Wednesday, July 29, 2009

Loans create reserves!

Got an email from a reader of this blog who sent me the latest Fed study on why banks are holding so much excess reserves. (Get the paper here.)

In this report the economists said this:

"The total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions."

They got it backwards and I'll illustrate by using the following example.

A bank enters into a loan not based on its excess reserves, but on whether or not it has a creditworthy borrower and it sees a chance to make a profit.

Let's assume that a bank has only enough to meet its legal reserves. It makes the loan. At that instant it is short reserves. If if does nothing the Fed will automatically credit the bank's reserve account with the required reserves (this functions like an overdraft account). So, the reserves are created from the loan.

However, let's say the bank borrows the needed reserves from the market. If we also assume that other banks are lending, then the borrowing of excess reserves will tend to push up the overnight interest rate to a level above the Fed's target. So, what does the Fed do?? It adds reserves to bring the rate back down to its target.

Therefore, loans create reserves and it is irrelevant whether or not the banking system has $20 billion in excess reserves or $2 trillion. The ability of banks to make loans is independent of that.

Loans create reserves!

Now you know more than the authors!!!


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