How money is created by the central bank and the banking system

Z├╝rcher Volkswirtschaftliche Gesellschaft, Zurich, 16.01.2018

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The financial crisis and the massive expansion of liquidity by central banks have raised the level of public interest in monetary topics. This also applies to the question of how interaction between central banks, commercial banks and the general public affects the supply of money and credit.

Traditionally, a distinction is made between two types of money: central bank money created by central banks, and bank deposits created by commercial banks interacting with the central bank and the public. Central bank money is legal tender, while deposits with commercial banks represent a claim on central bank money. These deposits result from the banks' lending activities. When a bank grants a loan to a customer, it credits the amount in question to their account in the form of a sight deposit. This deposit disappears from the bank's books as soon as the customer uses it to make payments, but it remains in the banking system.

Constraints on the creation of bank deposits are imposed by the banks' risk/return considerations and by the central bank's monetary policy. When making lending decisions, banks take into account current and future interest rates, the likelihood of deposit withdrawals and credit defaults, and the liquidity and capital adequacy requirements in force. Central banks steer interest rates via their monetary policy, which has an impact on the public's demand for money and credit and curbs money creation.

Various proposals calling for broader access to central bank money have recently been put forward as an alternative to the present-day system. In Switzerland, a people's initiative known as the sovereign money initiative has been submitted and will be voted on by the electorate later this year. It aims to have sight deposits with commercial banks replaced by central bank money. Banks would no longer be permitted to create deposits through their lending activities. Acceptance of the initiative would have serious consequences for the structure and stability of the financial system, as well as for the monetary policy of the Swiss National Bank (SNB), and plunge the Swiss economy into a period of extreme uncertainty. Switzerland would have a financial system which is untested and fundamentally different from that of any other country. The Federal Council and the SNB therefore firmly oppose the sovereign money initiative.

As an alternative to the concept of sovereign money, some academics have launched the idea of allowing access to a sight deposit account at the SNB not only to commercial banks, as is currently the case, but also to the public. Unlike the sovereign money initiative, this would not bar commercial banks from creating deposits through lending. However, the proposal could well have consequences on the structure of the financial system similar to those of the sovereign money scenario. The SNB would assume a greater role in financial intermediation. Such a change would call into question the traditional, tried-and-tested division of tasks between the central bank and the commercial banks. The SNB therefore takes a critical stance on this proposal.