How commercial banks create money by lending

Ask most people where the money in their bank account came from and they will describe a chain: someone deposited savings, the bank lent those savings on, and the borrower spent them. It is a tidy story and it is wrong in the one respect that matters. A bank does not need to find money before it lends. It writes the loan and the deposit into existence in the same act, on both sides of its own balance sheet, at the same instant.

This is not a fringe view. The Bank of England set it out plainly in its 2014 Quarterly Bulletin article "Money creation in the modern economy", and the Deutsche Bundesbank published a similar correction in its own monthly report. The reason it still surprises people is that the textbook alternative — the money multiplier, where a central bank injects reserves and banks lend a fixed multiple of them — is taught first and rarely unlearned. Understanding the real mechanism changes how you read credit cycles, house prices, bank capital rules and central bank policy.

The accounting, in full

Suppose a Zurich bank approves a mortgage of CHF 500,000. Here is everything that happens on its balance sheet at drawdown:

• Assets: loan to customer, +CHF 500,000
• Liabilities: customer's sight deposit, +CHF 500,000

That is the whole entry. The bank's balance sheet is CHF 500,000 larger on both sides. No existing deposit was moved. No saver was asked for permission. The bank has created a new asset (a claim on the borrower) and a new liability (a claim on the bank), and the second of those liabilities is what we call money — it circulates, it settles debts, it is counted in the M1 and M3 aggregates the Swiss National Bank publishes.

The borrower now owes CHF 500,000 and holds CHF 500,000. Net worth is unchanged. What changed is that the economy contains half a million francs of purchasing power that did not exist a minute earlier, and a matching half million francs of debt.

The reverse is equally important and almost never mentioned. When the borrower repays CHF 100,000 of principal, the deposit falls by CHF 100,000 and the loan falls by CHF 100,000. The money is destroyed. It does not go into a vault; it ceases to exist. This is why a period in which households and firms collectively repay more than they borrow is deflationary in a mechanical, not merely psychological, sense. The stock of money shrinks.

Note the asymmetry with interest. When the borrower pays CHF 8,000 of interest, that deposit moves from the customer to the bank's own income account. It is not destroyed, only reassigned. Interest is a transfer; principal repayment is destruction.

Where reserves actually come in

If banks can create deposits at will, what stops one from creating infinite deposits? The first constraint is settlement.

The mortgage borrower does not leave the money sitting there. They buy an apartment, and the seller banks with a different institution. Now CHF 500,000 must move from Bank A to Bank B. Interbank payments in Switzerland settle in sight deposits at the SNB — central bank reserves — through the SIC system. Bank A must hand over CHF 500,000 of reserves it holds at the SNB, or borrow them.

So the loan did not require reserves to be created, but it does require reserves to be settled. This is the crucial distinction. Reserves are the settlement asset between banks; deposits are the settlement asset between the public. They are different instruments on different balance sheets, and households cannot hold reserves at all.

In aggregate, reserves do not leave the banking system — Bank A's loss is Bank B's gain — so the system as a whole always has exactly the quantity of reserves the central bank has chosen to supply. What an individual bank faces is the price of obtaining them: the money-market rate, anchored by the SNB policy rate. That is the mechanism by which a policy rate constrains lending. It is a price constraint, not a quantity constraint.

This also explains why reserve requirements are a minor feature of modern systems. The United States cut its requirement to zero in March 2020; the United Kingdom, Canada and Australia have no mandatory ratio at all. Switzerland retains a minimum reserve requirement on certain short-term franc liabilities, set at a low single-digit percentage, but it is a prudential and operational detail, not the throttle on credit that the multiplier story implies.

The real constraints: capital, profitability and demand

Capital is the binding regulatory constraint. Under the Basel framework, as implemented in Switzerland through the Capital Adequacy Ordinance and supervised by FINMA, a bank must hold loss-absorbing equity against its risk-weighted assets.

Work the mortgage through. Under the standardised approach a well-secured residential mortgage has historically carried a risk weight in the region of 35%, with the finalised Basel III framework replacing that single number with a ladder keyed to loan-to-value. Take 35%:

• Risk-weighted assets: CHF 500,000 × 35% = CHF 175,000
• Total capital requirement at, say, 12% of RWA: CHF 21,000

Separately, the non-risk-based leverage ratio requires capital against total exposure regardless of risk weight. At a 3% Basel minimum that is CHF 15,000 on the same loan — and Switzerland's too-big-to-fail regime imposes materially higher leverage requirements on its systemically important banks. Whichever number is larger is the one that actually bites. In the example above the risk-weighted requirement (CHF 21,000) exceeds the leverage requirement (CHF 15,000), so it is the binding constraint even on a well-secured mortgage. The leverage ratio bites instead where risk weights are very low relative to size — large books of government bonds, reserves and repo — which is precisely why a non-risk-based backstop was added.

The bank cannot conjure equity the way it conjures deposits. Equity comes from retained profits or from issuing shares. So the real chain of causation runs: capital and expected profitability determine how much a bank wants to lend, credit demand determines how much it can lend at an acceptable rate, and reserves adjust afterwards.

The other constraints are commercial. A loan that defaults destroys capital. Deposits are not free — a bank that grows its book much faster than its rivals will lose reserves to them at every settlement cycle and must bid for funding, which compresses its margin. Competition, credit risk and funding cost do most of the disciplining that the multiplier was imagined to do.

Banks create money in other ways too

Lending is the largest channel but not the only one. If a bank buys CHF 10 million of Confederation bonds from a pension fund, it credits the fund's deposit account by CHF 10 million. New money, no loan. The same is true when a bank pays its staff or its suppliers, or when it buys a building.

Central banks create money for the public indirectly. When the SNB bought foreign currency to resist franc appreciation, it paid in newly created sight deposits held by banks — reserves, not public money. Those reserves became public money only to the extent the banks' counterparties were non-banks whose deposit accounts got credited. That distinction is why large-scale asset purchases inflated bank reserves dramatically in the 2010s without a proportional rise in broad money.

The Swiss shape of this

Swiss bank balance sheets are unusually mortgage-heavy: domestic mortgage claims exceed a trillion francs, a very large figure relative to an economy of roughly CHF 800 billion in annual output. When Swiss banks create money, they overwhelmingly do so against residential property. That is why Swiss macroprudential debate is really a debate about mortgage underwriting.

The self-regulatory rules matter here in a way they do not elsewhere. Swiss lenders typically require a 20% down payment, of which at least half must come from sources other than pillar 2 pension assets; require amortisation of the second mortgage tranche down to two-thirds of property value within 15 years; and test affordability against an imputed interest rate around 5% rather than the rate actually charged, with total costs capped near one third of gross income. Each of those is a direct, quantitative limit on money creation through the dominant Swiss channel. Change the imputed rate and you change the money supply.

Switzerland also held the only modern national referendum on abolishing this system. The 2018 Vollgeld ("sovereign money") initiative proposed that only the SNB be permitted to create deposit money. Voters rejected it by roughly three to one. Whatever one thinks of the proposal, the debate forced the Swiss authorities to state publicly and precisely how the current system works — which is exactly what this lesson describes.

Finally, deposits are a liability of a private company, not state money. Swiss depositor protection through esisuisse covers privileged deposits up to CHF 100,000 per client per bank, funded by contributions from other banks after a failure rather than by a pre-funded state pot. Above that threshold, the money in your account is an unsecured claim on a bank. The 2023 absorption of Credit Suisse by UBS was, among other things, a demonstration that the authorities understand this and will act to prevent a test of it.

What to take away

• A bank loan creates a deposit; the deposit is new money, and repaying the principal destroys that money — so the money supply expands and contracts with the credit cycle, not with anything a saver decides.
• Reserves are the settlement asset between banks and cannot be held by the public; a policy rate constrains lending through the cost of settlement, not by rationing a quantity of reserves.
• The binding limits on a bank's money creation are capital (risk-weighted and leverage-based), credit risk, funding competition and borrower demand — check which of those is tight before predicting a credit boom or a credit crunch.
• In Switzerland the dominant money-creation channel is mortgage lending against residential property, so the self-regulatory rules on down payments, amortisation and the roughly 5% imputed affordability rate are macroeconomic instruments in all but name.
• The balance in your account is an unsecured claim on a private company, protected only to CHF 100,000 per client per bank under esisuisse; treat bank credit quality as a real exposure rather than a formality.

Sources

• Michael McLeay, Amar Radia and Ryland Thomas, "Money creation in the modern economy", Bank of England Quarterly Bulletin, 2014 Q1.
• Deutsche Bundesbank, "The role of banks, non-banks and the central bank in the money creation process", Monthly Report, April 2017.
• James Tobin, "Commercial Banks as Creators of 'Money'", 1963.
• Richard A. Werner, "Can banks individually create money out of nothing? — The theories and the empirical evidence", International Review of Financial Analysis, 2014.
• Basel Committee on Banking Supervision, the Basel III framework, including the leverage ratio and the finalised standardised approach to credit risk (BIS).
• Swiss National Bank, Monthly Statistical Bulletin and Annual Report — monetary aggregates, sight deposits and the SIC payment system.
• Swiss Bankers Association, self-regulatory guidelines on the examination, valuation and handling of mortgage-secured loans.
• Hyman P. Minsky, Stabilizing an Unstable Economy, Yale University Press, 1986.