BANKS ARE NOT MYSTICAL

(Cross posted from Modern Monetary Realism)

The recent crisis has been beneficial in at least one way – it has begun to shed light on some of the myths of our monetary system that have poisoned economics and politics for many decades.  If I had to rank some of these myths I would almost certainly put the currency user vs. currency issuer myth at the top of the list.  But a close second is the myth of the money multiplier.  Students are generally taught that our banking system works through some sort of “loanable funds” market or “money multiplier” whereby banks obtain deposits so they can then loan them out.  There’s just one problem with these ideas – they’re not right.

These ideas have all come to a head in recent weeks when Paul Krugman and Steve Keen got into a bit of a back and forth about the operational realities of the banking system.  I won’t comment specifically on the ideas of either men, both of whom are fantastic economists, but I think this conversation exposes the degree to which most people continue to misinterpret modern banking and requires some brief discussion.

The standard banking model says that banks are reserve constrained and that the amount of loans a given bank can make is a multiple of its reserves.   But the recent crisis has shot king sized holes in this myth.  The Fed has substantially expanded the amount of reserves in the banking system, but lending has flat-lined:

(Figure 1 – Total Reserve Balances vs. Total Loans)

This is a monumentally important chart so it’s important to understand a few points if you’re going to understand why the above chart looks the way it does:

  • Reserve balances are determined by the Federal Reserve who acts as the supplier of reserves to the banking system.  Banks can never “get rid” of reserves in the aggregate.  They can shuffle them among each other, but only the Fed can destroy or create reserves through open market operations.   The Fed oversees the payments system and in doing so must act to ensure that banks can obtain reserves in order to settle payments and meet reserve requirements as needed.
  • Bank lending is not reserve constrained (in fact, many countries don’t even have reserve requirements at all).  This means that banks do not need reserves before they make loans.  Instead, banks make loans first and obtain reserves in the overnight market (from other banks) or from the Fed after the fact (if needed).   New loans result in a newly created deposit in the banking system.
  • Banks are capital constrained.  Banks can always find reserves from the central bank so banks do not check reserve balances before making loans.  Instead, they will check the creditworthiness of the borrower and their own capital position to ensure that the loan is consistent with the goal of their business – earning a profit on the spread between their assets and liabilities.
  • Banks attract deposits because they want to maintain the cheapest liabilities possible in order to maximize this spread on assets and liabilities.   Banks are, after all, in the business of making a profit!
That pretty much sums up the above chart.  You don’t need to understand balance sheet recessions or liquidity traps to know what’s going on there.  You just need to understand how banking works.   Yes, it’s true that the balance sheet recession has been a truly unique period in American history.  But the above chart is only unique in that it exposed this great myth to the public.   When the demand for credit collapsed the Fed was nearly helpless in reviving the credit markets.   Despite a $1.6 trillion reserve injection the lending markets just didn’t budge.  This might have appeared like an anomaly to some, but to those who understood banking this made perfect sense.  More reserves were never going to result in more loans.  This was not because it had temporarily become true, but because this is the way banking works.  Not just inside a balance sheet recession or liquidity trap or whatever you want to call it, but always….
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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • SS

    Nice brief summary of a very important and complex topic. Thanks CR.

  • FDO15

    You’re way too generous letting Krugman off the hook like that. He deserves to be skewered for misunderstanding this so badly.

  • HankB

    Isn’t this just a chicken and egg story though? Reserves are needed in the sense that they’re required to settle payments and meet reserve requirements? No?

  • Jo

    Bayjayzus, Cullen’s a banking expert now as well…..no end to ‘is talents.

  • tom

    Cullen loans cant create enough deposits because they dont create cash, and money supply consists both of deposits and cash. And as Krugman said no responsible benking officer would make loan without prior having enough deposits.

  • But What Do I Know?

    Thanks for putting this so clearly, Cullen. The problem is getting the academic economists to admit they were wrong, and, in many cases, that their life’s work is based on misguided assumptions and faulty understanding of the real world. It’s easy enough for those of us with no vested interest to change our minds, but the ivory tower guys like Krugman (who I often agree with) simply can’t reverse course and admit they were wrong without facing professional scorn and losing prestige–the facts be damned.

    Something similar happened with the acceptance of quantum physics at the turn of the twentieth century–the old guard like Mach refused to accept it, leading to someone’s (Niels Bohr?) quip that Science advances one funeral at a time.

    Unfortunately we don’t have that long. . .

  • Dunce Cap Aficionado

    Loans create deposits.

    Bank A loans me $$ for a car.
    I take the $$ and buy the car from the dealership.
    The dealership deposits the $$ in Bank B.

    $$ is a loan first then becomes a deposit.
    Loans create deposits.

  • tom

    Dunce you are wrong. Banks know that some clients want cash so they can not loan without having enough cash. Their lending is constrained by monetary policy of central bank which controls monetary base. And no banking officer would make loan without prior having enough deposits.

  • Dunce Cap Aficionado

    Where did I say there is no capital (not reserve, capital) restraint for banks?

  • tom

    So do you agree that their lending is constrained by monetary policy of central bank which controls monetary base?

  • tom

    You have to assume that bank will either:

    1)have enough deposits before making loans or that
    2) it will receive money from central bank at predetermined price.

    It’s obvious that second assumption is much more riskier for banks in terms of profitability of their activities.

  • Dunce Cap Aficionado

    “So do you agree that their lending is constrained by monetary policy of central bank which controls monetary base?”

    In this context, can we agree ‘that controlling the monteary base’ is really a way of saying controlling the supply of reserves? That’s what you’re getting at, correct?

    “1)have enough deposits before making loans…”

    Yes but the desposits do not ‘create’ loans. The capital, as we can agree, must be there to loan out first (banks are capital constrained). BUT just because the capital is there does not mean it WILL be leant out in an amount according to the reserve ratio. It WILL be leant out based on the demand for loans from borrowers that banks consider loan-worthy. That’s the crux of ‘loans create deposits’- because the common (mis)understanding is that deposits directly create loans, when in fact there is not necessarily a direct correlation. ‘Loans create deposits’ is a way of simplifying a reality of the modern banking system- if a bank issues a loan, it WILL end up somewhere in the banking system as a deposit (at least the vast majority of the time).

    “2) it will receive money from central bank at predetermined price.”
    By ‘money’ are we, again, talking specifically about reserves? I think I see what you’re getting at, but correct me if I’m wrong. You seem to be making the argument that the CB must provide enough reserves in relation to the demand for loans from banks (and that they willing to make) and if they do not, banks WOULD become reserve constrained. Straighten me out if I’m reading you wrong.

  • Colin, S.Toe

    Great thinkers have a knack for seeing simplicity underlying apparent complexity.

    Great teachers have a knack for expressing this simplicity clearly for others to understand.

  • http://www.pragcap.com Cullen Roche

    Are you referring to reserve requirements? That’s 10%…

  • http://www.pragcap.com Cullen Roche

    Banks can always obtain funds from the central bank. That’s one of the key points here….

  • Dunce Cap Aficionado

    I don’t want to put words in Tom’s mouth, but he seems to be making an argument that if the CB wanted to they could ‘withold’ enough reserves from the system so that banks would be reserve constrained. This ignores the overnight market, correct?

    Dan M. posted the link to PKs latest shot across Scott Fullwiler’s bow over at MMR.
    http://krugman.blogs.nytimes.com/2012/04/02/things-i-should-not-be-wasting-time-on/

    PK seems to be saying (this is my lay interpretation, kindly correct me if I’m wrong) ‘Look, the maintence mechansim currenlty in place was not always and the rate (in the overnight market, I assume) for reserves used to fluctate wildly.’ Ok, sure, but that doesn’t mean banks could not obtain them at will…

  • Dan M.

    If reserves are essentially free, but the fed window costs 3% (no idea here), is that not an implicit “constraint.”

    Note, I’m not saying it’s IMPOSSIBLE to secure funds su much as it is a form of a constraint.

    Maybe the terms “soft constraint” vs “hard constraint” would be appropriate.

    Thanks for any input.

  • tom

    Cullen, banks can not always obtain funds from the central bank at predetermined price. That is only assumption that MMT is constantly making. It is obviously wrong.

  • http://www.pragcap.com Cullen Roche

    This ins’t MMT. It’s just banking. Banks can always obtain funds from the central bank if necessary. Every banker knows they can obtain funds from the overnight market or Fed Discount Window.

  • Dunce Cap Aficionado

    “A smart man can understand something complicated, but the nature of genius is understanding something complicated and being able to explain it a simple way.”
    – I have no idea and can’t find the source.

  • http://www.pragcap.com Cullen Roche

    I guess you could say that if the Fed didn’t supply funds ever then yes, the banking system might freeze up. But it’s their job to ensure a smooth payments system.

  • tom

    Dunce, Krugman is right. Just think about it. If banks wanted to make loans without prior deposits relying only on funds from CB without fixed price that would be very risky, wouldnt it?

  • http://www.pragcap.com Cullen Roche

    No one is saying banks don’t want deposits for purposes of obtaining cheap liabilities. What we’re saying is that these deposits aren’t multiplied. There’s a big difference.

  • Dan M.

    But in using term “constraint” in lending we’re not talking about the whole system freezing up so much as it being progressively more risky for banks to lend,are we not?

    You are right about banking being a game of spreads, but if you are tapping the fed window now you’ve entered a degree of increased potential interest rates, and will probably start increasing rates on borrowers, correct?

  • tom

    Cullen, but Fed can always change its rates, right? And how can you make loans knowing it and not having deposits? Dont yoo think it’s risky?

  • Dunce Cap Aficionado

    “If banks wanted to make loans without prior deposits…”

    No one said that, your assumptions about my view are incorrect. I have said several times that banks ARE captial constrained.

    “…relying only on funds from CB without fixed price that would be very risky, wouldnt it?”

    These funds are reserves, yes? (You still have not answered that question) Banks don’t lend reserves…

  • http://www.pragcap.com Cullen Roche

    The Fed Funds rate is generally pretty stable and when it does change it generally only changes by 0.25%. So I wouldn’t worry too much about variance in rates and being able to predict loan profitability.

  • tom

    Cullen but it cant be true that loans create deposits because it implicitly assumes that banks are always able to provide cash. And it is not true because it depends on monetary policy of CB. As Krugman points out “The Fed didn’t introduce Fed-funds targeting until the 1980s. Before that, the interest rates at which banks could borrow additional reserves fluctuated day by day”
    So it means that banks had to have deposits before making loans because it was too risky to rely only on CB.

  • tom

    Cullen, during the eighties effective funds rate fluctuated from 7% to more than 20%. So if you had bank you certainly would think about it before pushing these MMT “theories”.

  • http://www.pragcap.com Cullen Roche

    Back when banks were first founded by goldsmiths, they quickly realized that they could lend out more than they had because the customers didn’t come for all the gold at once. The world is no different today….

  • tom

    Banks lend deposits. It is as simple as that. It doesnt matter that these loans are later deposited. Because deposits always come first. You cant run safe banking business if you dont know the price of your funds. And you can know it with adequate precision only if you first acquire deposits and then lend them.

  • http://www.pragcap.com Cullen Roche

    Of course the rates change. The Fed sets them. There’s nothing theoretical there.

    The Fed targeted short rates in the 70’s and briefly switched their operating target to other monetary aggregates in the period from 79-82. They noticed higher fluctuations in rates so switched back. This doesn’t really change anything though….

  • tom

    Cullen, I agree that world is no different because today just like with goldsmiths deposits always come first. And goldsmiths didnt lend more than they had because their assets always equalled their liabilities. There was only a problem of maturity mismatch but that is different matter.

  • DanH

    Tom – There is 60 trillion in credit outstanding and about 5 trillion in cash. Where do you think the credit came from?

  • http://www.pragcap.com Cullen Roche

    Goldsmiths DID lend more than they had. They could do so because they knew all the customers didn’t come back for their gold all at once….

  • Dimm

    I think prof. Krugman is wrong on banking. This is the only area where his argument is narrative driven vs charts and numbers. He tells a story, not hard facts.
    If deposits create loans he should show the relationship on few graphs.
    2 banks, 2 nations and Global. 5 graphs can solve the argument.

  • Johnny Evers

    This is a mildly terrifying concept.
    Not only have I learned in here that the Fed has no constraint on what it borrows, other than hyperinflation which we can never see until it’s too late, now I learn that banks have no constraints on what they lend — other than their ability to find reserves from the central bank, which, as we’ve learned in the financial crisis, are also limitless.

  • Dunce Cap Aficionado

    I never disagreed with that, you again seem to be assuming things about my view of the banking system- as I said above (10:37 am post) the oft used (around here) line ‘loans create deposits’ is a response to the widely held belief that banks loan out as much as they can and the ONLY constraint or determing factor of that amount is the reserve requirement. So can we just get past the point that we AGREE that banks are capital constrained? I have never disagreed with you about that…

    The fact is (and this is an operational reality, not theory) banks loan first (based on whether they want to make the loan once the ‘demand’ for the loan has presented itself) and then make sure they meet the reserve requirements, usually going to the overnight market if they have to acquire more reserves.

    Banks generally hit keystrokes to make loans, then go make sure they have the reserves to back the loan. I know you know this- your point is that if that rate fluctuated greatly instead of being ‘set’ by the CB (as it did back in the early 80s under different policies than are currently in place…) it would create ‘risk’ because the loan could be made based on the FFR being lower than it is when the bank actually goes to the ONM to meet the RR.

    Why would the CB allow that destabilization (them no longer setting the rate) to occur? Their mandate is to the contrary…

  • Dan M.

    DCA,

    Regarding the overnight market, isn’t that looking at it from a micro perspective, when we should be looking at macro? A SINGLE bank can access the overnight markets, but they can’t all do so, so in general, as lending overall pushes closer to the limits of the reserve requirement, aren’t banks going to start looking to the fed window, which is inherantly at least somewhat more risky than their own reserves or overnight rates?

  • Geoff

    This is at least the second time that Mr. Krugman has pushed things to the extreme in an attempt to make a point against MMT/R. The first was when he tried to argue that financing the deficit by “printing money” instead of borrowing would be inflationary if taken too far. Of course it would be if the deficit became too large, but that is not the case at present. Quite the opposite. Now he is trying to argue that banks would not be able to obtain reserves in the extreme case that the Fed cuts them off? Give us a break.

  • Dunce Cap Aficionado

    Could be wrong here, but my understanding is that the discount window is ‘usually’ around 1% above the FFR. But througout the crisis the Fed has actually made the window cheaper than that- walking down the spread in 2007 to 50 bps and then down to 25 bps in 2008 (March).

    I don’t see a great deal of risk there- the time periods that the Fed even considers changing the discount window’s rate are well known and the ‘spread’ is fairly predictable.

    I would bet that we won’t see them walking the spread back up to the 1% range until the window is much less likley to be used.

  • Dunce Cap Aficionado

    Dan M.,

    I don’t see the window as being risky- see my comment in response to your comment below.

    PK’s whole argument is based on the idea that the Fed will act in a way that will make the monetary system less stable (by them no longer setting the rate!). Why would they do this- their job is the opposite of this? The argument is based almost entirely around a potential gross negligence or malevolence. Not PKs usual style.

  • Dunce Cap Aficionado

    “The time periods that the Fed even considers changing the discount window’s rate are well known and the ‘spread’ is fairly predictable.”

    Sorry, that first part isn’t really accurate. But the window’s rate ‘follows’ the target rate and has gotten closer to it as the crisis has gone on. I would think there is no reason to see the window’s rate creeping back up to the 1% above FFR range until the window is in less demand.

  • jt26

    Dumb question on banks vs. others in creating horizontal money …

    I’ve previously read Mosler and others say, as examples, that the following can create horizontal money:
    (a) credit card companies
    (b) foreign entities issuing in USD (e.g. an Indian steel company issues USD bonds)
    (c) anyone that issues commercial paper in USD
    (d) anyone that extends”credit”/IOU

    I can understand how banks are special in that (most of the time) banks trust each other in lending, and can borrow fed funds or at the discount window (i.e. banks have a special credibility in creating money that is recognized by other banks and the Fed).

    I’m having a tough time understanding the other examples, unless the banking system works in parallel (e.g. for (c) someone borrows the money from a bank to invest in commercial paper). I can see (d) creates a balance sheet item (accounts receivable), but that doesn’t create deposits anywhere.

  • tom

    Geoff, but the problem is that Krugman was both right in his opposition to this mmt “theory”. And Fed can cut off any bank if it doesnt serve its main goal (inflation and unemployment control). Actually more than 300 hundred banks failed in the last four years. In contrast, in the five years prior to 2008, only 11 banks had failed.

  • Geoff

    Tom,

    I don’t know the history of all 300 cases, but my bet would be that they failed for capital reasons, not reserves.

  • tom

    Dunce, the fact is that no bank would make any loan out of proportion to its deposits. If you dont believe it go to any investemnt comitte in the bank. And in regards to CB their mandate is to control inflation and unemployment not save every bank. In fact more than 300 banks have failed from 2008.

  • http://www.pragcap.com Cullen Roche

    Banks always fail for capital reasons. Reserves are an asset. If a bank can’t make loans because of capital problems it’s not because reserves weren’t plentiful. It’s most likely because they’re underwater on their loans. Of course the govt shuts down banks that are insolvent. That’s what they’re supposed to do.

  • tom

    Actually it doesnt matter. They didnt have enough money to meet their obligations.

  • tom

    Cullen so your claim is that bank may not be able to make loans even if it has plentiful of reserves? But you have admitted that they are assets. Surely you can change any liquid asset into a loan, right?

  • Pierce Inverarity

    I have to ask, have you ever worked at or for a bank?

  • Dunce Cap Aficionado

    “Dunce, the fact is that no bank would make any loan out of proportion to its deposits”

    I have agreed with you repeatedly on this- Banks are capital constrained, banks that are not responsibly capitalized get into hot water and/or ultimately fail. That failure has nothing to do with reserves (reserves are never loaned, because they are reserves).

    “And in regards to CB their mandate is to control inflation and unemployment not save every bank”

    Yes, my use of the word mandate was inaccurate. That is a more than fair cirticism.

    Let me rephrase; why would the Fed stop setting rates and allow the FFR market to go back to the way it was in the early 80s? I can’t think of a reason the Fed would want to do that, so I’m interested in your ideas.

    Also, if they did stop setting the rate for whatever reason, it does not prevent banks from getting reserves (although your ‘risky’ argument then applies to the reserves obtained, but this is hypothetical and not how the current system is operating) either from the ONM or DW.

  • Dunce Cap Aficionado

    Replied to your below post so we don’t keep running out of ‘reply’ tabs.

  • tom

    Dunce, do you also agree that excessive reserves can be loaned? And what do you mean by “Banks are capital constrained” if banks can always get money from CB as MMT claims? It doesnt matter if CB sets interest rates or monetary base because CB should be always treated as lender of last resort. In daily activities banks buy assets using earlir acquired funds.
    And ONM and DW are also CB dependant

  • tom

    Pierce,
    Yes

  • Dunce Cap Aficionado

    “Dunce, do you also agree that excessive reserves can be loaned?”

    In the ONM, yes, at the FFR which is generally the same at which they would have obtained the reserves.

    “And what do you mean by “Banks are capital constrained” if banks can always get money from CB as MMT claims?”

    (I continue to assume you mean ‘reserves’ in this context when you say ‘money’ as you still have not address it when I have asked twice) Banks get, specifically, reserves from the CB. Reserves do not get loaned, they are loaned against, that is the definition of reserves, no?

    ‘Loaning’ excess reserves in the ONM and putting an actual loan out into the private sector (which would be above the are 2 very, very different things to me.

    “And ONM and DW are also CB dependant”

    Obviously. The DW and ONM are how banks obtain reserves. The CB is the monopoly supplier of reserves. Please elaborate I’m failing to see your point- If its that the CB ‘could’ pull the rug out from the ONM and close the window, I again ask you why they would do this.

    I feel like we’re talking in circles, but I have enjoyed the discourse thus far.

  • Dunce Cap Aficionado

    Sorry, hit reply to my own comment above instead of yours here. Reposted-

    “Dunce, do you also agree that excessive reserves can be loaned?”

    In the ONM, yes, at the FFR which is generally the same at which they would have obtained the reserves.

    “And what do you mean by “Banks are capital constrained” if banks can always get money from CB as MMT claims?”

    (I continue to assume you mean ‘reserves’ in this context when you say ‘money’ as you still have not addressed it when I have asked twice) Banks get, specifically, reserves from the CB. Reserves do not get loaned, they are loaned against, that is the definition of reserves, no?

    ‘Loaning’ excess reserves in the ONM to banks looking to meet their RR and putting an actual loan out into the private sector that (which would be above the are 2 very, very different things to me.

    “And ONM and DW are also CB dependant”

    Obviously. The DW and ONM are how banks obtain reserves and the CB is the monopoly supplier of reserves. Please elaborate I’m failing to see your point- If its that the CB ‘could’ pull the rug out from the ONM and close the window, I again ask you why they would do this.

    I feel like we’re talking in circles, but I have enjoyed the discourse thus far.

  • Dunce Cap Aficionado

    Yikes, in my above post, ‘Loaning’ excess resvers….. should be-

    ‘Loaning’ excess reserves in the ONM to banks looking to meet their RR and putting an actual loan out into the private sector (at a rate that would be above the FFR they obtained the reserves that are held against the loan for) are 2 very, very different things to me.

  • Mr. Market

    1. There’s no “”money multiplier””-machine. Banks multiply credit. (Source: “”Conquer the crash””, Robert Prechter, 2001 & 2009).
    2. The only one that can create “”money out of thin air”” is a Central Bank (e.g. ECB, FED, BoC, BoJ, BoE).
    3. When a central bank creates new money “”out of thin air”” and increases banks reserves then banks can play their “”multiply credit”” game.
    4. The central bank can – most definitely – increase bank reserves. And what do these banks do in the current situation with their reserves ? They buy T-bonds or (in the US) municipal bonds (Source: Meredith Whitney). This is O.K. as long as interest rates remain flat or don’t rise. In this particular case banks act like any other investor. So, they WILL sell their T-bonds when (NOT IF) interest rates rise.
    5. When interest rates rise (Greece anyone ???) then banks do REALLY get into trouble as well. That’s precisely what’s happening in Europe these days.
    6. But when all asset classes fall in price then central banks can create all the money they want but then no speculator or investor is willing to borrow that money to bet on rising asset prices. And then EVERY central bank is powerless.

  • Mathew Gibson

    tom,

    The position you espouse seems commonsense enough: smart banks do not lend beyond their means, and those that do eventually go under. Ergo, smart banks ensure they have the means to cover a loan before they make it. In your version, this means they already have the capital.

    Consider Cullen’s model from another commonsense approach: a bank will never refuse a loan when they are (broadly) certain the loan will be repaid. This is how they make (most of) their money. They are, in this sense, no different to other smart business, in that they will not easily turn away a customer. They will find the means to make the loan happen, because that is their business.

    What is critical is that it is the loan that drives the process, not the deposit. If there there was no desire to borrow, banks would simply not exist (vaults would, banks wouldn’t). The presence in the marketplace of credit-worthy customers compels the profit-seeking bank to find the capital once the loan has been signed.

    The only part of the process that changes over time is how a bank defines “credit worthy,” and I think this is what Krugman is getting at with his view that deposits drive loans, because part of the model for defining credit worthiness is the projected cost of the funds a bank will need to secure in order to cover the loan they want to make.

    This is not a chicken-and-egg thing, however. A bank will not go out and secure capital to back up loans they have not already made, because the cost of the liability (the funds they have secured) should the loan not go ahead (borrower backs down, chooses another bank, etc.) would mean a loss.

    So, while loans not only “create” deposits in an accounting sense, they drive deposits, they are the agent in the process of banking, and not the other way around, not philosophically or financially.

  • Dunce Cap Aficionado

    Very, very well stated.

    I’m taping out and taking this hat off.

  • ES71

    > Banks can always obtain funds from the central bank. That’s one of the key points here….

    That is a key assumption, actually. In case of run on the bank CB must be willing to back stop the bank. Wouldn’t that bve called a “bailout” in our current speak? So, I don’t think it is not necessarily a given since population is against any sort of bailouts.
    In my experience with Russian default the CB refused to give banks even rubles, so they all toppled like dominos when people started withdrawing the money due to panic. These banks weren’t underwater on the loans.

  • http://www.nowandfutures.com bart

    A much fuller and accurate view, which shows the actual raw relationship between base and *total* credit. It has been quite stable overall for decades.

    http://www.nowandfutures.com/images/base_vs_total_credit.png

  • jgb

    Totally dumb question, but what is the difference between reserves and capital?

  • tom

    Matthew, bank will certainly not refuse loan (with the exception of the client being too big) but it will charge higher rates if demand is high so it can earn more and/or ensure that it will find stable financing base even at the higher cost. So by higher interest rates they are exactly securing capital to back up loans. When demand for loans is high they also increase their advertising on deposits so the growth of loans and deposits is comparable.

  • tom

    Matthew, and Krugman pointed out that loans are financed both by deposits and cash. And because of that it’s wrong to assume that loans can create enough deposits (on aggregate level). It would imply that the level of cash is not important in the economy and it’s obviously wrong.

  • skeptic

    So how do you explain the banking system in countries that don’t have reserve requirements?

  • Dan M.

    I believe it’s the equity position of the bank… Assets – Liabilities = Equity.

    So if on 9/20/08 ABC Bank’s loans to homeowners drop a bucketload in value, that’s the bigger constraint on a bank’s ability to borrow.

    Obviously, the liability portion of their balance sheet tends to stay pretty fixed. Good loans are what keeps the asset side of their balance sheet more boueyed and good investment (collateral) is the backbone of a good loan.

  • http://www.pragcap.com Cullen Roche

    Yes, capital is equity. Reserves are an asset.

  • Cy Hailow

    Thanks for the coverage on this topic Cullen :)

  • InvestorX

    On the previous debate, he could have had some merit. But with this one he totally discredits himself. He should give back his Nobel prize.

  • http://www.pragcap.com Cullen Roche

    In his defense, his Nobel is on international trade. Not banking. He can keep it in my opinion. :-)