Fractional-“Collateral” Money Creation

Economists view the money creation process through two separate channels. Each has its own economic effects as well as risks.

In the current fiat monetary system, central banks can increase the amount of base money through their open-market operations. The standard example sees a central bank purchasing a bond from a private bank, and crediting that bank´s account by the value of the bond. The central bank accumulates assets in the forms of bonds, and the offsetting liability is the base money held in the reserve account of a private bank.

On the other hand, private fractional-reserve banks can also create money. By holding less than a 100 percent reserve, these banks make loans which are used and deposited in other banks, thus increasing their reserves. As the process continues, each loan increases the money supply though at a diminishing rate dictated by the reserve ratio. As each bank holds a fraction of the deposit in reserve, either for regulatory reasons or as a precautionary measure, the process of bank-created money expansion cannot continue unabated.

The risk in this system is well known. If the demand to withdraw reserves from the system increases, as is the case when depositors’ increase their demand to hold currency relative to deposits, the real scarcity of reserves becomes apparent. The common bank run is one example of such a situation.

While this is the common explanation of the money creation system, there is another increasingly significant component to the story. This component revolves around the money creation process based on re-pledged collateral by financial institutions in the form of repurchase agreements.

Consider that in the modern fiat monetary system, credit creation results in money creation. As credit is issued and spent, the proceeds are deposited in the banking system and act as money. Credit is issued against collateral. Thus the extent of the money creation process hinges what is acceptable collateral.

The common repurchase agreement (repo) involves borrowing an asset against cash, with the promise to reverse the transaction at a future date. Thus, company A can borrow $1 mn. from company B, and pledge collateral in the form of a bond for the loan. At some future date, say one year, the transaction will be reversed, with the loan being paid off and the bond serving as collateral returned to the borrower.

The following example, provided by Manmohan Singh and Peter Stella , demonstrates this process.

“A Hong Kong hedge fund may get financing from UBS secured by collateral pledged to the UBS bank’s UK affiliate – say, Indonesian bonds. Naturally, there will be a haircut on the pledged collateral (i.e. each borrower, the hedge fund in this example, will have to pledge more than $1 of collateral for each $1 of credit). These bonds are ‘pledged collateral’ as far as UBS is concerned and under modern legal practices, they can be ‘re-used’. This is the part that may strike non-specialists as novel; collateral that backs one loan can in turn be used as collateral against further loans, so the same underlying asset ends up as securing loans worth multiples of its value. Of course the re-pledging cannot go on forever as haircuts progressively reduce the credit-raising potential of the underlying asset, but ultimately, several lenders are counting on the underlying assets as backup in case things go wrong.”

The Indonesian bonds serve as collateral for UBS, and in most countries they can be re-used. This practice known as securities lending allows one asset to serve as collateral against multiple loans simultaneously. Perhaps a pension fund demands to hold the Indonesian bonds. UBS can post these bonds as collateral to secure a short-term loan from the pension fund. The transaction depends on the level of trust between the two parties, which can in large part be signified through the haircut on the bond.

Note that re-pledging collateral in this example results in credit creation in the same way as the re-use of reserves results in credit creation in the fractional-reserve banking system. The haircut is analogous to the reserve ratio and the posted collateral serves as bank reserves. The number of times the collateral is re-pledged is what determines the money multiplier, just as the number of times a reserve is “fractioned” determines this in the banking system. Thus every time collateral is reused, an offsetting loan results. When this loan is used the result is money creation, just as is the case when a fractional-reserve bank generates a loan against its reserves.

To give some idea of the magnitude of this credit creation, Singh and Stella estimate that at the end of 2007 the world’s large banks received about $10 trillion in pledged collateral, while the primary source of collateral held by custodians was only about $3.4 trillion. Each dollar of collateral was thus used about three times. The levels of pledged collateral have since come down, though still remain significant.

pledged collateral

Figure 1: Pledged collateral

Source: Singh (2012), The (Other) Deleveraging. IMF working paper, WP/12/179.


Deleveraging this money creation, just as in the traditional banking system, can happen in three ways: 1) increase the haircut, 2) reduce the supply of assets to be used as pledged assets, or 3) reduce the re-pledging of collateral.

As uncertainty increases and trust evaporates from the financial system, the amount of re-pledged collateral decreases. Since most businesses rely on repo credit for their operations today, any decrease in the amount of pledged collateral will reduce their ability to receive credit and hamper their ability to maintain their operations. As the supply of credit decreases, the price of borrowing will jump. The Federal Reserve’s low-interest rate policy of the past five years cannot control this jump in borrowing rates, and businesses will find their investments unprofitable as a result.

Allowing banks to hold only fractional reserves results in bad investments as multiple loans are issued against the same piece of underlying reserve asset. Allowing financial institutions to re-pledge collateral on the repo market results in the same outcome. While the Federal Reserve thinks that it can control credit creation and borrowing costs through its own open-market operations, borrowing against re-pledged collateral is wholly outside of its control.

Austrian economists have been unified throughout the crisis in demanding an end to fractional-reserve banking because of the instability caused by using each unit of money multiple times. It is time we extended this demand to all types of assets used as collateral in the credit creation process.

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7 Responses to “Fractional-“Collateral” Money Creation”

  1. Even the catalyst for the American Revolution, the Boston Tea Party, was not a grand political statement on the unjustifiable nature of taxation without representation click here

  2. "Austrian economists have been unified throughout the crisis in demanding an end to fractional-reserve banking…."

    This statement is not true.

    "…because of the instability caused by using each unit of money multiple times."

    Instability is not cause for intervention.

    It is unfortunate that the right to contract – the basis for free markets – is so often ignored by advocates of free markets.

    • David Howden says:

      bionic mosquito:

      I suppose it all depends on who you define as an "Austrian economist".

      On the topic of infringing on the right to contract, please keep in mind that all types of contracts would be prohibited on free markets. Minors and those lacking the mental capacity to contract, just as today, would not be allowed to enter into contracts. Also similar to today, there must be a meeting of the minds for successful contractual agreement – something which is missing in the basic deposit. Furthermore, contracts cannot be impossible to fulfill. Deposit contracts are impossible to fulfill, and this becomes apparent, e.g., in times of bank runs.

      Being free is not having the ability to do whatever you want.

  3. David Howden says:


    "Bad" is defined here as unsustainable. The crux of the Austrian business cycle is that expansion of the money supply by banks leads to a shift in the time structure of production. Loosely stated, it means that as your discount rate falls investors take on projects of longer duration than would otherwise be the case. This is unsustainable (bad) because savers have not changed their savings preferences, and the funding will not be available for the duration expected by the investors. (The banking system operating with less than 100% reserves causes the discount rate to fall, not an increase in savings which are actually probably decreased due to the lower interest rate bank credit expansion brings forth.)

    A good example of this is the credit freeze in 2008. Investors thought that funds would be available for a longer duration than turned out to be correct. Bank deposits are a tenuous funding source between depositors can always reclaim them on demand at a pre-established price (par). If these investments were funded by equity there would have not been a funding shortage as savers would have withdrawn their funding but only received the market value for it. Alternatively if they were funded by loans there would not have been the opportunity for investors to withdraw their funds until some pre-established time.

    In regards to your final (very good) question – how would financing occur in a system of 100% reserve banking? It would rely more heavily on equity and loans, instead of bank-created credit against the deposit base. This may curtail credit availability (which may actually be a good thing), though I am not convinced that would be the case. It would secure investors that the funds they have borrowed are not going to be withdrawn in the way that deposits can be. Alternatively it makes depositors think about whether they really want to invest their money (through stocks or loans) and incur the risk, and how much money they actually want to hold as a deposit (since it would not longer be a costless option).

    If you are interested in more, this article is a pretty good summary of the fundamentals of the Austrian business cycle:



  4. alaska3636 says:

    I guess it depends on what the definition of "is" is…

  5. alaska3636 says:

    I should have been more clear.
    "The reason why I brought it up is because it is a reason why not any voluntarily agreed upon contract is enforceable, or permissible even, in a free society. "
    Say what? In a free society, *pause*, not just any voluntarily agreed upon contract is enforceable or permissible?
    Where to begin is what you mean by free. Then perhaps what you mean by free society. Free to submit to coercion in the marketplace for peaceful and voluntary transactions?

  6. David Howden says:


    yours is a common objection to the viewpoint that "in a free society not all voluntarily agreed upon contracts are legitimate." Consider some others:

    1. Two people voluntarily contract to have a third murdered.
    2. An infant voluntarily contracts with an adult for sexual services.
    3. A person signs a contract to purchase a car while the other party thinks the contract is to lease the car.

    All three are voluntary, and also illegitimate. The first has an obvious rights violation. The second brings up a thorny issue about who can actually contract (maybe you're okay with no. 2, but it's a tricky one nonetheless). The final example can be handled in one of two ways, either through misunderstanding (in which case, as today, it is not enforceable), or through contradictory terms.

    Being voluntary is a necessary but not sufficient condition for contract enforcement. In this regard contract law has already grappled with these problems for hundreds of years and so provides partial answers. There must be capacity, and a meeting of the minds (i.e., the terms must be aligned). Furthermore, for enforceability there can be no logical contradictions in the terms. To understand why not, please read my article here:

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