Important though coins and banknotes may be in everyday life, it is safer and more convenient to make large payments by credit transfer or card. The money we use for such payments is the “book money” deposited in our bank accounts. You cannot touch book money because it is no more than a set of data in banks’ computer systems.
Book money can be converted into cash and cash into book money.
The term book money dates back to the early days of banking, when money changers noted their customers’ credit balances manually in their ledgers. Such records are now kept electronically. This “immaterial” book money is the basis for cashless payment systems. It is passed on from bank account to bank account in a kind of cycle, which is why it is often also referred to as “giro money” (from the Italian word “giro”, meaning “round trip”). In today’s economy, there is much more book money in circulation than cash. Unlike banknotes and coins, however, book money is not legal tender. Nevertheless, it is generally accepted in business transactions. Book money can be converted into cash by making a withdrawal at a bank counter or an automated teller machine (ATM). Conversely, cash becomes book money when it is paid into a bank account.
Book money in bank accounts is also referred to as a deposit. There are different types of deposit, which vary in terms of how quickly the depositor can access the money. Current account balances are referred to as transferable deposits and are primarily intended for payment transactions. Time deposits and savings deposits can only be accessed after an agreed period of time has expired or following termination of the account in question.
The fact that payments made from account to account in cashless form are more convenient and secure than cash payments is something that merchants and traders already recognised as far back as the Middle Ages. In northern Italy, in particular, they developed something akin to a banking system. This is why numerous technical terms relating to the monetary system are of Italian origin.
Banks play a key role in the monetary and economic system. They grant loans to households, businesses and the government, whilst also providing customers with a place to store and invest their money. In this context, banks work closely together to transfer payments quickly and securely from one account to another. They also offer a number of other money-related services.
Banking activities are subject to strict regulation. Anyone in Germany who, in a professional or commercial capacity, conducts the business activities that are defined as banking business – particularly deposit-taking or lending business – is considered to be running a bank. The necessary authorisation for doing so is granted by the European Central Bank (ECB) on the basis of a recommendation from Germany’s Federal Financial Supervisory Authority (BaFin). All banks are specially monitored and supervised by banking supervisors. This also applies to enterprises that conduct banking-related activities, such as leasing, buying and selling securities, or settling payments. They receive authorisation for this solely from BaFin.
The commercial banks and the Deutsche Bundesbank together form Germany’s banking system. The Bundesbank, as Germany’s central bank, has a fundamentally different role to that of the commercial banks. As a public sector institution, it is responsible for implementing the euro area’s single monetary policy in Germany, the primary objective of which is to safeguard price stability. As the “bank for banks”, it provides commercial banks with central bank money.
The central bank and the commercial banks together form the banking system.
Furthermore, the Bundesbank is the only bank entitled to put legal tender (banknotes and coins) into circulation. Commercial banks, on the other hand, are usually private enterprises that provide money-related services with the aim of generating profits. Commercial banks offer their services to individuals, business enterprises and the government.
The density of banks in Germany has declined in recent years, but is still high compared with other countries. Banks in Germany vary greatly in size. The big banks and the Landesbanken, which generally also operate internationally, stand in contrast to a large number of medium-sized and smaller banks. The banks also have various legal forms, falling under public, private or mutual ownership. Most banks in Germany are universal banks. Unlike special-purpose banks, these banks offer a wide range of banking services.
Commercial banks comprise big banks such as Deutsche Bank and Commerzbank, regional banks, other commercial banks and branches of foreign banks. Most savings banks are publicly owned, usually by local authorities or local authority associations, but there are also independent savings banks organised under private law.
Savings banks are generally universal banks that conduct many types of banking business. However, their primary focus is on deposit-taking and lending. Owing to the regional principle laid down in the Savings Banks Acts (Sparkassengesetze) of Germany’s federal states, savings banks must restrict their business activities to the region in which they are based. The Landesbanken, as the lead institutions of the savings banks, were originally created as central clearing houses for cashless payments, and still perform this function today. As part of their public mandate, they traditionally also provide financial services to government authorities such as state and local governments.
Cooperative banks or credit cooperatives primarily serve medium-sized and smaller enterprises as well as private customers. The commercial credit cooperatives (people’s banks) were established as self-help organisations for small businesses in commerce and trade. Rural credit cooperatives (Raiffeisen banks) were originally farmers’ unions. Cooperative banks have close ties to their central institutions, also known as the regional institutions of credit cooperatives. DZ Bank, a central institution of credit cooperatives, is one of Germany’s biggest credit institutions.
Special-purpose banks focus on specific business activities and include, for example, mortgage banks. These grant long-term loans to finance public projects and the construction of real estate. To this end, they issue debt securities (known as “Pfandbriefe”), which are purchased by individuals, insurance companies and other banks. Building and loan associations collect money from their savers on the basis of savings and loan contracts and grant loans to them according to a distribution plan. Banks with special tasks provide support, for example, for long-term investment financing. Such banks include the KfW banking group (Kreditanstalt für Wiederaufbau), which is closely involved in the state-led promotion of economic activity in Germany and abroad. Other special-purpose banks include guarantee banks and housing enterprises with savings facilities.
Lending and deposit-taking are key banking activities.
Lending and deposit-taking are some of the most important economic functions of banks. A borrower who needs a loan pays the bank interest for it. Banks pay customers interest on their deposits, especially in the case of savings and time deposits. The difference between lending rates and deposit rates (interest margin) is one of the main sources of income for banks. Because borrowers sometimes fail to repay their loans or fail to repay them on time, the lending rate includes compensation for the default risk that the bank has to factor in. In order to minimise this risk, banks check their customers’ creditworthiness very carefully. In addition, they often require collateral to be provided for a loan (e.g. the property being financed). In the event of a default on the loan repayment, this can be used to reduce the loss incurred by the bank.
Banks offer a wide range of money-related services.
In addition to traditional banking business – lending and deposit-taking – most banks offer other services as well. They carry out cashless payments, underwrite securities issued by enterprises in particular, and advise their clients on financial matters. Furthermore, on behalf of their customers, they buy, sell, hold and manage assets, particularly securities. Section 1 of the German Banking Act (Kreditwesengesetz) lists further types of banking business.
Additionally, the Banking Act also lists the activities carried out by financial services institutions (including investment broking, investment advice and investment management, as well as financial leasing and currency exchange business) and other financial enterprises (including credit broking and the holding of corporate investments).
The aggregate balance sheet for all German banks reveals the size and structure of banking business as a whole. It shows banks’ assets on the left-hand side against their equity and liabilities on the right-hand side. The assets, which consist largely of loans granted and securities purchased, reflect the type of business a bank conducts (use of funds). By contrast, the liabilities indicate how these operations are financed (raising of funds).
Cash reserves are the banks’ cash holdings and their account balances at the Bundesbank, which can be exchanged for cash at any time. Compared with most other items, cash reserves are relatively small – much lower, even, than the overnight transferable deposits. This is because banks can afford to have relatively small cash reserves, since not all customers want to withdraw their money in cash at the same time. In addition, banks can obtain additional cash at short notice at any time via their direct access to the central bank (see Section 6.3.3).
The bank balance sheet is dominated by lending to banks and non-banks on the assets side...
Loans to domestic and foreign non-banks constitute the largest item on the assets side. This includes all loans to enterprises (e.g. for working capital and investment), to households (e.g. overdrafts on current accounts, instalment loans and real estate loans) and to public sector entities. Interbank lending also accounts for a fairly large share. Banks that have a surplus of central bank money at a given time lend this money to banks that need central bank money at that time. In doing so, the lending banks receive collateral from the borrowing bank – usually in the form of securities. Such loans are often only granted “overnight”. If a loan is granted, the lending bank’s claim corresponds to the borrowing bank’s liability. The money market is where banks’ supply and demand meet.
In addition, banks have large-scale holdings of marketable securities, which they use as an income-generating liquidity reserve. If they need central bank money, they can deposit these securities as collateral as part of refinancing operations with the central bank or with commercial banks. Banks also acquire securities with the aim of realising price gains. Additionally, banks hold shares in other banks and enterprises. In doing so, they provide these banks and enterprises with long-term equity capital and, in return, generally gain the right to have a say in the running of these entities as well as a share in their profit and loss. Tangible fixed assets (e.g. buildings or machinery) play almost no role for banks in terms of value and are therefore recorded under “Other assets”. The largest share of “other assets” is accounted for by claims arising from special trading activities. Through these trading activities, banks give their counterparties the ability to hedge against certain risks or to profit from changes in the market prices of certain goods without having to purchase them directly. In addition, banks use these trading activities themselves to hedge against certain risks.
… and liabilities to banks and non-banks on the liabilities side.
Liabilities to banks and non-banks dominate the liabilities side of the balance sheet. Liabilities to banks result from direct lending between banks, while liabilities to non-banks are the overnight transferable deposits, savings deposits and time deposits of enterprises, households and public sector entities. Bank debt securities – including mortgage Pfandbriefe, public Pfandbriefe and certificates – are securities issued by banks themselves. Buyers of these debt securities provide the bank with money for a limited period of time, which is why these securities constitute debt capital for the banks. In other words, banks not only buy and sell securities, but also issue them themselves in order to obtain funding.
Much like “other assets”, “other liabilities” mainly include liabilities from special trading activities. Through these trading activities, banks give their customers the ability to hedge against certain risks or to profit from changes in the market prices of certain goods without having to purchase them directly. Banks’ capital consists of shareholder capital and reserves. In Germany, the precise nature of this share capital depends on the legal form of the bank in question (e.g. joint stock company (AG), registered cooperative society (eG), or limited liability company (GmbH)). Undistributed profits are transferred to the reserves.
Not all assets and liabilities of a bank appear on the balance sheet. In the case of guarantees and sureties, for example, it is not immediately known whether the bank will actually have to honour them. Therefore, these items – also referred to as contingent liabilities – are reported “below the bottom line” on the balance sheet.
Not all banking business appears on the balance sheet.
In addition, a portion of banks’ business activities is also attributable to derivative financial instruments. These are transactions derived from ordinary financial instruments that are not settled until a future date – known as forward transactions. Their value depends on the development of a specific underlying asset (see the box entitled “Derivatives transactions” in Section 7.3.2).
These transactions are generally not yet recorded on the balance sheet when the transaction is initiated, because at this point in time no payment has been made by the parties involved.
Many people entrust banks with their money. However, banks’ business activities have inherent risks. If a bank collapses, this can cause its customers severe financial damage. Other banks may also experience financial difficulties as a result, which could ultimately impact the whole economy. Banking supervision is in place to prevent this from happening.
Banking supervision is a prerequisite for a stable financial system.
A stable financial system is predicated on effective banking supervision. Supervisors monitor banks’ business activities and risk management practices with the aim of preventing banking crises. In order to be solvent and equipped to deal with unexpected outflows of funds at all times whilst also making a profit, banks must aim to be “as liquid as necessary and as profitable as possible”. The compromise must always be made under conditions of uncertainty with regard to assumptions about future incoming and outgoing payments. Banks therefore have to invest a sufficient proportion of their funds in such a way that they can satisfy unexpected claims from their creditors at any time and thus always remain solvent.
As many banking transactions involve risks, some transactions may occasionally fail and cause financial losses for the bank (e.g. a default on a loan). To prevent such losses from immediately leading to the collapse of the affected bank, banks are required by law to identify and assess each and every risk and to hold a specified level of capital against them. Banks are also required to hold a specific amount of liquidity, i.e. have sufficient funds available for immediate use.
While banking supervisors thus aim to ensure banks’ solvency and hence also indirectly protect customers’ deposits, deposit guarantee schemes directly protect customers from losing their deposits at their bank.
If a bank is unable to repay its deposits, the deposit guarantee scheme will cover the repayment claims up to a certain amount. Without this protection, real or alleged payment difficulties could lead to a bank run, where customers rush to banks to withdraw their deposits in cash. Deposit guarantee schemes are designed to prevent such bank runs from happening, and thus contribute to the stability of the financial system.
Deposit guarantee schemes directly protect bank customers’ deposits.
The complexity of banking operations has increased over time. Moreover, banks often engage in cross-border activities and are highly interconnected. Banking supervision needs to adapt to the changed landscape and cannot end at national borders. In the euro area, a Single Supervisory Mechanism (SSM) has been in place since 2014. The SSM forms part of the banking union. A common European deposit guarantee scheme is also being discussed in the context of the banking union, but has not yet been adopted or implemented. However, the EU already has common rules in place to harmonise national deposit guarantee schemes. For details on the design of the banking union, the SSM, and rules on deposit guarantee schemes, see Section 4.4.
In order for book money to be able to fulfil its function as a means of payment, the banking system ensures that it can be transferred from one account to another. In the case of cashless payments, the payment information is transmitted electronically and triggers bookings on the accounts involved. The payer’s account balance goes down, while the payee’s account balance goes up. If both have their accounts with different banks, the payment has to be “transported” and booked between the two banks concerned.
Banks use cashless payments to ensure that money is “transported” between bank accounts.
To this end, banks electronically transmit payment orders with all the information necessary for the payments. The payments are then booked to the relevant accounts, with the book money “flowing” from one account to the other.
In retail payments, everyday payments are carried out with somewhat smaller amounts (e.g. telephone bills, salaries or rent payments). To facilitate such payments, the banks concerned need to be linked to each other. For this purpose, banks can use their own giro system or the giro system of their banking group (e.g. savings banks). Giro systems in Germany are interconnected, allowing payments to be forwarded to banks in other banking groups.
For payment settlement, banks are linked to each other directly or via giro systems.
Alternatively, banks can settle payments via another bank or via what are known as clearing houses. These clearing houses record and settle the mutual claims and liabilities of banks. To support cashless retail payment transactions, the Deutsche Bundesbank also operates its own clearing house (RPS/SEPA-Clearer).
Via this clearing house, even banks that are not integrated into the German giro system have access to cashless payments with all other banks in Germany and Europe.
In the euro area, a single currency and a common means of payment for cash transactions has existed in the form of the euro since 2002. In order to also harmonise cashless euro payments, the Single Euro Payments Area (SEPA) was introduced in 2014. It comprises all European Union countries as well as Andorra, Iceland, Liechtenstein, Monaco, Norway, San Marino, Switzerland, the United Kingdom and Vatican City in addition to Jersey and the Isle of Man, amongst others. Within the European Economic Area (EEA: EU plus Norway, Liechtenstein and Iceland), SEPA payments no longer make a distinction between national and cross-border payments as far as fees and maturity, say, are concerned. Payments outside the EEA may be subject to higher fees.
In the Single Euro Payments Area (SEPA), a distinction is no longer made between national and cross-border payments.
For cashless euro payments within SEPA, an International Bank Account Number (IBAN) must be used. The IBAN is structured differently in each individual country and consists of a maximum of 34 alphanumeric characters. A unique IBAN is assigned to every account. In Germany, an IBAN has 22 alphanumeric characters and is structured as follows:
The first two characters are the country code, followed by two check digits and the eight-digit German bank sort code. The last ten digits are the account number. If the account number has fewer than ten digits, it is placed at the end of the IBAN and the missing digits between the account number and the bank sort code are filled with zeros.
The IBAN uniquely identifies each account and, in Germany, comprises 22 alphanumeric characters.
Stating an IBAN is sufficient for all domestic and cross-border SEPA payments within the European Economic Area. For payments outside the EEA, for example to Switzerland, a Business Identifier Code (BIC) may also be required. This is a kind of international bank sort code that consists of eight or eleven characters.
In contrast to retail payments, high-value payments are large payment amounts that are individually processed within a matter of seconds (“in real time”). T2 can be used for this purpose. This Eurosystem payment system was developed by the Bundesbank, the Banque de France, the Banca d’Italia and the Banco de España, which operate it jointly. Via T2 all euro area banks are directly or indirectly connected, and many other banks around the world can also be reached indirectly. Payments are settled in accounting terms via the ECB. Eurosystem central banks use T2 to settle monetary policy operations, such as the payment of loans to banks. Furthermore, commercial banks use T2 for their customers’ large-value payments or to settle payments among themselves. Until its shutdown in March 2023, TARGET2, the predecessor of T2, was used for an average of around 400,000 payments per day with a value of approximately €2.2 trillion. In addition, TARGET2-Securities is a European service for the harmonised and cross-border settlement of securities transactions.
Processing cross-border payments via T2 leads to the creation of TARGET balances, which are a national central bank’s claims on (positive TARGET balance) or liabilities to (negative TARGET balance) the European Central Bank. These balances arise, for example, when Customer A from Italy pays for a machine that they purchased from Customer B in Germany. This transfer is ultimately processed via the T2 system. The Italian central bank (the Banca d’Italia) debits the relevant amount from the account of the transferring Bank A in Italy, which in turn debits the account of Customer A. At the same time, the Italian central bank credits the amount to the German central bank (the Bundesbank). The German central bank credits this amount to Bank B in Germany, which then credits it to the account of Customer B (the recipient) at their bank.
The German central bank credits this amount to Bank B in Germany, which then credits it to the account of Customer B (the recipient) at their bank.
The TARGET balances are created by netting these claims and liabilities between central banks and consolidating them into a single balance at the end of each business day. If the positions do not balance during the course of the day, each national central bank has exactly one claim or one liability from TARGET vis-à-vis the ECB. These claims and liabilities are referred to as TARGET balances. A central bank with a claim on the ECB has a positive TARGET balance, whilst a central bank with a liability to the ECB has a negative TARGET balance. A positive balance therefore indicates that more money has flowed into a given country from other countries than vice versa.
For cashless payments, bank customers in the SEPA zone have a choice between credit transfers and direct debits. These forms of payment can be initiated by various methods, e.g. by using a debit card, a credit card or even a mobile phone.
A credit transfer is always initiated by the payer, who instructs their bank to transfer a certain amount from their account to another account. The payer’s account balance is debited, while the other account is credited. A SEPA credit transfer can be used for credit transfers in euro.
Payments by credit transfer are initiated by the payer.
For credit transfers, banks provide their customers with standardised, electronically readable paper-based forms (paper-based credit transfers). However, credit transfers are made much more often via online banking or using branch-based terminals (paperless credit transfers).
If you want to make a credit transfer via online banking, you must first log in to your bank’s online banking system using your personal identification number (PIN) or password. The credit transfer itself usually has to be confirmed with a transaction authentication number (TAN), which is generated using a card reader or sent by the bank to a mobile phone at the customer’s request, for example.
A standing order is suitable for regularly recurring payments of the same amount.
A standing order is a special form of credit transfer. It is useful when it is necessary to make regularly recurring payments of the same amount, such as rent payments. The payer issues a single instruction to their bank to transfer a fixed amount to another account at regular intervals.
Currently, it usually takes one day for the transferred amount to become available on the other account. With instant payments (real-time payments), cashless euro payments are settled within seconds around the clock. Unlike the present retail payments, the money is available to payees immediately after the payment has been sent. Thanks to instant payments, these payments are processed independently of banks’ operating hours, i.e. also at night or at weekends. When used in conjunction with mobile phone applications, in particular, instant payments allow for cashless payments between individuals and enterprises to be made in a matter of seconds, whether online or at a retail outlet. Like cash, this makes delivery-versus-payment transactions possible. Purchased items, such as a second-hand car, can be taken straightaway because the seller sees the payment arrive on their account immediately.
With instant payments, the amount appears on the other account within a few seconds.
TARGET Instant Payment Settlement (TIPS) is a component of the TARGET-Services platform, designed for the settlement of instant payments. Euro payment orders are settled in central bank money within ten seconds. This is possible 24 hours a day, 7 days a week, 365 days a year. This service therefore gives banks the opportunity to offer their customers real-time payments.
With a direct debit, a payer authorises a payee to debit an amount from their account to be credited to the payee. Direct debits are particularly suitable for irregular payments or payments of varying amounts, such as fluctuating monthly telephone charges. Since the creation of SEPA, direct debits are now collected using a standardised procedure. This requires a SEPA direct debit mandate for the collection of SEPA direct debits. It includes both the payer’s consent to the payee collecting the payment and the instruction to the payer’s bank to execute the payment.
Payments by direct debit are initiated by the payee.
SEPA core direct debits are available to consumers and businesses. Core direct debits with a valid mandate may be returned (“refunded”) at the payer’s request up to eight weeks after the debit date without the payer having to state a reason. If there is no mandate, this deadline is extended to 13 months. A SEPA B2B (business-to-business) direct debit is only possible for payments between enterprises. In this case, the payer is not able to reverse the payment.
To be able to use direct debits as a payee within the SEPA direct debit scheme, the payee requires a creditor identifier for unique identification.
In Germany, this identifier is 18 characters long and can be requested from the Bundesbank via the internet. The unique mandate reference is an identifier of a mandate that is individually assigned by the payee. Together with the creditor identifier, it allows for clear identification of the payee that has collected the direct debit.
Creditor identifier and mandate reference identify a direct debit payment.
The payee is obliged to issue a pre-notification informing the payer of the settlement date and direct debit amount in good time (usually at least 14 calendar days before the settlement date) so that the payer can respond to this and ensure they have sufficient funds on their account.
Besides cash, it is also possible to pay at POS using a debit card. The most frequently used debit card in Germany is the girocard (formerly known as the EC card), which is issued to the account holder when a current account is opened in Germany. It is called a debit card because the payer’s account is debited by the payment amount. To initiate a payment transaction, an electronic point-of-sale (POS) terminal reads the chip on the card for the data needed to collect the amount from the account.
Two different payment methods can be used at this point, which differ in terms of the payment guarantee and the cost to the retailer. In one method, the customer authorises the payment by entering a personal identification number (PIN) at the terminal. This is followed by online checks to ensure that the card is not blocked and that the cardholder has sufficient funds to pay the amount in question. If both of these checks are passed, a credit transfer is initiated – the retailer is guaranteed the payment as the payer cannot later request a reversal of the payment from their bank. However, the retailer has to pay higher fees for this greater level of security.
Debit cards enable cashless payments at the point of sale.
In the other payment method, the customer authorises the collection of a SEPA direct debit from their account by providing their signature, which must match the signature on their card. Retailers that use this payment method pay lower fees but have no guarantee of actually receiving the money. This is because the bank will only execute the direct debit if the account to be debited contains sufficient funds. However, with the customer’s signature, the retailer obtains the customer’s consent to the release of their data in the event of non-payment. It can therefore assert its claim through other channels. In addition to payments at a POS, debit cards usually also offer the option of withdrawing cash from ATMs using a PIN.
With credit card payments, the account is not debited until later.
When paying with a credit card, the account is usually not debited immediately but at a later point in time, for instance at the end of the month. The credit card company thus grants the cardholder an interest-free loan for a certain period of time. If the outstanding amount is not paid or not paid in full on the settlement date, the cardholder must pay interest on the unpaid amount. The credit cards offered by various credit card companies (such as Mastercard or VISA) are usually issued by banks. The holders of such a card are able to make cashless purchases at all stores connected to the global credit card system as well as withdraw cash at ATMs using a PIN. When making payments at a POS, the customer must authorise the payment by entering a PIN in the POS terminal or by signing a receipt. Credit cards are also a means of payment for online purchases, in which case the corresponding credit card data have to be entered.
The contactless method, which works via NFC (near field communication), makes payments more convenient. If a card is equipped with an NFC chip, it is held close to the POS terminal in order to transmit the payer’s data. This procedure generally does not require a PIN to be entered for amounts up to €50. The actual payment process takes less than a second. While this method means that payment is easier and faster, it also dispenses with security measures such as entering a PIN or checking a signature. Most mobile phones are now equipped with NFC technology so that they can be used to make “contactless” payments at the POS.
For online shopping, retailers usually offer a variety of payment methods, such as credit transfers, direct debits or credit cards. Furthermore, specially developed online payment methods such as “giropay” or “Sofortüberweisung” are also available options. Both services use an online banking application to automatically generate a credit transfer to the retailer. As a result, customers no longer have to enter the data required for payment into a credit transfer form themselves, but simply confirm the transfer with a transaction authentication number (TAN).
The internet offers a wide range of different payment options.
Another widespread online payment method is “PayPal”. In order to pay with PayPal, customers need a PayPal account. The online purchase is processed via this user account. PayPal requires customers to have prepaid credit on their user account, or it collects the payment amount from the customer’s bank either directly or via a credit card account. PayPal is offered in many countries around the world and can therefore be used across borders as well. A comparable payment method for customers is “giropay”, which was developed by German banks for the domestic market. Using this method, the payment amount is settled directly via the current accounts held with each bank.
Before a cashless payment is made, the initiator’s authorisation must be verified.
In cashless payments, security aspects play an important role for all parties involved. One such key aspect is the check carried out by banks and payment service providers to verify whether the payment was actually initiated by an authorised person. Traditionally, personal signatures have been used for this, but now there are numerous other methods available, some of which have also been designed for online banking and online payment transactions. These methods are based on the criteria of possession (debit or credit card, mobile phone), knowledge (PIN, password) and biometrics (fingerprint, iris recognition, facial recognition). To ensure a high level of security, at least two of these criteria should be checked during a payment transaction.
How much money actually exists? This question has no clear answer. Because the lines between the different types of deposit and short-term financial instruments are blurry, a range of monetary aggregates that differ in broadness have been defined. Practical monetary policy usually looks at the monetary aggregate that appears to be most appropriate for fulfilling monetary policy objectives.
The Eurosystem has defined three different monetary aggregates.
As a general rule, cash and book money held by non-banks (enterprises, households and public-sector entities) are always defined as the money supply. This does not include cash that banks store in their vaults or their balances with the central bank or other banks. Monetary aggregates are linked to aggregate demand for goods and services, making them important economic variables that can shed light on future price developments. Because money can be used not only as a means of exchange and payment but also as a store of value, the Eurosystem defines three types of money supply (monetary aggregates) that build on each other but differ in how quickly bank customers can access the money, i.e. how “liquid” it is. These monetary aggregates are referred to as M1, M2 and M3, with the letter “M” standing for the word “money”.
The monetary aggregate M1 includes cash circulating outside the banking sector as well as the overnight deposits (transferable deposits) of non-banks. M1 is thus the money that is available at any time. It therefore comprises the means of payment that have a very high level of liquidity.
M1 = currency in circulation + transferable deposits
Time deposits are funds that are invested with banks at a fixed interest rate for a predefined period of time. They cannot be accessed during this period. When they mature, they are usually credited back to current accounts, which means that they are converted back into transferable deposits.
Savings deposits are deposits that are typically open-ended and can only be accessed after a certain notice period. Interest rates on savings deposits are generally variable, i.e. they fluctuate in line with general interest rate movements. Unlike transferable deposits, time and savings deposits therefore cannot be accessed for payments at any time.
M2 = M1 + short-term time and savings deposits
In addition to the monetary aggregate M2, M3 also includes assets issued by banks and financial institutions with a comparable level of liquidity to the bank deposits contained in M2: bank debt securities with original maturities of up to two years, money market fund shares, and repurchase agreements.
Bank debt securities are securities for which the issuing bank undertakes to repay the nominal value of the debt security when it matures. Buyers receive interest on their invested capital. Money market funds sell fund shares (money market fund shares) to investors and invest the funds they receive in short-term assets such as corporate securities. Investors can return the shares to the fund at any time and are then credited with a transferable deposit on their bank account.
M3 = M2 + short-term bank debt securities + money market fund shares + repurchase agreements
Repurchase agreements, as included in M3, are used to conduct “repo” transactions between banks and non-banks. Banks use these to raise funds at short notice, where – similarly to pawnbroking – the bank sells an asset (e.g. a security) to a non-bank against payment of a sum of money with the obligation to repurchase the asset after a certain period of time. Repos are short-term financing instruments generally with a maturity of no more than one year, and frequently of just a few days. From an investor’s perspective, these short-term investments can be converted into deposits relatively quickly and are therefore an alternative to liquid bank deposits.
Another monetary definition that is important for understanding monetary policy and payment transactions is central bank money. Central bank money includes cash in circulation and banks’ balances with the central bank. Generally speaking, this refers to the money that can only be created by the central bank. Central bank money is also referred to as the “monetary base”, or M0 for short.
Commercial banks’ transferable deposits with the central bank are especially important. Commercial banks use these balances to meet their minimum reserves, which the central bank requires from each bank. At the same time, transferable deposits are used to ensure the smooth settlement of payments between banks. Furthermore, banks can exchange their balances with the central bank for cash at any time in order to meet their customers’ withdrawal requests. Commercial banks’ constant need for central bank money is a key point of reference for monetary policy. When we talk about central banks providing “liquidity” to or absorbing “liquidity” from commercial banks, we are actually referring to the provision and absorption of central bank money.
Commercial banks’ need for central bank money is a point of reference for monetary policy.
To understand the monetary system, it is important to distinguish between the central bank monetary base M0 and the monetary aggregate M3, as they essentially represent different concepts of money. One includes cash as well as the central bank’s book money that circulates within the banking system. The other comprises cash plus commercial banks’ book money, which is the result of their interaction with their customers, the non-banks. An increase in the central bank monetary base does not automatically mean an increase in the monetary aggregate M3. The latter depends on the extent to which commercial banks expand their asset-side business (especially lending) and thereby create additional book money, which then usually increases the money supply.
Central banks are exploring how the currencies they issue can be made future-proof. In response to the challenges of advancing digitalisation in payment transactions, debates are becoming increasingly centred around central bank digital currency (CBDC). CBDC would be a third type of central bank money alongside cash and banks’ deposits with the central bank.
The format of CBDC and the purposes for which it could be issued are currently being scrutinised by more than 60 central banks around the world. It is conceivable that the issuance of CBDC could be restricted to certain types of users, such as commercial banks, or extended to households and enterprises as well. A CBDC available to everyone has even been introduced already in a small number of countries (e.g. the Bahamas).
The use of cash as a means of payment has been declining over the past few years. In this context, CBDC could be a digital complement to cash for households and enterprises – for example, in the form of a digital euro that could be transferred directly from one smartphone to another or even used in online shopping or at a POS.
This would also make CBDC an alternative to digital currencies developed in the private sector, such as crypto-assets (see Section 1.3). In some countries, CBDC could help to increase public access to financial services overall.
In July 2021, the ECB Governing Council launched a project on the digital euro. In a two-year investigation phase, its potential design and implications – for monetary policy and financial stability, inter alia – will be explored in more detail. The digital euro is also not intended to replace cash, but rather to be, at most, an additional option for daily payments. The Governing Council of the ECB plans to make a decision regarding the introduction of a digital euro only once these investigations have been completed.
Money creation refers to how money is generated.
Nowadays, there is much more book money in circulation than cash. People often imagine that book money is created only by paying cash into an account. But this overlooks the fact that the cash had previously been withdrawn from an account, meaning that the book money was already there before. So the question is, who creates the book money? It is the banks, when they grant loans, for instance. In a nutshell, the creation of book money is an accounting process.
Book money is generated through bank lending.
When Bank A grants a loan, it credits the loan amount to the current account in the form of a transferable deposit. For example, if a loan of €1,000 is granted (e.g. with a maturity of five years, 5% p.a.), the transferable deposit on the current account held by Customer 1 with Bank A increases by €1,000. This has created new book money. Bank A records the claims on the borrowers on the assets side of its balance sheet and the newly created transferable deposits as liabilities on the liabilities side. When the loan is repaid, the corresponding book money is then “destroyed” again.
Book money is also created when a bank purchases an asset, such as a security. The accounting process is then much the same. The asset is recorded on the assets side and the purchase amount is credited to the seller’s current account as a transferable deposit – new book money has been created. Banks thus create new book money “out of thin air”, as it were. However, the money they create does not belong to them, but to their customers. From the bank’s perspective, its customers’ transferable deposits are a liability – it owes them this money. Customers can use the credited amount for credit transfers or withdraw it as cash.
The creation of central bank money follows the same principle. If commercial banks require central bank money (e.g. in order to obtain cash for cash withdrawals by their customers or to make payments to other banks), they can procure it from the central bank in the form of a loan. The central bank then checks whether the conditions for lending have been met. As a rule, the central bank only grants a loan if the bank secures it by providing collateral (e.g. securities). If this condition is met, the central bank credits the amount borrowed to the bank’s account with the central bank in the form of a transferable deposit. In this case, central bank money has been created. The monetary base M0 has expanded. When the bank pays back its loan to the central bank, the monetary base M0 contracts again.
Central bank money is created when the central bank grants loans to banks.
In addition to lending and crediting, there is also a second way in which the central bank can help provide banks with transferable deposits, i.e. central bank money. In this case, the central bank purchases an asset from a bank (e.g. securities, gold or foreign currency) and credits it with the proceeds of the sale. This also creates central bank money.
The fact that commercial banks can actively create book money does not mean that they can do so without limits. This is because corresponding demand for loans from their customers is a prerequisite for the creation of money through lending. Whether the loans on offer are ultimately taken up by enterprises, households or public sector entities depends, amongst other things, on the credit terms (e.g. maturity and interest rate), the profitability of an investment project, and income prospects. The obligation to pay interest serves as a financial incentive to borrow only if it appears to be economically justifiable. For an enterprise, this means that the loan amount must be invested in such a way that it is likely to generate income in order to finance the interest and principal repayments. A personal loan allows consumers to bring forward purchases (e.g. real estate or cars) without having to save up the money they need first. However, their expected future income must be sufficient for them to repay the loan with interest.
Lending depends on demand.
However, the demand for credit is not met in every case. If there is no prospect of repayment, the bank will not approve a loan application. Before a bank pays out a loan amount, it conducts a careful check to ascertain whether borrowers will be able to make the required interest and principal payments. The creation of book money entails income for banks, but it also involves risks and costs. This encourages them to be cautious.
Loans are only granted if there is a prospect of repayment and payment of interest.
At first glance, lending appears to be a very lucrative business for banks: they receive the interest payments for the loan, but usually pay the customer either no interest or only a very low interest rate for the transferable deposit. However, customers use the newly created transferable deposit to make purchases. Consequently, this usually means that customers end up transferring their newly acquired credit balances to customers of other banks or withdrawing them in cash. This results in a refinancing requirement for the lending bank.
Following on from the example above, Customer 1 transfers the €1,000 from their account with Bank A to Customer 2’s current account with Bank B. For the lending Bank A, this means that its customer’s transferable deposit – the newly created book money – will flow out of the bank and that it will now have to “refinance” the loan in full. In the simplest ideal scenario, Bank B would grant it a loan for this purpose. Bank B then grants, for example, an “overnight” loan, cancellable at a day’s notice, for which it charges Bank A an interest rate (e.g. 2% p.a.). Hence, Bank A has to use part of its interest income from the personal loan to pay the interest on its loan with Bank B, thus reducing its profit from lending.
The profit from the creation of book money is offset by risks.
This does not complete the transaction, however, as Bank A typically seeks to limit its risks. Bank A took on several risks by lending to its customer. If the customer is unable to service the loan’s interest and repayments, a loss occurs (credit default risk). Nevertheless, the bank must continue to service its own financing (the loan from Bank B). Additionally, there is a risk that the interest rate will rise (interest rate risk) and that short-term refinancing (the loan from Bank B) will become more expensive.
This further reduces the remaining share of the interest income from the personal loan. Finally, there is a risk that Bank A will not find another bank that is willing to provide the necessary funding (liquidity risk).
Risks arising from lending can be reduced by raising deposits.
To try to limit the latter two risks, banks pursue a deposit policy. They offer their customers an attractive interest rate so that they will invest their money with the banks for a longer period. In the example, Customer 2 of Bank B accepts Bank A’s offer, transferring their unremunerated transferable deposit with Bank B to a savings account at Bank A. In return, Bank B also closes out its loan to Bank A since Bank A no longer requires refinancing from another bank that is cancellable at a day’s notice. In the example, Bank A has instead refinanced the loan it paid out by means of a longer-term savings deposit. However, this also means that it has to pass on the majority of the interest income from the personal loan of 5% p.a. – in the example, 3.5 percentage points – to the saver.
In the euro area, there are thousands of banks that grant loans and accept savings deposits, which means that, in reality, these transactions are much more complex than described here. Nevertheless, the example illustrates one important issue: in order to limit the risks that arise from lending, the banking system has to raise longer-term deposits from customers. In doing so, it has to pass on part of its interest income from lending – and thus a portion of the profit generated by creating book money – to its customers. In this sense, it is true that banks need savings from their customers in order to be able to lend. However, it is not a strict requirement.
Another key factor limiting the creation of money by banks are prudential regulations. Capital and liquidity regulations limit lending in order to secure customers’ deposits with banks and to keep banks solvent at all times. For instance, capital regulations force banks to finance a certain quantity of capital against their lending, depending on the risks involved.
Monetary policy and banking supervision regulations limit money creation.
Central banks can also exert influence on the creation of book money through their monetary policy. Through their policy rates, they influence the interest rate level. If the central bank raises its policy rate, banks will have to pay more for loans from the central bank and, in most cases, raise the interest rates at which they themselves issue loans. However, this tends to dampen the demand for loans from enterprises and households. Hence, by raising or lowering the policy rate, the central bank can influence the economy’s demand for loans and thus the creation of book money as well.
Lending and the associated creation of money tend to bring about investment and advance consumption. This, in turn, has the tendency to increase aggregate output and value added in the economy. However, if excessive lending and therefore money creation occur, this can cause unwelcome developments. For example, consumer prices may rise too sharply, thereby jeopardising price stability, or there may be excesses in the securities and real estate markets.
Excessive money creation can jeopardise price stability.