Introduction

In our increasingly digitized economic landscape, banks have evolved far beyond their traditional roles as mere custodians or facilitators of funds. Today, they sit at the epicenter of modern money creation, wielding a power and responsibility that significantly shapes financial stability, economic prosperity, and, most times, the very pulse of society itself. This article explores the three principal theories of banking—financial intermediation, fractional reserve banking, and credit creation—while emphasizing the profound truth: banks are the true creators of money in contemporary economies. Drawing from insights garnered during a recent course at Oxford University, in collaboration with the Association for Research in Banking and Economics and under the pioneering tutelage of Professor Richard Werner (a program I recently attended), we will illuminate the empirical realities and consequences of this often-overlooked banking function.

The Three Theories of Banking

1. Financial Intermediation Theory

The financial intermediation theory posits that banks function as intermediaries between savers and borrowers. Under this model, banks collect deposits from individuals and institutions, which they then lend out to borrowers—families in need of mortgages, businesses seeking capital, or governments funding infrastructure. The bank’s role is thus seen as facilitating the flow of existing money from surpluses (savers) to deficits (borrowers), earning a margin through the difference in interest rates between deposits and loans.

While this theory neatly frames banks as neutral agents, it underrepresents their creative capacities and limits their role to mere conduits, not originators, of money. In reality, however, banks possess powers far beyond that of simple financial matchmakers, as later theories reveal.

2. Fractional Reserve Banking Theory

Fractional reserve banking builds upon the intermediary model, but introduces the concept that banks are only required to hold a fraction of their deposit liabilities in reserve, either in the form of cash or central bank deposits. The remainder can be lent out, thus enabling banks to “multiply” money through repeated rounds of deposit and loan creation.

This theory acknowledges that banks have the capacity to expand the money supply beyond the original deposits—a process known as the “money multiplier.” For example, with a 10% reserve requirement, a $1,000 deposit can theoretically support up to $10,000 in new loans across the banking system. Nevertheless, this framework still suggests that banks are constrained by prior deposits and central bank reserves, implying a limited and indirect role in money creation. In Nigeria, many bankers complain loudly about the very tight reserve requirement and liquidity ratios that the Central Bank of Nigeria has imposed on them. With Liquidity Ratio at 30% and Credit Reserve Ratio at 50%, it looks like banks have been totally strangulated in Nigeria. But the paradox lies in their consistent ability to churn out fantastic profits year on year – even with the challenge coming in from Fintechs and neobanks. Perhaps the explanation lies in the very formidable role of banks in society and economies – the ability to create money (virtually out of thin air) when they book loans in their systems. In fact, the Fractional Reserve Theory of banking gets pushed back in some quarters. Some powerful folks would want Nigerians to only consider banks as subtle, even suffering financial intermediators, while we consider money creation as a function of central banks. More than 90% of people in the world actually stick to the first theory, believing that banks are mere intermediators who hustle for money from surplus units (deposit mobilization as it is called in Nigeria), to lend to deficit units, while making a tiny spread in between. Of course, with the level of demand for money and credit, such a model will break down all too often and is therefore unrealistic.

3. Credit Creation Theory

The credit creation theory, most prominently championed by Professor Richard Werner, but also fundamentally recognized and propounded by all-time-greats like John Maynard Keynes, Irving Fisher, Henry David Macleod, and Joseph Schumpeter to name a few, presents a revolutionary paradigm: banks do not merely redistribute existing money (Financial Intermediation Theory), nor do they simply multiply it within regulatory constraints (Fractional Reserve Theory). Instead, when banks issue new loans, they simultaneously create brand new money—effectively out of nothing.

When a commercial bank approves a loan, it does not transfer funds from another depositor’s account, nor does it require additional reserves upfront. Rather, it credits the borrower’s account with a deposit (or enables a limit in its system for the customer to continue to withdraw funds based on the loan agreement) conjured into existence via a simple accounting entry. This deposit – or credit limit – is immediately spendable, circulating within the economy as new purchasing power. Thus, banks are the primary engines of money creation, with loan origination being the direct channel through which new money enters the system. Imagine all banks in their daily activities doing this. Imagine just how central and important banks are in making the economy go round. Imagine also the cumulative effect of this MONEY CREATION process. How is it backstopped? Perhaps that is the reason why the CBN has put a tight leash on things – to prevent frequent blowouts. Anyhow, this theory explains the ability of banks globally to be irrepressible in their profitmaking abilities. A banking license is therefore a license to ‘print money’, a great responsibility that no one in their right minds should toy with. Yet we see many instances where that privilege is mismanaged by sheer irrational exuberance when the possessors of the privilege just go bonkers and start to steal from themselves or start creating money recklessly without a thought to backstopping their liquidity. Of course, like the Fractional Banking theory propounds, the first fallback for a bank that creates credit is to find more deposits from sundry customers and new clients. The second fallback is their fellow banks (interbank loans from other banks to help with their liquidity), while the third  fallback is the central bank (through several windows to ensure banking sector stability). But there are many options by which a bank can find liquidity in today’s open world. There are development banks, multilateral institutions, private equity funds, and all sorts of other money troughs that have been consolidated over time. Still there are major risks as can be found in major global financial meltdowns from time to time. In fact, it can be argued that the bigger the system grows, the harder the fall that will come when things go south.

Empirical Evidence: The Werner Experiment

A highlight of my recent program at Oxford University, under the guidance of Professor Richard Werner and the Association for Research in Banking and Economics, was an eye-opening demonstration of this process. Professor Werner’s empirical research, ground-breaking in its clarity, involved a practical experiment within a German bank.

In this experiment, Professor Werner applied for a loan of 200,000 Euros. As he meticulously documented, upon approval, the bank simply credited his account with the requested sum—no funds were transferred from elsewhere, no existing deposits diminished. The money was newly created, not by the central bank or by mobilizing someone else’s savings, but by the commercial bank itself through a keystroke. This experiment provided irrefutable evidence of the credit creation theory in action, debunking the long-held notion that banks are constrained by the deposits they collect or the reserves they hold. Werner calls this the FIRST scientific/empirical experiment in banking. He believes that attention has been deflected from this hard reality for too long.

The Digital Age: Amplifying the Power and Responsibility of Banks

With the advent of digital banking, the process of money creation has become even more abstract and instantaneous. No longer bound by the physical transfer of cash or the limitations of paper bookkeeping, banks can now issue loans and generate new money with unprecedented speed and efficiency. Every mortgage, business loan, or personal credit line becomes a fresh injection of money into the economy, underlining the immense creative power vested in banks. Now Fintechs and neobanks have joined the fray so long as they lend.

This tremendous capability, however, is accompanied by a critical responsibility. The choices banks make—how much to lend, to whom, and under what conditions—directly influence not only local economies but the global financial system. Poorly regulated or excessive credit creation can fuel asset bubbles, inflation, and financial instability, as history has repeatedly demonstrated.

The Neglected Imperative: Consequences of Ignoring Money Creation

Despite the empirical clarity provided by researchers like Professor Werner, the dominant narratives and regulatory frameworks often ignore or underestimate the central role of banks in money creation. By treating banks as intermediaries or mere multiplier agents, policymakers and economists risk misunderstanding the real mechanisms driving financial cycles.

This oversight has contributed to intermittent financial and economic crises. When credit expands too rapidly, fueled by unchecked bank lending, it can inflate unsustainable booms. Conversely, when banks suddenly contract lending, the economy can plunge into recession. The 2008 financial crisis, for example, was as much a crisis of excessive credit creation as it was of regulatory failure. The recent saga involving ways and means and the involvement of our own central bank in several sectors of the economy is also another example. Thankfully, under Governor Cardoso, we are back to the straight and narrow and can expect a fairly long period of stability. Banking in Nigeria is back to that conservative strain, despite the credit creation theory being potent still.

Conclusion

Banks are not just passive intermediaries—they are the architects of modern money. The credit creation theory, validated by empirical research and personal experience, reveals that commercial and investment banks wield the tremendous power to create and direct the flow of money in our economies. In today’s digital age, this responsibility is greater than ever. It is imperative that academics, regulators, and society at large recognize and confront the realities of bank-driven money creation, ensuring that this formidable power is exercised prudently, transparently, and in service of sustainable economic prosperity. I still harbor great concern for the financial sector on a global level though. For how long can banks keep creating money and credit? For how long can central banks and governments keep bailing the system out when they go bust – often with taxpayers money? Are we building a global bubble? Who is getting the real chunk of the credits created on a daily? How much is heading to Africa (Nigeria) to create real things – industry, manufactures, infrastructure, education, technology, new intelligence? The answers to some of these questions are still blowing in the wind.