Technology tends to remove intermediaries from supply chain and thus increase efficiency. Bill Gates in 1994 commented that banking is necessary, banks are not. Since then, technology has helped banks to innovate and grow. However, with the advent of fintechs globally, Gates’ comment gained relevance. Part of the uncertainty associated with the future of banks is attributable to the popular narrative that banks’ are intermediaries. It may be argued that banks are much more important to an economy and government than the tag of a ‘financial intermediary’ may suggest.
Commonly two models are used to describe banking. As per “financial intermediary” model, banks take deposit from savers and lend it out to borrowers. The second being the “fractional reserve” model of banking. Here banks are treated as intermediaries, which requires an initial deposit to kickstart the credit creation cycle. Both these models suggests that deposit gives rise to credit .While simplicity and intuitive appeal make these models popular, they do not explain banking comprehensively.
Richard Werner’s empirical work (A Lost Century in Economics: Three Theories of Banking and Conclusive Evidence) suggests that fractional reserve banking and financial intermediation theory are not borne out in terms of data evidence. Implication being that in a modern economy, the credit creation model, which is the third model and also the oldest, may be used to explain significant portion of the bank’s functioning. This model suggests that credit creates deposit and not the other way round.
Operationally, when banks disburse credit they simultaneously open a liability/deposit account in the name of the borrower. So, where nothing existed, an asset (loan) gets created along with a liability (deposit) in the banking system. The deposit adds to the money supply as it adds purchasing power to the economy. Banks are like agent of the ..