Document Type : Resear Paper (Islamic Banking)

Authors

• Mohammad Talebi ¹
• Hosin Hasanzadeh Sarvestani ²
• Mahdi Nouri ³
• Alireza Navabpour ⁴

¹ Associate Professor, Department of Finance, Faculty of Islamic Studies and Management, Imam Sadiq University, Tehran, Iran.

² Assistant Professor, Department of Finance, Maaf Islamic Faculty and Management, Imam Sadiq University, Tehran, Iran

³ Assistant Professor, Faculty of Economics, University of Tehran, Tehran, Iran

⁴ PhD Student in Financial Engineering, Department of Financial Management, Faculty of Islamic Studies and Management, Imam Sadiq University, Tehran, Iran

Abstract

1. Introduction and Objective
Understanding the mechanism of money creation within modern banking systems constitutes one of the most fundamental issues in both monetary economics and Islamic jurisprudence. The ability of banks to create money—whether as financial intermediaries, through fractional reserves, or via direct credit creation—shapes not only macroeconomic stability but also the moral and legal legitimacy of banking activities from an Islamic perspective. Misconceptions or incomplete interpretations of the money creation process can lead to flawed economic forecasts, ineffective financial regulations, and, in the Islamic context, inaccurate jurisprudential rulings (fatwas) on the permissibility of banking operations.
      Historically, conventional economic thought has been dominated by two principal theories of money creation: the Financial Intermediation Theory and the Fractional Reserve Theory. The former views banks merely as intermediaries that channel funds from savers to borrowers, while the latter explains money creation as a multiplier process based on fractional reserve lending. However, both have been increasingly criticized for failing to reflect the real-world mechanics of bank balance sheets and the endogenous nature of money.
      Following the 2008–2009 Global Financial Crisis, these theoretical frameworks faced renewed scrutiny. The crisis exposed fundamental weaknesses in conventional banking assumptions and reignited debates about how money is actually created and circulated within modern financial systems. In this context, the Credit Creation Theory, which posits that banks create money ex nihilo through lending, gained prominence as a more realistic representation of banking operations.
      Against this background, the present study seeks to systematically review and analyze the evolution of scholarly perspectives on money creation theories after the global financial crisis. Its central objective is to determine which theory—financial intermediation, fractional reserve, or credit creation—most accurately describes the actual processes of modern banking and to evaluate how academic and empirical research has shifted in this regard between 2009 and 2023. Furthermore, the study aims to provide an analytical foundation for jurisprudential and policy-oriented interpretations in Islamic finance, where the conceptual understanding of money creation plays a pivotal role in issuing lawful rulings and designing Sharia-compliant financial systems.
 
2. Methods and Materials
This study employs a Systematic Literature Review (SLR) approach, chosen for its methodological rigor, transparency, and replicability. The systematic review enables the integration of empirical evidence from multiple studies while minimizing bias in the selection and interpretation of data.
      The research process followed the PICOC framework—Population, Intervention, Comparison, Outcome, and Context—to formulate precise research questions and search strategies. The research question was defined as follows: “In modern banking practice, which theory of money creation is actually implemented, and do existing theoretical models adequately explain this reality?”
      Population: Commercial and central banks in modern banking systems.
      Intervention: Theories and mechanisms of money creation and credit issuance.
      Comparison: Financial Intermediation, Fractional Reserve, and Credit Creation theories.
      Outcome: Empirical alignment of theoretical models with actual banking operations.
      Context: Post-crisis global banking systems between 2009 and 2023.
      To address this question, comprehensive searches were conducted across eight major databases: JSTOR, EconLit, ScienceDirect, SpringerLink, SSRN, Web of Science, Scopus, and Google Scholar, supplemented by the Iranian database Noormags for Persian-language studies. Keywords were developed based on the PICOC model, combining terms such as money creation, credit creation, monetary policy, fractional reserve, banking theory, and financial intermediation.
      The time frame was deliberately restricted to 2009–2023, as the post-crisis period represents a paradigm shift in both theoretical debates and empirical validations of banking practices. Initially, 204 studies were retrieved. After removing duplicates and applying inclusion criteria—focusing on peer-reviewed journal articles addressing money creation mechanisms—178 papers were retained.
      Subsequently, two independent experts in monetary economics reviewed the articles for relevance and quality. Through iterative screening and consensus discussions, the final corpus was narrowed to 54 studies that explicitly discussed or empirically tested at least one of the three main theories of money creation. Data extraction was performed using a predesigned form and validated through double-coding to ensure reliability. Analytical synthesis emphasized both quantitative and qualitative aspects, identifying patterns of theoretical adoption and empirical confirmation.
3. Research Findings
The systematic review revealed a clear and consistent trend in the post-2009 literature: a decisive shift toward the Credit Creation Theory as the dominant explanatory model of money creation.
      Out of the 54 analyzed studies:
- Only one paper explicitly adhered to the Financial Intermediation Theory,
- One paper supported the Fractional Reserve Theory, and
- Fifty-two papers (≈96%) either explicitly or implicitly endorsed the Credit Creation Theory.
 
      This overwhelming empirical and theoretical consensus demonstrates a near-complete rejection of the older models. Prior to 2009, the fractional reserve view—based on the deposit multiplier—dominated textbooks and policy discussions. However, empirical investigations of bank balance sheets, especially those conducted by Werner (2014, 2016) and subsequent studies, have shown that loans create deposits, not vice versa, thereby validating the credit creation mechanism.
      Moreover, comparative analyses across geographical and institutional contexts (including the U.S., U.K., and European banking systems) revealed that money creation is an endogenous process driven primarily by the demand for credit and banks’ willingness to lend, constrained by regulatory and capital adequacy requirements rather than reserve ratios.
      Several subtheories under the credit creation framework were also identified:
- Structuralist perspectives, which emphasize partial central bank control via interest rates and reserve requirements;
- Horizontalist views, which consider money supply fully demand-driven and reserves supplied endogenously;
- Post-Keynesian credit money theory, which links money creation to profitability and borrower creditworthiness; and
- Modern Monetary Theory (MMT), which highlights the fiscal dimension of money creation in fiat systems.
 
      The findings further indicate that the Islamic banking model, while distinct in its prohibition of interest (riba) and speculative uncertainty (gharar), inherently rejects both the fractional reserve and credit creation mechanisms in their conventional forms. Instead, it promotes asset-backed and profit-and-loss-sharing frameworks such as murabaha, mudaraba, and ijara. Nonetheless, the operational realities of Islamic banks suggest a partial functional resemblance to credit creation, highlighting the need for deeper jurisprudential analysis.
 
4. Discussion and Conclusion
The results of this systematic review provide compelling evidence that, since 2009, the Credit Creation Theory has become the prevailing paradigm for understanding the mechanics of money creation in modern banking. This theory accurately captures the endogenous and credit-driven nature of money, aligning closely with empirical data from banking operations.
From a policy standpoint, this finding carries profound implications. If banks are indeed the primary creators of money through lending, monetary authorities must focus on regulating credit allocation, capital adequacy, and risk management rather than relying solely on reserve-based controls. Central banks, acting as lenders of last resort, can influence but not directly determine the money supply. This necessitates more sophisticated frameworks for macroprudential supervision, liquidity management, and crisis prevention.
      From a jurisprudential perspective, particularly within Islamic finance, these insights call for a re-examination of fiqh-based rulings concerning money, debt, and the legitimacy of bank-created credit. Understanding that modern money is essentially a form of socially accepted credit reshapes the conceptual foundations of halal financial intermediation. Jurists and policymakers must align Islamic legal reasoning with the actual mechanisms of money creation to avoid issuing rulings detached from economic reality.
      Furthermore, the dominance of credit creation theory suggests an urgent need for policy innovation. Regulators and central banks should design mechanisms that ensure responsible credit creation while minimizing systemic risk. Educational institutions and research centers are encouraged to incorporate these findings into economic and Sharia curricula to bridge the knowledge gap between theoretical economics and Islamic jurisprudence.
      In conclusion, this study confirms that the Credit Creation Theory offers the most empirically valid and conceptually coherent explanation of how money is generated within modern banking systems. It provides a robust foundation for advancing both monetary policy reform and Islamic financial jurisprudence. Future research should further explore:
      1) The interaction between credit creation and financial stability,
      2) The adaptation of Islamic financial contracts to align with endogenous money realities, and
      3) The potential of emerging technologies such as blockchain and artificial intelligence in enhancing transparency and oversight of credit creation processes.
 
      By integrating empirical economics with jurisprudential inquiry, this research contributes to a more comprehensive understanding of money creation—bridging the gap between theory, policy, and ethics in the evolving architecture of global and Islamic banking.

Keywords

• Money Creation
• Fractional Reserve Theory
• Financial Intermediation Theory
• Credit Creation Theory
• Systematic litrature Review
• Banking

Main Subjects

• Islamic Banking