John Carney — The Irrelevance of Bank Reserves

John quotes from a 2009 piece in The Economist that gets it right.

Read it at CNBC Net Net
The Irrelevance of Bank Reserves

by John Carney | Senior Editor

You may be wondering what this means, however.

When a commercial bank makes a loan, it will usually finance it with deposits from customers. The Fed, on the other hand, gets to create its own deposits by simply creating reserves.

Since banks cannot create reserves, only deposits, they have to fund the cost obtaining the reserves needed to settle after making loans and to meet reserve requirements. Since people borrow in order to use the funds, this generally involves issuance of checks to other banks. The bank making the loan and creating the corresponding deposit has to transfer reserves in the interbank settlement system (FRS) to clear checks drawn on the bank when presented in the settlement system. The least expensive way for a bank to finance the needed reserves, if it doesn't have enough on hand, is to attract deposits from other banks. This increases its reserves as reserves are transferred between the banks'accounts in interbank settlement system.

Note: This doesn't imply that banks either lend reserves or against reserves, or lend out deposits. It is an internal financing operation managed by a department of the bank that is separate from the department managing credit extension. Banks meet creditworthy customer demand for loans that the bank deems profitable. The reserves needed for settlement and meeting reserve requirements are figured as part of the bank's costs in making the loan and which determine the interest rate the bank charges, along with risk assessment.