In this article, we provide a legal explanation, based on published sources, of the capacity of credit institutions to create funds in current accounts in excess of the funds or monetary assets received from account holders, i.e., to create money — and the incapacity of other entities like non-bank financial institutions and other firms of doing the same.
We have seen in another article that current accounts are a debt claim of the account holder on the credit institution issuing them; the account holder is in effect lending funds to the credit institution; their relationship is that of creditor-debtor.
We have also seen that, since balances in current accounts are frequently used in modern economies to discharge payment obligations (e.g., we ordinarily accept payment by our employers and debtors by transfer of funds to our current accounts), it is not surprising that we also accept — without much second thoughts — the tender of current account balances created out of nothing when our credit institution discharges obligations it has to us.
However, this in itself is not a sufficient condition for credit institutions to be able to create money. The reasoning is quite simple: if this were true, then e-money institutions (EMIs) — like Revolut and Wise in the UK , PayPal in the EU — would also be capable of creating money, for they, like credit institutions, issue a liability widely accepted in payments, i.e., e-money (in fact most people probably don’t know the difference between current accounts and e-money accounts), which represents a claim of the e-money holder on the EMI for repayment on demand.
Figure 1 shows the stock of e-money as a percentage of M1 (currency and deposits with credit institutions) in the euro area (see Figure 1). Although small, in some countries e-money is commonly used to make payments. For example, in Lithuania and Luxembourg, more than 1% of total payments by non-banks are settled using e-money (see Figure 2). Also, while a big share of transactions using current accounts are due to transactions in shares, bonds, real estate, etc., e-money is typically used for low-value (retail) transactions in goods and services.
Like credit institutions, EMIs hold the funds deposited by e-money account holders ‘in an account with themselves’; the funds belong to the EMI, and all the e-money holder has is a liquid debt claim on the EMI for instant repayment. Both the funds received (the EMI’s asset) and the e-money issued (the EMI’s liability) are recorded on the balance sheet of EMIs.
The figures below show the similarities between the balance sheets of credit institutions and EMIs when accepting funds from customers/depositors. In both cases, the credit institution/EMI becomes the legal and beneficial owner of the banknotes deposited, and in exchange, the depositor receives a credit to its current account (Figure 3) or e-money account (Figure 4).
Unlike credit institutions (which we know for certainty create money by granting credit to non-banks), we know that EMIs don’t create money and don’t grant loans. The business model is that of payments, not of intermediation.
It follows, then, that the mere ability to issue a medium of payment (e.g., current accounts, e-money accounts) as an on-balance sheet liability is not a sufficient condition for creating money — and other regulations must be in place to allow or disallow it.
Distinguishing between net money creation and gross money issuance
When a depositor/customer deposits funds with a credit institution or an EMI, the total amount of funds in possession of non-banks does not change; it simply changes its composition. It is for this reason that it is convenient to define net money creation as follows:
The creation of funds in accounts in excess of the funds or monetary assets received from account holders.
If we define funds and monetary assets to consist of payment media (i.e., the sum of banknotes, coins, reserves balances at the central bank, balances in current accounts with credit institutions, and e-money accounts), it follows that for money creation to occur, the balance sheet counterpart of a credit of funds to an account must be something other than any of these items. Put differently, for the total stock of funds to increase, the balance sheet entries must involve financial instruments other than payment media.
Let me illustrate with an example. When a depositor places banknotes with his/her bank, the amount of funds held by the non-bank sector (here represented by the depositor) does not change, it simply changes composition; non-banks have €500 less of banknotes but €500 more in current account balances. The credit institution issues money on gross terms, but it receives money in exchange — therefore, the net effect on the total money stock is nill (Figure 5).
If, on the other hand, instead of banknotes, the balance sheet counterpart consists of some non-monetary item like loans, then this results in an increase in the money stock held by non-banks. This is shown in Figure 6.
The same result can be brought about not by an increase in non-monetary assets of the credit institution — but by the redemption of a non-monetary liability like long-term deposits, which are not money for they can’t be used to make payments. This is shown in Figure 7.
It follows from these examples that what allows entities to create or destroy money (as defined above) is not their capacity to issue money liabilities, but their capacity to do so when the balance sheet counterparts to that transaction are non-monetary financial instruments, like loan assets or long-term deposit liabilities.
Why can’t e-money institutions create money?
Once we understand that, it is quite easy to see why credit institutions can create money, and why e-money institutions can’t. Let’s compare their business models, and the financial instruments they are allowed to book on their balance sheets.
E-money institutions (EMIs)
The business of EMIs is restricted to that of acting as payment masters for account holders. It is a requirement in EU and UK law that, for every €1 issued of e-money liabilities, EMIs must keep €1 of funds with a credit institution. In other words, they must observe a parity between the money they have issued and the money they hold. This is stipulated, for example, in Articles 21 and 22 of The Electronic Money Regulations 2011 and Article 7(1) of Directive 2009/110/EC). Furthermore, EMIs are mandated to keep the funds received segregated from their own funds, in a ‘safeguarding account’.
Also, unlike credit institutions in the case of deposits, EMIs are not allowed to grant credit from the funds received in exchange for e-money, and if they do, it must be ancillary and granted exclusively in connection with the execution of a payment transaction. This is stipulated, for example, in Article 32(2) of The Electronic Money Regulations 2011 and in Article 6(1) of Directive 2009/110/EC.
As a result of these requirements, the balance sheets of EMIs look something like what is shown in Figure 8. For every €1 of e-money liabilities, there is €1 of funds in the safeguarded accounts held for customers with a bank.
The way this is achieved behind the scenes is quite simple, actually. When €1,000 of funds are transferred from a customer’s current account with a credit institution to the e-money account with an EMI, the EMI simply credits the e-money account and gets debited its safeguarding account with the bank. If the customer were to transfer funds out of the e-money account, the opposite operations would take place. This ensures that parity (1-to-1 ratio) between safeguarded funds and e-money is maintained at all times (although often EMIs don’t adhere strictly to this rule; see here). This is shown in Figure 9.
The parity rule, and the prohibition from granting credit to account holders, ensure that the total stock of money held by customers (non-banks) does not change when they transact with EMIs.
Things are different in the case of credit institutions (read on).
The business model of credit institutions is much broader and thus less restricted than that of EMIs. They too can issue monetary liabilities (current accounts), used to make payments by non-banks.
But a crucial difference is that credit institutions are allowed to book a much richer set of financial instruments on their balance sheets, and are not mandated — unlike EMIs — to keep €1 of funds assets in accounts with the central bank for every €1 they have issued of current account liabilities. In other words, credit institutions can discharge payment obligations to their customers in situations other than the mere depositing of funds by the latter, e.g., in the course of granting loans to them.
This can be deduced both empirically and by looking at the relevant regulations. For example, EU law contains a definition of ‘credit institutions’ that has been used consistently since 1977 (EBA, 2014, p. 4) and can be found, for example, in Article 4.1(1) of Regulation (EU) No 575/2013:
Credit institutions are allowed to use the funds received from depositors to grant loans on their own account, and don’t need to segregate their own funds from the funds received from customers; in fact, both are commingled and indistinguishable.
This is why the balance sheets of credit institutions look the way they do, and there is an imbalance between the funds they keep with central banks or in interbank accounts and the funds in current accounts they have issued; typically (at least before the large scale asset purchase programmes post-2008 in the US and post-2015 in the euro area), current account liabilities would be 10–20 times that of the stock of funds held in reserves with the central bank.
Figure 10 shows a hypothetical example of the balance sheet of a credit institution. Balance sheets are ‘living entities’, and the figure below is just a snapshot of the cumulative effect of past transactions. Nonetheless, it can be appreciated that the funds credit institutions hold with central banks (reserves, their asset) are a small item in their balance sheets, and many of the rest of items, when involving non-bank counterparties (e.g., loans to non-banks), have been settled though debits and credits to current accounts, which means money creation and destruction as per our definition given above.
In the case of entities other than credit institutions and e-money institutions, the issuance of monetary liability is quite rare. Also, when financial firms like brokers ‘accept’ deposits from clients, they cannot issue a current account liability, and instead must keep the funds and the associated liability or offsetting item off their books in memorandum accounts (under client money rules; see here). This prevents them from issuing deposit liabilities as well as from creating money.
Being able to issue a payment medium as an on-balance sheet liability (e.g., credit institutions issuing current account liabilities; e-money institutions issuing e-money account liabilities) is not a sufficient condition for money creation to occur, and other regulations (i.e., the capacity to grant credit and record balance sheet counterparts other than monetary items in the course of transactions with account holders) are the ultimate determinants of whether legal entities can create money. For more details, see here.
 According to the European Banking Authority (EBA, 2014, p. 9), ‘other repayable funds’ appears to be interpreted in a broadly homogenous way between the Member States although the vast majority do not have a specific statutory definition; in practice ‘other repayable funds’ tends to mean: bonds, bond loans, mortgage credit bonds, company bonds etc., certificates of deposit (ibid.).
 With regards to who ‘the public’ is, most Member States do not define it (see EBA, 2014, p. 11).
 The EBA (2014, p. 7) notes that both activities (i.e., accepting deposits/other repayable funds and granting credits) must be carried on in order for the person concerned to be a credit institution.
 According to EBA (2014, p. 10), the vast majority of Member States have not made any provision in their domestic legislation for the purposes of defining the words ‘granting credit for its own account’. However, the term appears to be interpreted broadly homogenously across the Member States as meaning ‘the granting of any kind of credit [by way of business] to another person’. The report adds that “‘on its own account’ could be clarified to mean that the credit institution has to be the creditor of the loan” (ibid., p. 11).
EBA (2014), Report to the European Commission on the perimeter of credit institutions established in the Member States, 27 November 2014
Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 Text with EEA relevance. Available here: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32013R0575
The Electronic Money Regulations 2011, https://www.legislation.gov.uk/uksi/2011/99/made