Wednesday, February 29, 2012

Banks don't lend their reserves. Even if they could, it would be stupid.

The common story line we have been hearing for the past four years is that the Fed has "printed" all this money and reserves have grown exponentially so they will soon be "lent out" into the economy and that will create inflation.

Or what about this: Lawmakers wringing their hands over the fact that the gov't (Fed) gave the banks all this money and now they should be making loans.

It's wrong. All wrong.

First of all we need to understand that banks create loans by merely creating an accounting entry on their books. That's it. That's all there is to it. That's the power you have, granted to you by the government once you have a commercial bank charter. You create loans literally out of thin air. The only thing constraining your ability to do that is your capital. Nothing more than some capital and a blessing from the government and you're in business to "create money" (credit money) out of thin air. No reserves, no taking from Peter to lend to Paul. Nothing of the sort.

The point I am making is, if a bank needs nothing more than some capital and a book keeping system to make a loan, why would they lend out their reserves? From a business standpoint it would be really, really, dumb.

Don't forget, reserves earn interest for banks. Even if the interest rate is very low, the interest earned adds up. It's something. It flows to the banks' bottom line. More importantly, it's a no-risk stream of income and for a businesss that is fraught with risk (banking), that's a very precious thing. You don't want to play around with that.

So the obvious question is, why would a bank lend out its reserves and forego that risk free income when it's not even necessary? Again, the loan is just an entry on the banks' books. They can make that happen at will AND let the reserves sit there earning income at the same time.

Indeed, I'm not even sure if the banks are legally allowed to make loans with those reerves. I believe reserves can only be invested in things specified by the regulatory authorities and that mostly inlcudes government securities.

Therefore, no lending of reserves. Not necessary. Stupid, even.


The Economic Maverick said...

I've been trying to get my head around this for awhile now.
So let me get this right,

1.A bank makes a loan, and marks it as an "asset" on it's balance sheet, and also marks an equivalent "liability", but makes the loan first, out of thin air, and then goes and finds the reserves?

2. The Fed's has flooded the banking system with excess reserves. This protects the banks from a liquidity run, but it does nothing to facilitate credit expansion?

3. The only regulatory tool that can constrain credit expansion is the equity to assets ratio, aka bank capital requirements?

Did I get most of this right?

One last question?

4. Can you explain how this would differ with "Shadow banks" like Lehman and others using market based credit?

Matt Franko said...


You bank accounting looks good, Loans: assets; deposits: liabilities... (JKH in the blogosphere is a good source to follow about these ops on a detailed level)

Shadows did not have access to the CB or Fed Funds market I believe this was the big difference... they used commerical paper market to raise funds... this worked (until it didnt;)


Anonymous said...

Are you in the banking industry? Of course they lend out their reserves when there's a normal business cycle and not ZIRP and insolvency of the banks which is masked by mark to fantasy and the govt. borrowing roughly 10% of GDP each and every year to keep the banks open and the check coming for Granny. This is what passes for a recovery in bizzarroo world.

Fractional Reserve Banking is the essence of levering up, and banks have always done this.In fact, bank reserves have been repeatedly reduced to the current 10%. THEY LOBBIED FOR THIS, and it's always about the money.

They had a license to steal, but they were so damned greedy that they blew up the financial system with derivatives. Now, it's all about who takes the losses that have already occurred.

Leverage said...

Anon, no they don't.

Then lend against capital. reserves are NEVER a problem. In the expansionary phase of the cycle banks will leverage all they can, CB's will create reserves as needed.

They are only constrained by capital. reserves just matter to the payment system and interbank market, it does not matter for lending. What matters for lending is the capacity to leverage of the population (which is marked by incomes in reality), not even capital is a biggy problem (because capital will 'inflate' with rising asset prices and liquidity will flood the market).

Mike Norman said...

They don't lend out their reserves, at least not in the form of bank loans to customers. Reserves are invested in gov't securities are "lent" interbank.

Unforgiven said...

Leverage -

That's something I've yet to understand. What is capital? As I understand it, deposits are not capital?


Nice patience with FDO, by the way.

Tom Hickey said...

@ Econ Maverick

"Did I get most of this right?"


The only entities that have access to the interbank settlement system, where settlement takes place in exchanges of reserves among accounts on the cb spreadsheet, are members of the system, FRS in the US.

Other entitles in the shadow banking system don't have access to the settlement system, which is the only way to access bank reserves, since they only reside on the cb spreadsheet as accounting entries.

Reserves never cross the line into the economy as reserves. Banks exchange reserves for currency to meet window demand, Currency is used to settle transactions on the spot, where as reserves are used to settle transactions interbank. Intrabank transactions are settle on the bank's spreadsheet.

Reserves are stored as tsy securities and available as to non-government as saving instruments. This drains excess reserves created by deficits, allowing the cb to hit its target rate. The cb uses exchange of tsys and reserves for OMO and POMO (QE). This is simply a change in composition and maturity of net financial assets. It does not change the quantity, just how they are held.

Tom Hickey said...

Unforgiven: "What is capital? As I understand it, deposits are not capital?"

Basically, capital can be thought of simply as bank equity, although the terms is more complicated in terms of capital requirements. It is what the bank has to cover unexpected losses. See Federal Reserve Bank of San Francisco, What is bank capital and what are the levels or tiers of capital?

Unforgiven said...

Got it! Thanks, Tom!

TomatoBasil said...

If a bank makes a loan and the proceeds from the loan get deposited at a different bank, then the loaning bank will have their reserve account balance decreased by the amount of the loan and the bank where it is deposited will have their reserve account balance increased. The loaning bank doesn't have to have the reserves in their account before the loan is made but at the end of the day they are supposed to keep their reserve balance at the required level. If they don't have the required reserve balance in their account they can either attract deposits or borrow reserves from another bank. Small banks don't have a reserve balance requirement. Big Banks do.
See Fed Reserve Requirments.

New Bank Capital requirements from FDIC are here

marris said...

Do reserves at the Fed get included on a bank's balance sheet? As assets?

TomatoBasil said...

Reserves and Loans and Vault cash are bank assets.
Deposits are liabilities.

Tom Hickey said...

To round out what TB said, if a bank is short of liquidity at the close of a period, the Fed will count it as draft at the discount window and assess a penalty rate, sort of like banks charge an overdraft fee on a checking account. The bank's reserve account is its "demand deposit" account at the cb.

Adam1 said...

Just to add to TB's comment, "If a bank makes a loan and the proceeds from the loan get deposited at a different bank, then the loaning bank will have their reserve account balance decreased by the amount of the loan and the bank where it is deposited will have their reserve account balance increased."...

This just describes a clearing and settling of a payment that is tied to a loan. If TB wrote me a check from his bank account and I deposited at my (different) bank the same type reserve transfers would occur.

Reserves can only be used to clear and settle payments between banks; be lent to other banks short of reserves to clear and settle payments; and to buy treasuries.

Mike Norman said...

The Fed will necessarily add reserves ex-post to maintain its target Fed funds rate. If it didn't the funds rate would rise. Therefore, the loans themselves create system reserves.

marris said...

Well, if it is the case that these reserves count as assets then don't they affect the capital ratio? I mean an increase in bank reserves, either through Fed asset purchases or interest on reserves will boost the asset side. That needs to be allocated somewhere on the liability side. If the allocation is to equity, then isn't the bank now *able* to lend more?

So the relationship is not reserves drive loans, but increased reserves increase the upper bound on capital-ratio based lending.

If this is true, then the anti-inflationists can just say "Look, the Fed has increased these bounds. Any separate driver (e.g. inflation expectations) will now be able to run more wildly."

TomatoBasil said...

The Fed removes one asset, a bond or t-bill, from the bank's balance sheet and replaces it with a reserve balance. Unless there was a gain resulting from the sale of the bond, the capital of the bank should be unchanged. Going forward, the bank gets less income because interest paid on reserves barely, if at all, covers the cost of fdic deposit insurance.

marris said...

But what if the Fed buys a mortgage bond? The bank may be reserving capital against expected losses on it. If the Fed buys it, the bond is converted into cash at it's "marked value. So we go from a world with an hacky, uncertain capital ratio to one with a safer ratio.

Even in the case of a treasury purchase, the asset swap argument is misleading. The banks may only sell at a better-than-market price, so their assets still go up.

The FDIC argument is interesting. It would require some coordination between the FDIC and the Fed to keep the rates in sync. One reason to doubt this is that these two orgs have different roles. The FDIC works hard to protect its rescue fund (so it likes higher rates). The Fed IMHO wants to repair bank balance sheets (increase equity).

Anonymous said...

You have a fundamental misunderstanding of fractional reserve banking. Do you really think banks miss the chance to lever up when it's part of their charter?

I open a bank with $1 million in capital. I must hold a 10% reserve, so I can lend out $900,000 and wouldn't ya know it that a customer needs the same amount of money to make the next thing that everyone must have. He deposits the borrowed money at said institution which can now loan out $810,000 to the next customer who needs a loan. This happens repeatedly until the original $1 million is exhausted.

This is how our banking system works in the real world. If none of this mattered, why have banks repeatedly lobbied for less reserves? Because otherwise the money is losing value through opportunity costs, and the banks would never do this. It's not in their own best interest to do what you describe.

Anonymous said...

Commercial banks do lend reserves, but only to other organisations with reserve accounts at the central bank, i.e. other commercial banks. So they lend reserves to each other within the central bank system, but they don't lend them 'out'.

Cash notes are reserves in physical form, so reserves only get 'out' in the form of notes.

Leverage said...

If reserves increase the asset size of the balance sheet they dilute capital so banks need to rise liabilities to keep the books balanced (either equity, deposits, whatever).

Bigger asset side = capital is diluted and capital requirement is not met = need to rise deposits or capital (draw money from the market).

Anonymous said...

If you took a loan out from a bank, and then once the deposit had appeared in your account you asked the cashier to withdraw the sum in cash, then you could be said to have 'borrowed reserves', but only in the sense that cash notes were 'reserves' that were changed into notes by being withdrawn from the central bank system.

Leverage said...

"I open a bank with $1 million in capital. I must hold a 10% reserve, so I can lend out $900,000"

No, you can lend all the money you want until your capital is 10% of the total assets. So you can lend the equivalent of $10 million (not in practice, but still, for an example is good enough).

At that point you need to rise capital from the market to lend more.

Anonymous said...

Leverage: I thought capital is the amount by which a businesses assets oexceed its liabilities?

Leverage said...

We are talking by accounting standards here, capital of a bank firm is equity and is usually around 8-10% of the total liabilities.

Assets are things such as mortgages, credit, reserves with CB's etc. Liabilities for banks are deposits, capital, reserves etc.

So you need to rise reserves (you use profits to do this) to balance liabilities and assets or rise equity, deposits, etc.

Anonymous said...

Assets = liabilities + owners equity. Period. First thing you learn in Accounting 101.

Leverage said...

This need further clarification for someone who does not know accounting, there are two kind of reserves in cases of banks:

1) Reserves, like any other corporation, these are liabilities and used to cover possible loses, for example.

If you increase your assets, you need to balance liabilities. if you increase your assets your firm probably is at profit, so you commit a part of the profits to increase the reserve requiriments (by law) and the rest to share amongst shareholders or for example, increase capital (buyback your own equity rising prices!).

2) Reserves with CB's, that's the "money of CB's" used in the interbank market and to settle payments amongst firms. If you have exceed reserves you are increasing your assets and need to rise liabilities which is inconvenient. CB's can pay you interests on excess reserve (profit) which you can use to rise your liability reserves or capital.

Corporations AND banks will always lobby for lower reserves, these represent an opportunity cost and idle money which is eroded by inflation and you can't invest, but by lowering reserves you also increase risks, in case of banks, systemic risks as they can't cover loses. Banks will lobby maybe for lower central bank reserves for the reasons stated above: they are a non-beneficial increase of assets, unless CB's paid you high interests on reserves (above inflation), for example on excess reserves.

Anonymous said...

Leverage, that was the point of my example. They lever up with the very act of following their charter to the $10 million you mentioned. This is fact, and all the fancy this and that doesn't change the fact that it's in the bank's own self interest to lever up by way of fractional reserve banking.

Leverage said...

Yes, but they will do that even if you increase reserves requirements unless you go up to a 100% reserve system (which is a completely different system).

The private (or public!) sector has always found a way to lever real assets and create forms of credit. It's mostly a natural process in an economy which has expectations of future production.

So, I don't see the point of this, only thing we can do is try to decrease the abuse of it.

Adam1 said...

Anonymous, I’m sorry but it is you who does not understand the operations of a fractional reserve bank.

In your example the banks only assets were its $1M reserves.

Did you actually try running the accounting steps to "lend out" that money? Remember each transaction step requires 2 entries – it’s accounting 101 you know.

The only way you can do 2 entries AND lend out reserves is to give someone money in step one.

Did you ever leave a bank after signing for a loan with cash? Does the bank teleport money to you when you swipe your credit card at the store? And every time you write a check against your home equity line or credit the bank teleports money to you too, right?


A loan is a promise to clear and settle a payment. That’s why they give you a check – it’s a payment instrument! When the check comes back to the bank it will either come back as a deposit (which creates a liability for the banks & activates the loan account which is an asset) or as a request from another bank to clear and settle the payment (in which case the loan asset hits the books and the bank hands over reserves which decrease its assets by the value of the loan and the receiving bank who’s liabilities went up with the deposit also ups its reserves from the other bank).

Tom Hickey said...

Anonymous, you ignore that fact that banks can lend at a profit by borrowing on the interbank market or from the cb to meet their reserve requirement, so in principle they do not even need deposits to lend.

The fractional reserve understanding of banking is inapplicable under a non-convertible floating rate system.

Under the present system, the cost of reserves is the only factor operative, not availability of reserves. The cb ALWAYS makes reserves available (provides liquidity at a price) to a solvent member bank to settle its account in the interbank system. What the bank pays for this influences what the bank charges its customers for lending, as well as what it lends its excess reserve to other banks in the interbank market. These are the fed funds rate or overnight rate and the discount rate or penalty rate in the US. Setting these rates is a major aspect of monetary policy.

This is only one cost that the bank takes into account in determining what interest rate it charges customers based on different levels of risk using the five Cs of credit.

Tom Hickey said...

If you took a loan out from a bank, and then once the deposit had appeared in your account you asked the cashier to withdraw the sum in cash, then you could be said to have 'borrowed reserves', but only in the sense that cash notes were 'reserves' that were changed into notes by being withdrawn from the central bank system.

That is true, but physical currency is not bank reserves, which exist only as entries on the cb speadsheet. What physical currency (cash) does is allow final settlement of transactions on the spot — unless one finds one has accepted counterfeit, which does happen.

A couple of years agoI was in London with a friend I had travelled with the day before. That morning he had converted some USD into pounds. We were shopping in a Tesco shortly thereafter, and he paid with a large note. As we were leaving we were apprehended for passing a counterfeit note. My friend had to explain to the police what had happened, which they accepted. Even though he had received the note from a bank only hours before, he was out the money. It happens.

Tom Hickey said...

Anonymous, in figuring capital requirements for banks, all assets are not equal. They are risk-weighed and higher risk assets have to be offset by lower risk according to a set rate.

See A Primer on Bank Capital

Tom Hickey said...

Anonymous, banks lend based on demand from creditworthy customers willing to pay the rate the banks offer based on costs and risk-assessment. The reserve requirement is an accounting residual that shifts wrt to credit extension. Excess reserves do not cause banks to lend; causality runs the other way.

Banks have the option to shift reserves into tsys to obtain interest, or else lend their excess reserves to other banks in the overnight market at the overnight rate rate set by the cb if the cb doesn't pay IOR equal to or greater than the overnight rate.

Adam1 said...

Tom, just to be clear because I'm not sure Anonymous see this but when he says, "If you took a loan out from a bank, and then once the deposit had appeared in your account you asked the cashier to withdraw the sum in cash, then you could be said to have 'borrowed reserves', but only in the sense that cash notes were 'reserves' that were changed into notes by being withdrawn from the central bank system." ...

That's actually two bank transactions. The first one is the creation of the loan... Loan Booked (asset created) plus Deposit performed (liability increased) - one double entry transaction.

Withdrawing the cash is a separate transaction and it would look the same regardless of who was requesting (borrower or depositor)... Deposit decreased (liability) and vault cash (asset) decreased. Of course reserves at some prior point were used to purchase the cash from the government but that's even a third transaction that occurred long before the loan was ever booked.

The Economic Maverick said...

The post and the comments are very informative. It might be helpful to explain this graphically, or using very simple balance sheet spread sheets.
Back during the 2008/2010 period when there was more lay public interest in the financial crisis, I did many volunteer civic education sessions in my community on “Financial Crisis 101”. I found it helpful just to show a very basic bank balance sheet up on a PPT presentation. It was easier to show people that a deposit is a bank liability, and thus a depositor is not a "Customer" to a bank in the purest sense, but more like a "lender" to the bank. The liquidity and maturity mis-match between bank assets and liabilities was also easier to illustrate with such a basic spreadsheet, and with it an understanding on the inherent instability and elegance of fractional res banking, and thus the need for deposit insurance and lender of last resort for an otherwise "run-prone" system to function.
The analysis you guys did here takes it to another level – with the correct Post Keynesian focus on “credit demand” – is beyond the analysis that I gave at the time, and frankly, ur beyond the analysis of even 95% of those in the Econ/finance community of “experts”

Michael Rosmer said...

I'll avoid going back addressing all kinds of confusing statements and mixed up comments from people and simply give an overview.

Point 1: you need to understand the difference between Reserve Requirements, and Capital or Capital Adequacy Requirements.

What's the difference? Reserve requirements are based on deposits and are close to irrelevant, in fact in some countries such as Canada there are no reserve requirements. Reserve requirements are a percentage of deposits on hand a bank needs to make loans. Please note, reserves are NOT the bank's money, they are the depositor's money.

Capital requirements are specified for much of the modern world under Basel III and adopted in various forms in various countries. They state the bank must have a certain amount of capital on hand in order to make a certain amount of loans. Capital in this case is very tightly defined in three tiers of capital (the third can only be used to cover market risk not Credit Risk Weighted Assets or operational risk) and essentially include two things:

1. Retained earnings - in other words the profits of the bank (this isn't totally accurate because how those retained earnings eligible to meet capital requirements are calculated will have some conditions on it)

2. Shareholder equity - common stock, preferred shares in some cases, etc.

In other words CAPITAL in this case is not the depositor's money but the bank's money. So the bank's ability to lend is based on their own money not based on your money as a depositor. You could deposit $1 trillion in the bank and it wouldn't increase the bank's ability to lend because the bank's capital hasn't increased. You might loosely say the banks lend based on their assets minus liabilities (primarily deposits) but this wouldn't be accurate either because not all their assets on the balance sheet can be counted (for example, typically the gains and losses from real property are excluded, meaning the comments earlier about asset bubbles increasing liquidity is somewhat misleading, not entirely inaccurate, but misleading).

As to how much they can lend I'm not sure where people keep coming up with this 10% stuff. Basel III states 8% capital must be kept in reserve with 4% of that 8% being tier 1 capital...HOWEVER, it's not a straight forward calculation because not all loans are weighted the same, there's a formula that includes Credit Risk Weighted Assets that determines a bank's capital to loan ratio. For example, mortgages are typically weighted somewhere from 35-50%, meaning each dollar lent out on a mortgage only counts towards half of what is available to be lent out. Likewise, lending to AAA and AA governments have zero effect on capital ratios meaning it is possible to lend an unlimited amount of money to the government without affecting the bank's capital ratio.

In addition to this banks based on their size are required to keep a certain amount of capital on hand to cover operational risks, which is related to a percentage of their income (again, there's a formula), and further capital on hand (though this capital has a looser definition) to cover market risk.

It is IMPOSSIBLE for banks to "lever up" by multiplying the reserves on deposit, they are simply not permitted to do so. They "lever up" by multiplying their capital on hand through loans and increase that available capital through profitable operations and by raising the money in the market.

Serg Ivan said...

Leverage said...
""I open a bank with $1 million in capital. I must hold a 10% reserve, so I can lend out $900,000"

No, you can lend all the money you want until your capital is 10% of the total assets. So you can lend the equivalent of $10 million"”

How could you possibly do it without borrowing most of this $10 million from CB, interbank, or attracting deposits? Please correct me if I’m wrong:
This $10 mil (that are loaned out) are later either cashed by borrowers, or are transferred to other banks - in the first case you going to decrease your cash on hand, and in the second - your reserves at CB have to be decreased - both these operations will decrease your assets by $ 10 millions (nothing came out of thin air). So you need to attract deposits and/or borrow from CB or interbank to the tune of 10 millions. If this was happeneing in reality (banks lending multiples of the deposits they have, i.e. creating "money out of nothing"), you would see banks borrowing from CB and interbank trillions of dollars. Historic charts show that banks borrowing from CB was zero-to-few billion $ most of the time till recently (til Lehman), and interbank lending was in the 200-400 billions$ range last decade, while loans outstanding were around 5-7 Trillion$.

According to this data, it would be reasonable to say that banks could be "over-lending" (lending more than they have deposits) overall to the tune of few hundred billion $ - which would be just few percent of the total loans outstanding. Which makes “over-lending” an exception rather than a rule. It seems that case presented above (leveraging $1 million of capital into $10million of loans) doesn’t happen in reality unless you attract sufficient deposits.

Im a finance student, please correct me if I’m wrong, but this description in the posts above of how banking works just doesn’t seem to add up.

Tom Hickey said...

@ Serg Ivan

Yes, banks finance most loans they make using deposits, since this is the most cost-effective way to do the deal. Scott Fullwiler has pointed this out on many occasions.

MMTdebtkiller said...

It's not clear. If a bank acquires a Treasury security at public auction, what and from where does it get the money to pay the Treasury? If not the reserves, then what?

And how does the Fed acquire a security from a bank? Does it just "buy" it with money created out of thin air deposited in some account at the bank? I've been saying this in comments in the Web and I'd like clarification, so I get it right.

Tom Hickey said...

Tsy securities are exchanged for reserves and reserves only come from the Fed. This is the purpose of Tsy securities. They act as a reserve drain. Reserves are injected into non-govt when Tsy instructs the Fed to credit banks' reserve accounts to settle its expenditures, and the Tsy also instructs the Fed to auction tsys to offset its deficit. Those auctions shift the reserves injected by deficit spending into tsys. It's simply a shift in composition of non-govt net financial assets, leaving the amount non-govt NFA the same (actually increasing the amount over time through payment of interest on the tys).

This is an aggregate analysis. Confusion may arise when people forget that this is in aggregate and examine individual transactions that seem to suggest otherwise.

tino popsy hove said...

if you could answer me this please, if banks lend their excess reserves the imediate effect will be?

Tom Hickey said...

if you could answer me this please, if banks lend their excess reserves the imediate effect will be?

banks don't lend excess reserves. Reserves are for interbank settlement in the payments system only. Banks lend against their capital, putting equity at risk.

Joseph Brant said...

If banks can't have the reserves depleted by depositors how do bank runs and failures occur. If the theory is banks have power to create credit money why can't they satisfy the on demand withdrawals until everyone is whole again and the panic and run stops? If they can create credit money themselves to depositors, How is a bank run even possible if banks have such power?

Tom Hickey said...

Banks are capital constrained and their balance sheets also have to balance, Banks that don't meet requirements cannot borrow from the central bank. and other institutions will not lend to banks that are in trouble. Banks cannot create reserves, they have to get them, and if customers want to withdraw funds, then banks have to settle either in cash or reserves they don't have or would have to get by borrowing. The only other alternative is to raise more capital, which is usually impractical at that late stage.

In the Panic of 1909, IIRC, J. P. Morgan got the bankers to put up capital to stem the bank run. The outcome was the Federal Reserve Act of 1913, with the Fed as lender of last resort.

In the Great Depression, gold convertibility was ended domestically, decoupling reserves from commodity banking. Since then, reserves are an interbank settlement vehicles only.

In the 2008 crisis, not only did the Fed step up liquidity provision to the big banks, totaling trillions is roll-overs, but also Congress approved a fiscal bailout through Treasury as well (TARP).In addition, rules were suspended or changed (forbearance).

Joseph Brant said...

So when ever a depositors in a bank run wants to withdrawal "cash" or transfer funds into another competing banks account which i presume are the only two ways to get your money out of a bank, in a bank run that is depleting the banks actual reserves in it reserve account, due to it having to transfer the reserve to the other bank using inter bank settlements or cash being withdrawal which also depletes its reserve account because cash is considered to be a central bank reserve and not controlled by the actual banks but the central bank. which can then lead to it's insolvency of being short bank reserves from the run?

Tom Hickey said...

Yes. A bank gets vault cash to meet window demand from the cb by exchanging reserve balances (rb) it holds in its account at the cb. Similarly, if a customer makes a withdrawal by electronic transfer or a check that is deposited at another bank, then the reserve account of the bank from which funds are withdrawn will be marked down at the cb and the bank's reserve account receiving the deposit will be marked up. (This is final settlement after interbank netting).

So banks can create loans based on the capital requirement and they have to get reserves to clear withdrawals and to meet reserve requirements if any. The asset and liability side of the balance sheet must always balance, too. When bank makes a loan (bank asset) it is funded by the deposit (bank liability). As the deposit is drawn down, the bank has to seek other funding. Attracting deposits is the least expensive way to do this, and when a deposit is attracted, then the bank's reserve account at the cb is marked up too.

This is confusing at first in that banks have their customer book and their book at the cb.

Joseph Brant said...


Tom Hickey said...

I preder to not say that loans create deposits and reserves, even though true in a technical sense. But if you don't understand the process, you will likely be mistaken in thinking that banks create reserve with key strokes, like they create loans. That is not the case.

Reserves are only created by keystrokes by the cb, Reserves exist only on the cb's spreadsheet by admin and only the cb has the admin password.

What it means is that if a bank comes up short reserves in its account at the cb,, then the cb acting as lender of last resort will lend the reserves at the penalty rate so that the payments system always clears. However, banks that don't meet the regulatory requirements are put into resolution. they can't use cb liquidity largess to mask internal problems, unless the cb extends forbearance as the Fed did for the TBTF's at the time of the crisis and for some time after.

Tom Hickey said...

1.A bank makes a loan, and marks it as an "asset" on it's balance sheet, and also marks an equivalent "liability", but makes the loan first, out of thin air, and then goes and finds the reserves?


2. The Fed's has flooded the banking system with excess reserves. This protects the banks from a liquidity run, but it does nothing to facilitate credit expansion?

YES, but there is no possibility of a liquidity shortage with LLR anyway. Banks don't need reserves beforehand to lend and they can always get them for a cost. Credit expansion is based on availability of creditworthy customers willing and able to pay the going rate so that banks can turn a profit on the spread.

3. The only regulatory tool that can constrain credit expansion is the equity to assets ratio, aka bank capital requirements?

Warren Mosler says the most effective regulation is limiting what a bank accepts and collateral at what ratio. That would have eliminated much of the lending that resulted in the housing crisis.

4. Can you explain how this would differ with "Shadow banks" like Lehman and others using market based credit?

Peer to peer is based on trust. There are no banking regulations as exist for chartered banks, no direct access to the cb, and no government guarantees either.

Joseph Brant said...

Do you think this video explains it good?

Tom Hickey said...

As a conspiracy theory theory.

Unknown said...

Demonstrably false. The really sad thing is orthodox economists who laud DSGE have all been taught from the text books that fractional reserve lending does, in its fairytale economy where there is only one seller and one buyer (the same person), exist.
They, Geithner and Obama, actually flooded the banking system with excess reserves that they truly believed would get loaned out. The Chicago boys' desire to keep a grip on our economy forces them to lie to their students to keep the smoke and mirrors that is DSGE at least accurate in their make believe land of no money banks or debt.