"In the absence of legal reserve requirements, banks can build up deposits by increasing loans and investments so long as they keep enough currency on hand to redeem whatever amounts the holders of deposits want to convert into currency.” [p3]
Translation: banks can create as much money as they want by writing loans into their borrowers’ accounts, limited only by (a) legal reserve requirements (money that must be held in reserve – traditionally about 10% of outstanding deposits and loans) or (b) the amount of money they will need to keep on hand to pay any depositors who might come for their money (also traditionally about 10%).
“Banks may increase the balances in their reserve accounts by depositing checks and proceeds from electronic funds transfers as well as currency.” [p4]
Translation: the “reserves” that count toward the reserve requirement include currency, deposited checks, and electronic funds transfers. (Note that the “deposits” created as loans are excluded from this list of allowable reserves: the bank cannot just keep bootstrapping loans on top of loans but must have money from external sources backing its liabilities up equal to about 10% of its loans and deposits.)
“The money-creation process takes place principally through transaction accounts [accounts that can be drawn on without restriction]." [p2]
"With a uniform 10 percent reserve requirement, a $1 increase in reserves would support $10 of additional transaction accounts.” [p 49]
Translation: $1 deposited by a customer can be fanned into $10 in loans.
“In the real world, a bank’s lending is not normally constrained by the amount of excess reserves it has at any given moment. Rather, loans are made, or not made, depending on the bank’s credit policies and its expectations about its ability to obtain the funds necessary to pay its customers’ checks and maintain required reserves in a timely fashion.”
Translation: In practice, banks issue loans without worrying too much about whether they have the reserves to cover them. If they come up short, they can just borrow them:
“[Since] the individual bank does not know today precisely what its reserve position will be at the time the proceeds of today’s loans are paid out. . . . many banks turn to the money market - borrowing funds to cover deficits or lending temporary surpluses.” [p50]
"[A] bank may [also] borrow reserves temporarily from its Reserve Bank. . . . [However], banks are discouraged from borrowing [Reserve Bank] adjustment credit too frequently or for extended time periods.” [p29]
Translation: If the bank finds at the end of the accounting period that its reserves do not come to the required 10% of its outstanding loans and deposits, it can simply borrow the reserves it needs from the money market or its Federal Reserve Bank.
A 2002 article posted on the website of the Federal Reserve Bank of New York noted that today, few banks are constrained by reserve requirements at all:
“Since the beginning of the last decade, required reserve balances have fallen dramatically. The decline stems in part from regulatory action: the Federal Reserve eliminated reserve requirements on large time deposits in 1990 and lowered the requirements on transaction accounts in 1992. But a far more important source of the decline in required reserves has been the growth of sweep accounts. In the most common form of sweeping, funds in bank customers’ retail checking accounts are shifted overnight into savings accounts exempt from reserve requirements and then returned to customers’ checking accounts the next business day. Largely as a result of this practice, today only 30 percent of banks are bound by a reserve balance requirement.”3
Even without official reserve requirements, however, banks must keep enough money on hand to meet withdrawals or checks written against the accounts of their depositors; and that generally means about 10% of outstanding deposits and loans, as moneylenders discovered centuries ago. But if the banks come up short, they can borrow this money from the money market or the Federal Reserve; and if the Fed comes up short, it can create new reserves.4 So why the current credit crunch? What is limiting bank lending?
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