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This had been neglected by economists and finance researchers, but thanks to the crisis a wider debate on this issue seems to be the new normal.

Over the past century and a half, the role of banking in the economy has been described by three different theories, which are differentiated by their accounting implications.

The currently dominant theory is the financial intermediation theory of banking, which says that banks collect deposits and then lend these out, without any power to create money, just like other non-bank financial intermediaries.

The fractional reserve theory of banking says that each individual bank is a financial intermediary, gathering deposits and then lending these out without the power to create money, but the banking system collectively is able to create money through the process of multiple deposit expansion (the money multiplier).

Eminent scholars have been supporting each one of these different theories.

Recently, the Bank of England (2014) argued that textbooks have been wrong in their presentation of banks, and that the credit creation theory is, after all, correct.

The Basel approach has been predicated on the veracity of the financial intermediation theory.

Yet, proponents of each of the theories including the recent intervention by the Bank of England merely assert their viewpoints.

It is the purpose of the present paper to present another empirical test of the three theories, using a different methodology.

Analysing bank operations and bank accounting via the banks annual accounts reporting software, which allows the control of all other factors, it is found that the financial intermediation and the fractional reserve theories of banking are rejected by the evidence.

Policy implications are discussed, in particular for regulating bank capital adequacy as a tool to avoid banking crises.

Director, Centre for Banking, Finance and Sustainable Development, University of Southampton.

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