Accountability

n by Arfah Salleh & William G. Borges

Accounting Treatment of Bank Credit Creation

an Impersonation
of Reality PART 1

How can we resolve the issue of bank credit creation out of thin air by
accountants? Accountants must know that there is an absence of substance
inherent in these “debt” transactions (debit loan, credit deposit) and should
seek to discontinue giving ontological reality to these transactions, write
Arfah Salleh and William G. Borges.

The aftermath of the 2007/08 of relevant published documents

financial crisis has no shortage of issued by financial authorities,
explanations of its cause(s). These It is the simple act academic literature, and writings by
include one by Adair Turner, then of recording into private individuals on the subject. The
Chairman of the UK’s Financial the bank’s book materials, taken together, provided
Services Authority and a member (debit loan, credit us with a theoretical groundwork
of the Bank of England’s Financial deposit) what was clarifying commercial banks’ lending
Policy Committee, who identifies never in existence practices. But first, we highlight
commercial banks’ credit creation the fundamental difference between
that provides the
as a key contributor. In particular, money, currency and bank credit.
illusion of reality
Turner, in his speech at the South Money, by characteristic, has
African Reserve Bank on 2 November
of the otherwise intrinsic value in itself; currency is
2012, explained that, “The financial non-existing “debt”. representative money which currently
crisis of 2007/08 occurred because Hence, by using the comes in the form of printed sheets
we failed to constrain the private same process, in or coins in circulation; while bank
financial  system’s creation of private reverse, we offer a credit arises out of a loan transaction
credit and money.” solution. by commercial banks. But because
Motivated by Turner’s crisp contemporary economics lump bank
clarification, we undertook a review credit together with currency (and

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 Accounting Treatment of Bank Credit
Creation – an Impersonation of Reality

failed
The financial crisis
of 2007/08 occurred
because we failed to
constrain the private
financial system’s
creation of private
credit and
money.”

other currency equivalent) as money, illusion of reality of the otherwise ideals of their profession, they must
the true nature of bank credit becomes non-existing “debt”. Hence, by using discontinue giving ontological reality
muddled. the same process, in reverse, we to such “debt” transactions. This is our
This article, which comes in two offer a solution. That is, we conclude clarion call to accountants worldwide.
parts, describes our basic finding: that the route to resolving the The first part of the article
Commercial bank credit creation is issue of bank credit creation out of compares between some proposed
made possible through accounting thin air by accountants is through theories that are thought to describe
entries by accountants. It is the simple evidencing to accountants that there how banks create credits and what
act of recording into the bank’s book is an absence of substance inherent actually takes place as described by
(debit loan, credit deposit) what was in these transactions and, out of a the authorities and empirical evidence
never in existence that provides the sense of honesty and loyalty to the as observed in a real bank setting.

nov / dec 2015 | accountants today 57

Accountability

Accounting Treatment of Bank Credit

Creation – an Impersonation of Reality

Based on the findings, the contentious accounting standpoint. We also make lending as only remotely affecting the
philosophical state of bank credit reference to a publication by the Bank economy, and hence have removed it
creation is highlighted. of England – which we consider the from the modelling equation of fiscal
Having questioned the authoritative source on the subject and monetary policy formulation.
philosophical underpinning of bank matter. From then till about the 1960s,
credit creation, the second part of a new theory, termed the Fractional
the article highlights the implications Three Fundamental Theories Reser ve Theor y of Banking
of today’s bank credit practices on Werner, in 2014, divided the emerged. Briefly, according to this
borrowers and depositors. A call to theoretical models of banking into theory, individual banks are financial
accountants to take action to halt three main theories. The model of intermediaries which cannot create
extant accounting treatment that banking which assumes that bank “money”. Collectively however, they
allows for money creation out of thin lending is created out of the deposits end up creating “money” in the
air is made. collected is termed the Financial economy through systemic interaction
Intermediation Theory of Banking, of a multiplier-spinner process which
What the a theory dominant until the 1920s. changes the balance of the fraction
Literature Reveals The premise that undergirds this of depositors’ deposit required to be
about Bank Credit early theor y is that commercial retained by the banks.
banks merely gather resources and The third theory of banking,
We begin the discussion with re-allocate them, essentially playing a according to Werner, is the Credit
a brief overview of a theoretical role which is no different than those Creation Theory of Banking, which
outline by Werner that sketches the of non-financial institutions. Because was proposed during the first two
perception of the models of banking of the perceived mundane role of decades of the 20th century. This
practices. This is supported by an banks compared to other institutions, theory “maintains that each individual
empirical study confirming how loan proponents of this theory are said bank has the power to create money
creations are transacted, from an to view the consequence of bank ‘out of nothing’ and does so when it

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 Accounting Treatment of Bank Credit
Creation – an Impersonation of Reality

extends credit” (we term this as bank borrowers now create the deposits as a
credit to distinguish it from other forms consequence of the act of loaning nothing.
of credit). Unlike the first two theories, Notice the sequence of events.
this theory argues that each individual The key to understanding this bizarre
bank is not a financial intermediary phenomenon is observing the accounting
that passes on deposits or reserves to entries made when loans are given. This
borrowers, but instead creates the entire is why, if the practice of creating fake
loan amount out of nothing. money to impersonate real money is to be
abolished, accountants will have to take
What then is the lead. We will address this matter in
currently being greater detail, in a later section.
practised by
commercial banks? Accounting Treatment – Creation of New
Deposits from Loans
The Admission by the Authorities Not satisfied with merely explaining
The Bank of England’s Quarterly the operations of banks in the credit
Bulletin (2014a), “Money in the Modern creation process, Werner undertook
Economy: An Introduction,” supports our an empirical study to learn the relevant
basic hypothesis, as it clearly explains that internal accounting transactions that
most money in the economy “exists” in the accompany a loan in an uncontrolled real-
form of bank deposits, which commercial world environment. With the cooperation
banks themselves “create — over and Banks do not of a small bank in the small town of
above smaller amounts, in the form of perform as Wildenberg, Germany, a researcher
traditional paper currency and coins, “intermediaries” entered into a live loan contract agreement
that are minted by the central banks and between of 200,000, undertaken on 7 August 2013.
central bank reserves. depositors and In the presence of two directors of the
In a separate article in the same bank as observers, the procedure that
borrowers,
Quarterly Bulletin issue, “Money Creation the Accounts Manager cum Head of the
nor as agents
in the Modern Economy,” McLeay, Radia Credit Department took to record the loan
and Thomas, authors from the Bank of
working along was filmed.
England, explain and debunk the popular with their It was observed that no additional
misconceptions about modern banking. respective activity, such as ascertaining the available
Banks do not perform as “intermediaries” central banks deposits or funds within the bank, took
between depositors and borrowers, nor as to “multiply up” place before the loan was approved. No
agents working along with their respective existing money instruction to transfer funds from other
central banks to “multiply up” existing in order to sources, whether internal or external, was
money in order to make loans. In fact, make loans. given. Neither were instructions given to
McLeay et al. highlight that the reality of increase, drawdown or borrow reserves
how money is created today differs from from the central bank or from any other
the description found in some economics entity. In short, no evidence to support a
textbooks. “Whenever a bank makes a mere re-allocation of funds was sighted.
loan, it simultaneously creates a matching What took place was the signing of the loan
deposit in the borrower’s bank account, contract by both parties that immediately
thereby creating new money,” they point created the amount of “funds” credited
out. So banks, rather than receiving to the borrower’s account, followed by an
the depositors’ savings/deposits and increased balance in his current account
then lending the available funds to the by the loan amount. The whole transaction

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Accountability

Accounting Treatment of Bank Credit

Creation – an Impersonation of Reality

crediting the borrower’s deposit

account (although no such deposit
has taken place). With the book
entries, the bank can claim repayment
of the “loan” with rights to interest. In
essence, the loan paper is the “rented
property” which entitles banks to
receive rentals in the form of interest
– a recurring “secured” income – and
the right to foreclose the collateral or
property purchased from the “loan”
in cases of loan “default”. And do we
not wonder why loans are structured
so that borrowers pay the interest
portion first instead of the principal?
Reiterating, the crux of the matter
is that, the debt/loan which banks,
businesses and individual borrowers
have come to accept as a legitimate
from start to finish took only 35 minutes. “money” is really “fake” money. There
To assess the impact of the loan is no transfer of ownership of anything
on the balance sheet of the bank, the Reiterating, that belongs to the loaning bank. The
researcher obtained a scanned copy the crux of the transactions that are recorded into
of the balance sheet on 6 August and matter is that, the bank’s book are mere records of
compared it with the 7 August balance the debt/loan fabricated “debt” which are matched
sheet, after the loan was completed. which banks, to equally fake “deposits” given
Being a small bank with minimal businesses ontological reality – all at the press
daily transactions, the researcher was and individual of a computer key. Borrowers now
able to account for the impact of all become the depositors. Unfortunately
borrowers have
other transactions and the new loan the “debts” or IOUs” represented in
come to accept the bank’s records in the names of
that he took. It was found that if other
transactions had not taken place, the as a legitimate the borrowers, however, do have legal
bank’s balance sheet would have “money” is really standing.
expanded by the same amount as the “fake” money. Compare this to a typical credit
loan on both sides – assets (loans) and sales scenario: the merchant who has
liabilities (deposits). These discoveries ownership of the merchandise allows
led Werner to reject the financial a customer who buys on credit to
intermediation and fractional reserve take the merchandise in return with
banking theories. commercial banks a legal right to a promise to pay in the future. Here,
translate the relationship between the merchandise is real and there
Contentious the bank and the “borrower” into a is real exchange taking place. The
Philosophical quantifiable digit form (in the above relationship between the customer and
Foundation example 200,000) and given life the merchant is clear – the customer
through accounting entry by debiting is in debt to the merchant when the
What the findings suggest is that the loan account in the borrower’s merchant transfers the merchandise –
commercial banks “invent” the funds name (despite the bank not loaning the value being an amount accepted as
ex nihilo. The loan document gives any existing funds of their own) and equivalent to the merchandise value. It

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Accountability

Accounting Treatment of Bank Credit

Creation – an Impersonation of Reality

is the merchandise which has exchanged hands into the hands References
of the customer that gives the merchant the right to claim • Bank of England (2014a). Money in the Modern
future settlement from the customer who is in debt (and issue Economy: An Introduction, by Michael McLeay,
an IOU) to the merchant. In the merchant’s book, a debtor’s Amar Radia and Ryland Thomas of the Bank’s
amount equivalent to the selling price of the merchandise Monetary Analysis Directorate. Quarterly Bulletin
is recorded as asset and matched to the reduction of the Q1, 54(1).
merchandise (asset) (at cost and some profit, assuming selling • Bank of England (2014b). Money Creation in the
price is higher than cost). Until the full amount agreed is Modern Economy, by Michael McLeay, Amar
settled, the merchandise is still in a state of being partly owned Radia and Ryland Thomas of the Bank’s Monetary
by the debtor (or borrower). The true nature of the event is Analysis Directorate. Quarterly Bulletin Q1, 54(1).
clear since in substance, the exchange of the merchandise is • Hansard (2014). http://www.publications.
real. The debt therefore has a source of origin – has ontological parliament.uk/pa/cm201415/cmhansrd/
existence – hence captured in the accounting transaction. cm141120/debtext/141120-0002.htm
But with bank credit creation, the source of the right to • Jakab, Z. and M. Kumhof (2015). “Banks are not
claim future real money has no origin – no existence – given Intermediaries of Loanable Funds - And Why This
due right only by the accounting record. Hence, the question Matters”, Bank of England Working Paper Series
which follows is whether such accounting practice has the No. 529, May.
correct philosophical basis when in substance nothing has • Turner, A. (2012). Monetary and Financial
been lent. Stability: Lessons from the Crisis and from classic
Further discussion on the impact of the accounting economics texts. Speech at South African Reserve
transaction giving an ontological existence to the otherwise Bank, 2 November.
non-existing debt is continued in Part 2 of this article. n • Werner, R.A. (2014). Can banks individually
create money out of nothing? – The theories
Arfah Salleh, PhD, FCPA (Aust) is Professor of Human and empirical evidence. International Review of
Governance, Founding President and CEO of Putra Business Financial Analysis, 36: 1-19
School, where William G. Borges, PhD is an associate.

MIA notice
Decisions of the Disciplinary Committee of the Malaysian Institute of
Accountants (‘Institute’) against members pursuant to Rule 18(1) of
the Malaysian Institute of Accountants (Disciplinary) Rules 2002

Lim Boon Kiat (4005) as the sole proprietor of the firm Lim Thong of the Institute on 10 August 2015 for failing to return the com-
& Associates (‘the Firm’) had been punished and imposed a fine of pleted Practice Review Questionnaire to the Institute pursuant to the
RM1,500-00 and costs of RM2,000-00 by the Disciplinary Committee Institute’s By-Laws despite several written reminders to do so.
of the Institute on 23 June 2015 for failing to return the complet-
ed Practice Review Questionnaire to the Institute pursuant to the Kew Yik Sang (4377) as the sole proprietor of Y.S. Kew & Co. (‘the
Institute’s By-Laws despite several written reminders to do so. Firm’) had been punished and imposed a fine of RM3,000-00 and
costs of RM2,000-00 by the Disciplinary Committee of the Institute
Jerome Tan Thiam Poh (7855) as the sole proprietor of Jerome & on 10 August 2015 after the Firm had been rated as ‘unsatisfactory’ as
Associates (‘the Firm’) had been punished and imposed a fine of indicated in the Follow-up Review Report dated 12 April 2012 which
RM2,000-00 and costs of RM2,500-00 by the Disciplinary Committee detailed the weaknesses in the audit work performed.

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