I understand, commercial banks are entitled by the Central Bank to "create new money" when they issue a loan and correspondingly "destroy the money" when the loan is paid back (with the constraints of the fractional reserve system). Correct?

If so, I wonder how a Swiss bank, which is entitled by the Swiss National Bank rather than the FED, can issue a new loan in USD. What is the mechanism?

thank you!


In order to understand this its important to understand how actually commercial banks contribute to money creation. It is true that commercial banks are part of money creating process but I think that you misunderstand the way in which they are part of it. When you go to commercial bank to get a loan commercial bank neither domestic or foreign is allowed to just create the money for that loan out of thin air. Only central bank can do that.

Rather the money creation process works in a way that central bank creates base money and in addition also allows commercial banks to borrow from it newly created reserves. Afterwards, the commercial banks help to multiply the base money due to fractional reserve system. For example, if fractional reserve requirement is $10\%$ that means that if a person deposits $\\\$100$ into the commercial bank they are allowed to lend out $\\\$90$ and keep $\\\$10$ as a reserve. Afterwards when the person who borrowed $\\\$90$ deposits them (or spends them and someone else deposits them), bank will again be allowed to keep only $\\\$9$ as reserve and lent out $\\\$81$. In this way eventually up to $\\\$1000$ of new money can be created. This process is reversed once the loan is being paid back. The point is that commercial banks cannot simply create the money out of nothing so their domestic/foreign status does not matter that much.

Foreign commercial banks can make loans in dollars by simply first entering the forex market, buying some amount $X$ of dollars and then lending that amount to its customers. Alternatively foreign bank can also borrow dollars from other bank that has them and then lend them further. When we talk about dollars in particular foreign banks have even access to federal funds market (see this Fed Cleveland explainer) so they can borrow from there as well.

  • $\begingroup$ thanks! so you are basically saying that foreign banks cannot create directly USD loans in the way domestic US banks do. However foreign banks have access a liquid interbank USD loan markets, which in a way allows them to be a "proxy" of US banks. Finally a note on the alternative you propose to resort to FX markets. That would no be straightforward, because it creates currency risk for the lending Bank. $\endgroup$
    – elemolotiv
    Jul 21 '20 at 11:42
  • 1
    $\begingroup$ @elemolotiv essentially yes. Also the currency risk is passed down then to other people who then borrow those dollars from that foreign bank. Also currency risk is always involved in any international economic activity which is not within monetary union. Its not trivial but its not big deal too firms and banks can often hedge such risks. $\endgroup$
    – 1muflon1
    Jul 21 '20 at 11:46
  • $\begingroup$ -1 for misleading explanation of the monetary system. See this for better explanation: bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/… $\endgroup$
    – Mick
    Jun 29 '21 at 21:27
  • $\begingroup$ @Mick 1. I know the paper. 2. What is written above is fully consistent with what is written in that paper although simplified because for the purpose of the question more nuance is not necessary. $\endgroup$
    – 1muflon1
    Jun 29 '21 at 21:30
  • $\begingroup$ The explanation you gave implies that there is an unbreakable ceiling on the money supply which is absolutely not the case in practice. $\endgroup$
    – Mick
    Jun 29 '21 at 21:35

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