Banks are never constrained by reserves

In a fiat money system, there is not a very good correlation between base money and M1 and credit because reserves don’t create loans. In practice, the lending operations of commercial banks have no interaction with reserve operations. Lenders simply take applications from customers who seek loans and assess creditworthiness and lend accordingly.

In approving a loan, banks instantly create a deposit, a zero net financial asset transaction – and this happens entirely independently of the reserve requirement. In Australia, Canada, Sweden and New Zealand there are no bank reserve requirements.

–Chart of the Day: Excess Reserves

So, let’s talk about the banking sector, bank capital, leverage and fractional reserve banking for a second.

Capital and Leverage

Banking is problematic because it creates an inherent financial instability due to a potential mismatch between a financial institutions’ liabilities and its assets. Many financial institutions have fewer liquid assets than short-term liabilities and demand deposits. Moreover, if a financial institution gets into trouble from reckless lending or investing, it could sell its assets in order to cover its liabilities; but this would result in fire-sale prices. So even if the bank had enough assets to cover its liabilities, a run on the institution could render it insolvent, cascading its problem down the line to its own lenders.

Leading up to the credit crisis, the Federal Reserve under Alan Greenspan relaxed the  investment banking net capital rule, effectively allowing them to increase their leverage tremendously. This was an extreme act of reckless anti-regulation by the Greenspan Fed which had disastrous results when the investment banks’ investments went pear-shaped in 2007 and 2008, resulting in a run in the wholesale lending market. Yet, the relaxed anti-regulatory stance remains in effect today. That means another major asset downturn would create the preconditions for similar runs and insolvencies. Anyone who wants greater economic stability understands this is a problem. Some people like Simon Johnson have argued we need much more capital for these banks, as much as 30%.

But capital is not reserves. Capital is capital. Reserves are another matter.

Fractional Reserve Banking

Some people still believe in the money multiplier taught in old economic textbooks that fractional reserve banking has banks taking deposits, multiplying them as much as possible, subject to the reserve ratio, and making a much larger amount loans. That is not how it works. In practice, banks don’t wait for the reserves to be available to issue loans. They make loans first and then borrow the reserves in the interbank market. The loans come first, not the reserves.

Banks are never constrained by reserves or reserve ratios. Banks are capital constrained. In our fiat money system, the central bank uses reserves in the system to help the it hit a target interest rate. So, the central bank provides the system with enough reserves to meet any reserve ratio at its target rate. The reserves are about helping set interest rates, not about pyramiding money on a reserve base.

Understanding this should also help you understand why QE has been a boon for financial speculation but a bust in the real economy:

Now, the money multiplier – which is the mathematical ratio of base money to larger monetary aggregates like m2 m3 or MZM – exists. It’s just that the Fed doesn’t control it. They can print all the money they want, but if creditors and debtors aren’t solvent there isn’t going to be any additional lending.