash - the liabilities represented by each deposit constitute only partly debt liabilities of the issuing bank, which as such require reserve coverage. The remaining part of the liabilities is a source of income for the issuing bank - an income that derives from the bank's power to create money by issuing deposits, which is therefore a form seigniorage. Note that, in accounting terms, to the extent that this income is undistributed it is equivalent to equity[6].

It should be noticed that this double (accounting) nature of money is stochastic in as much as, at the point of issuance, every deposit unit can be both debt (if, with a certain probability there will be a request for cash conversion or use in interbank settlement) and equity (with complementary probability). Faced with such stochastic double nature, a commercial bank finds it convenient (for profit purposes) to provision the deposit unit issued with an amount of reserves that equals only the expected value of the associated debt event, rather than the full value of the deposit unit issued.

"Stochastic" refers to the fact that - ex ante - the bank creating a deposit unit expects (probabilistically) that only a share of that unit will translate into debt, whilst the remaining share (still probabilistically) will not be subject to requests for conversion or settlement, and will therefore represent equity proper for the bank. The share of debt and equity (which obviously are each complementary to 1) are stochastic variables that are influenced by behavioral and institutional factors as well as by contingent events. For example, in crisis times the share of debt tends to increase, and it tends to be lower when there is strong trust in the banking system. Policy and structural factors that strengthen such trust, such as the elasticity with which the central bank provides liquidity to the system when needed or institutional arrangements that support confidence in bank money (e.g., deposit insurance), increase the share of deposits having nature of equity.

This argument is eminently evident when applied to the whole banking system, but it does hold identically for each individual bank - albeit to a different extent depending on the size of each bank for a given settlement system and cash usage[7]. From the discussion so far follows that, all else being equal, the stochastic share of debt deposits for a small bank are greater than for a larger bank. Vice versa, the larger is the bank, the greater is the share of equity contained in its deposit liabilities.

Accounting principles

The stochastic double nature of bank money is consistent with the principles of general accounting as defined in the Conceptual Framework of Financial Reporting that sets out the concepts underpinning the International Financial Reporting Standards (IFRS). According to the Framework,
"A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably"[8].

Therefore, when an outflow of economic benefits is "not probable", there is no debt obligation and sight deposits become a hybrid instrument - partly debt and partly revenue, which, once accumulated, becomes equity, as discussed above.

Now, since there is no accounting standard that governs hybrid instruments explicitly, IAS 32 applies (in force of IAS 8) and provides that in the context of a hybrid liability instrument the debt component must be separated from the equity one[9]. From such separation derives that once the debt component is identified, the residual component is equity[10]. In the case of deposits, the nature of undistributed income of the share of deposits that (probably) will not translate into debt represents retained earnings (or equity).

The application of IAS 32 is a textbook case. It implies that the balance sheet of the issuing bank should report amongst debts only the share of deposits that gives origin to a "probable" outflow of economic benefits, while the residual share should be reported in the income statement as (seigniorage) revenue. Moreover, since the share of profits attributable to this revenue is undistributed, it would add to the bank's equity in the statement of assets and liabilities.

To further support the validity of the approach here proposed, consider IAS 37 (governing risk provisioning, charges and contingent liabilities)[11]. This standard considers as debt all commitments that fall under the Framework's definition of "liability", that is, those that generate outflows of economic benefits with a probability greater than 0.5. Below such threshold, the liability is a contingent liability and must only be reported in the Notes to the financial statements.

The implication is inescapable: the existence of legal claims is not per se sufficient for a liability to be considered as debt; the essential requisite is the probable outflows of economic benefits. In the case of bank money, the share of deposits that are not debt must be regarded as revenue, and since such revenue from money issuance (seigniorage) is not reported in the income statement, it constitutes retained earnings (or capital).


The double nature of commercial bank money draws its origin from the power de facto conferred by the state on the banks to create a form of money of their own, which only partly can be considered as debt. An important implication, which has been largely ignored so far, is that a relevant share of deposits that banks report in the balance sheet as "debt towards clients" generate revenues that are very much similar to the seigniorage rent extracted by the state through the issuance of legal money (coins, banknotes and central bank reserves). As shown elsewhere[12], such type of seigniorage introduces in the economy a structural element of net detraction of real resources, with deflationary effects on profits and / or wages, potential distributional consequences, and frictions between capital and labor, which should all be studied carefully.

Riferimenti Bibliografici

Bossone, B. (2017), Commercial bank seigniorage: A Primer, mimeo (available from the author on request).

Graziani, A. (2003), The Monetary Theory of Production, Cambridge University Press, Cambridge UK.

McLeay, M., Radia, A. and Thomas, R. (2014b), "Money Creation in the Modern Economy", Bank of England Quarterly Bulletin, 54(1), 14-27.

Moore, B. (1979), The Endogenous Money Stock, Journal of Post Keynesian Economics, 2(1), 49-70.

Moore, B. (1983), Unpacking the Post Keynesian Black Box: Bank Lending and the Money Supply, Journal of Post Keynesian Economics, 5(4), 537-556.

Werner, R. A. (2014), How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking, International Review of Financial Analysis, 36, 71-77.

[1] See, for instance, Moore (1978, 1983) and the literature on monetary circuit theory. As this is too vast to be cited here and do justice to its many contributors, we refer only to the work by Augusto Graziani (2003), one of the theory’s most authoritative exponents.

[2] The new non-cash deposits from clients can only consist of deposits transferred from other banks, which fall under item ii) above.

[3] This multiple value varies according to payment settlement modalities: it is larger in netting settlement systems and lower in gross settlement systems.

[4] As regards the use of cash, in cases where the monetary authority declares deposit inconvertibility and prohibits deposit transfers across borders, bank money effectively replicates central bank money, whereby reserves cannot circulate out of the central bank’s books: any single commercial bank may dispossess itself of it own reserves (if some other banks demand them), but all of them cannot altogether do so since reserves once created remain outstanding until they are paid or sold back to the central bank.

[5]Lending deposits features very close analogies to selling deposits. As banks issue deposits to clients in exchange for money, they become owners of the money received and acquire the rights to use the many as they wish (subject to existing laws and regulations). Even if the banks are constrained in the use of the money – such as, for instance, in the case of regulation prescribing types of assets to be held – they (not the depositors) are the owners of the purchased assets and they (non the depositors) are the owners of the income generated by the purchased assets.

[6] See discussion in Bossone and Costa (2018).

[7] Size here refers specifically to the volume of payment transactions that the bank intermediates relative to the total payment transactions in the system.

[8] Seection 4.46 of the Framework.

[9] Specifically, IAS 8 (Sections 10-11) requires that, “In the absence of an IFRS that specifically applies to a transaction, other event or condition, … management shall refer to, and consider the applicability of, the following sources in descending order:

(a) the requirements in IFRSs dealing with similar and related issues; and

(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”

[10] See IAS 32, Sections 28 et.ss. It is noteworthy that, in the case ruled by the quoted standard, the hybrid instrument has the double nature of 'liabilities-capital' and not of 'liabilities-revenue'; however, both capital and retained earnings belong to equity. Briefly, equity can be shared into at least two major components: capital and other ownership's contributions, on the one hand, and retained earnings, on the other. IAS 32 provides regulation for splitting hybrid instruments between a part attributable to liabilities and a part attributable to equity. As said, based on the definitions of the Framework, once the component recognizable as debt liability is identified, the residual component is attributed to equity.

[11] See IAS 37, Section s 12-13, where the fundamental distinction is drawn between the adjective "probable" for the debt liabilities and the adjective "possible" for contingent liabilities to be reported in the Notes to the financial statements.

[12] See Bossone (2017).

Photo Courtesy of Steven Lilley