Give Commercial Banks Some Credit: Commercial Bank Money, Cryptocurrencies, and CBDC Regimes

Kevin Rutter , 09 Aug 2017 - BankingCryptocurrencyOpinion

Kevin Rutter is a Research Associate at R3, an enterprise software firm working with over 80 banks, financial institutions, regulators, trade associations, professional services firms and technology companies to develop Corda, our distributed ledger platform designed specifically for financial services.

The use of coins and paper money as a “token of exchange” can lead to mistaken impressions about the nature of modern money. Coins and paper money are only a small part of the money supply, and most of that supply does not follow the same rules as coins and paper money. Modern money is not like gold, paper certificates exchangeable 1-1 with gold, or a cryptographic token that is exchangeable electronically.

In the modern financial system, physical cash constitutes only about 3% of “broad money,” while most of the rest involves commercial bank deposits, much of which have been created by commercial banks themselves. Central bank-issued money, or “outside money,” is either physical (cash or coins), or central bank reserves. This money is also known as high-powered money or the monetary base, and is a liability of the central bank. Commercial bank money, or “inside money,” is produced by commercial banks as part of the credit creation process, and is a liability of commercial banks. Commercial bank money is fungible and exchangeable with central bank-issued money.

Commercial bank money supply fluctuates based on both a domestic population’s demand for loans from commercial banks and commercial banks’ willingness to issue those loans. As a result of this decentralized money creation process, the total amount of money in a modern advanced economy is relatively flexible and difficult to precisely measure, control, and predict. When considering the potential impact and applications of cryptocurrencies and central bank-issued digital currencies (CBDCs), an understanding of commercial bank money and credit creation is imperative.

Credit creation is a financial innovation that first gained traction in the 17th century. The transition from an inflexible supply to a flexible supply of money continued to evolve over hundreds of years, beginning with Stockholms Banco in 1657, when the bank began lending in excess of its metallic reserve. I use inflexible or fixed to mean a pre-set allocation, whether that be a hard-wired algorithm set by a cryptographer or the amount of gold that happens to be on the planet. I refer to inflexible or fixed money as a type that has no form of credit creation beyond the hard asset “reserve.” In such a regime, the asset can be an exchange of value or a bearer certificate that designates ownership of the asset only if it is convertible 1-for-1 with the asset itself and backed by a 100% reserve.

Today, commercial banks create marginal amounts of new money in response to loan requests by borrowers after commercial bankers evaluate the credibility of a borrower’s promise to repay. The bank’s balance sheet expands as the newly created commercial bank deposit becomes a liability of the commercial bank, a corresponding asset in the borrower’s promise to repay, and positive or negative equity based on the performance of the loan. This credit creation through double-entry accounting is demand-based, as commercial banks’ discretionary decisions on loans are always in response to an individual’s request for a loan, and the bank takes a financial risk by creating the money. Whether the money is created is determined on a case-by-case basis by commercial bankers hoping to maximize profit in a competitive lending environment.

The central bank can affect the willingness of a commercial bank to issue these (sometimes risky) loans by setting the discount rate, but ultimately there is no central body that makes loan decisions across an economy. It would be a Herculean task for a single entity to properly evaluate potential loans for an entire domestic economy. Central banks have multiple other tools to influence the money supply, such as the interest rate on excess reserves and the reserve requirement. See: “A lost century in economics: Three theories of banking and the conclusive evidence,” by Richard A Werner for a perspective on the effectiveness of some of these measures in controlling the money supply, and for analysis of different views on commercial bank money. Further, regulations are in place that establish ratios that intend to limit capital inadequacy and liquidity risks.

Advantages of credit creation

Credit creation resulted in the wider availability of finance through the expansion of “easier” credit for people around the world, due to a larger supply of loans and significantly lower borrowing rates. More freely available credit facilitates entrepreneurial activity – access to credit is essential for economic growth and risk-taking. “Good” (worthy and likely to be repaid) credit through loans funds new ventures that aim to provide a future positive return on investment. The innovation of credit creation in the financial system also democratized the lending process and lowered the market power of the wealthy in setting borrowing rates for loans.

Disadvantages of credit creation

The modern money system remains imperfect. Lending standards can deteriorate, particularly in “credit booms,” if there are not sufficient or appropriate underwriting and risk controls in place.

Credit can also expand at too fast a rate. Excess credit can lead to reactionary “credit crunches” when borrowers either are unable or become unable (due to changes in economic conditions) to cover the costs of loan repayment. “Boom and bust” cycles have occurred in fixed and inflexible money supply regimes, but likely become more exaggerated in money systems with large amounts of commercial bank money.

Further, central bank mechanisms to control and moderate cyclical credit activity can occasionally be ineffective and different central banks implement their monetary policy objectives with varying degrees of success. For example, central bank policy to set the discount rate guides credit activity, but cannot precisely control it.

Also, there are occasionally controversial applications of this ability to create money. In the wake of the 2007-2008 financial crisis, several major global banks made loans that were not intended to foster new economic activity external to the bank, but that instead financed a capital increase for that issuing bank.

A cryptocurrency regime

The design of cryptocurrencies (in their current structure) makes it an effective “exchange of value” mechanism for those looking to make censorship-resistant payments, but an ineffective substitute for a modern money system. A (very hypothetical) move to a cryptocurrency-based money regime would return to a 16th century-era approach to the provision of credit by using a fixed and inflexible monetary base that would raise interest rates for borrowers. Some might argue that a credit creation system could be built around a cryptocurrency with the base asset like Bitcoin. Such an approach would reproduce the existing financial system from scratch and would involve many third parties, diverging from the initial aims of the cryptocurrency community.

Fixed money supply regimes have less lending activity, as individuals hoard and store their wealth, leaving relatively less money available for loans to spur new economic activity. Further, in fixed supply money regimes, individuals that own large amounts of the money have outsized influence in setting interest rates for (the often poorer) individuals who seek loans to fund new economic activity. Today, in developing economies where there are no commercial banks to offer loans, “loan sharks” emerge when well-off individuals gain outsized market power in setting lending rates and earn high returns at the expense of the borrower. The centuries of usury (and reactionary moral laws prohibiting it) in fixed money supply regimes demonstrate this tendency.

In a (again, hypothetical) monetary regime based off current implementations of a cryptocurrency protocol like Bitcoin, for example, the supply of loans (due to the lack of money suppliers, commercial banks) would be substantially lower, and the cost to borrowers would increase as borrowing rates would be higher. Bitfinex lending rates for bitcoins illustrates borrowing rate pricing dynamics for nascent lending markets. Because of the relative scarcity of bitcoins, they act similarly to a hard-to-borrow stock, which has a much higher cost to borrow than a stock such as AAPL, with large inventories held by loaners. Rates that are too high stifle enterprise, creativity and initiative, and make debts unpayable. A financial system that makes lending activity either more difficult (tightened supply) or more expensive (higher borrowing rates) would slow economic growth. There are better ways to address any shortcomings of modern credit creation than such extreme measures, such as improving loaning standards through regulations.

There are several further reasons, outlined in previous R3 Research, why cryptocurrencies won’t be broadly assimilated into economies on the scale of advanced economy fiat money regimes. Price volatility, an unwillingness for companies to hold cryptocurrencies on their balance sheets, and excess inertia with money innovations given “network effects” are examples of these reasons. Having a central bank issue a digital currency would eliminate these barriers.

A CBDC regime

These shortcomings of cryptocurrencies, along with the potential benefits that distributed ledger technology (DLT) can bring to payments within regulated regimes. See the discussion of benefits in the R3 Research papers ”Evolution in Cash and Payments,” by JP Koning, “Vision Series: Cash and Payments,” by Kevin Rutter. This has led to increased interest in DLT from central banks around the word. A CBDC regime would differ from a cryptocurrency regime in that the protocol rules and design would be set by a central bank.

CBDC implementations will either aim to keep the monetary supply constant, or could potentially be a tool for central banks to implement expansionary or contractionary monetary policy. For example, “The macroeconomics of central bank issued digital currencies,” by John Barrdear and Michael Kumhof, explores the macroeconomic effects of using a CBDC as a policy tool that expands the central bank-issued monetary supply (which in the paper’s model also increases the amount of commercial bank money).

In the model proposed in this working paper, the initial stock issuance of central bank digital currency (CBDC) would be financed through a central bank purchase of government bonds equal to 30% of U.S. GDP, through open market operations or repo transactions. This would be a process similar to Quantitative Easing (QE). However, instead of the usual method of purchasing government bonds through commercial banks and increasing central bank reserves at those commercial banks, this model involves the central bank purchasing government bonds directly from non-bank private-sector agents, and issuing CBDC to those agents. The proposed CBDC model would circumvent commercial banks as a conduit for QE. Exchanging government debt with a CBDC that has no default risk would lower real interest rates, and be an expansionary policy tool. A majority of the 3% of GDP output effect gain from the CBDC proposed in the paper, would result from these QE-like effects. The paper does not evaluate in depth the other potential GDP benefits that could eventually result from greater fluidity and velocity of money with a CBDC, for example.

On the other hand, in the (incredibly hypothetical) case that a central bank were to outlaw commercial bank money and move strictly to a fixed supply CBDC, the central bank would be implementing an extremely contractionary monetary policy decision.

Due to the financial soundness of central banks, a CBDC issued to the general population could lead to flight out of commercial bank deposits and into the CBDC. Central banks will consider whether a particular CBDC implementation they employ disincentivizes bank loaning activity or otherwise affects commercial bank balance sheets. See Ben Broadbent’s “Central Banks and Digital Currencies” speech for further discussion of commercial bank money, cryptocurrencies, or CBDCs. Because of complex macroeconomic considerations for a domestic economy, central banks likely will avoid significantly changing the money supply in initial implementations of CBDCs.

Central banks are researching or experimenting with DLT implementations that are potential substitutes for either physical (cash or coins), or central bank reserves. For more on the differences between wholesale and payments solutions for central bank-issued money, see Rod Garratt’s R3 paper, ”CAD-coin versus Fedcoin.” Practical experiments with the central bank-issued money for wholesale payments in the R3 consortium use depository receipts as a means of avoiding changes to the money supply, like in Project Jasper. Thinking regarding optimal initial distribution, in a way that avoids unintended consequences, continues to evolve within the R3 consortium and is an area of continued research.


Central banks, commercial banks, and credit creation comprise an imperfect modern money system. Still, the modern flexible money system facilitates lending activity in a way that a money system that strictly uses an inflexible money supply – such as a cryptocurrency, “hard” asset such as gold, or strictly central bank-issued money – cannot. There is also a large amount of existing literature on full reserve banking and fixed money supply regimes (such as gold or Bitcoin), for a recent take, see the IMF report, “The Chicago Plan Revisited,” by Jaromir Benes and Michael Kumhof. Work is underway in the R3 consortium, alongside several advanced economy central banks, to determine the best early stage implementations of CBDCs that consider the implications for a domestic economy’s money supply.