Banks are Capital Constrained, Not Reserve Constrained

Generations of economics students have been misled into believing that banks are reserve constrained. Even today, though most specialist monetary economists would likely cringe at the idea, there are widely used textbooks that teach this mistaken view to a new generation of students. Usually the story is framed in terms of a ‘money multiplier’ model in which an addition of reserves into the monetary system by the central bank will supposedly cause a multiplied increase in bank lending and in doing so expand the ‘money supply’ (in this context meaning currency plus deposits). In reality, banks create deposits (add to the money supply) in the act of lending. If they subsequently find themselves short of reserves, they can obtain them from other banks or, in the event of a system-wide shortage, they can borrow them from the central bank which is committed to acting as lender of last resort, a function that it must perform under present institutional arrangements to ensure smooth functioning of the system. The constraint on bank lending is profitability and bank capital, not reserves.

A 2015 Bank of England paper expresses the matter this way:

In the deposit multiplier model, the creation of additional broad monetary aggregates requires a prior injection of high-powered money, because private banks can only create such aggregates by repeated re-lending of the initial injection. This view is fundamentally mistaken. First, it ignores the fact that central bank reserves cannot be lent to non-banks (and that cash is never lent directly but only withdrawn against deposits that have first been created through lending). Second, and more importantly, it does not recognise that modern central banks target interest rates, and are committed to supplying as many reserves (and cash) as banks demand at that rate, in order to safeguard financial stability. The quantity of reserves is therefore a consequence, not a cause, of lending and money creation. (emphasis added)

The first point made in this passage is that banks do not (and cannot) lend out reserves, other than to other banks. Reserves, so long as they exist, never leave the banking system. They are used for final settlement of transactions between banks and for transactions between banks and the central bank. Nor do banks lend out funds deposited by customers. As the passage states, deposits are created by lending, not the other way round. (Deposits can also be created by government spending. But here, too, banks do not and cannot lend out the resulting deposits.)

The second and more important point emphasized in the passage concerns the conduct of monetary policy. If the central bank did not supply reserves on demand at its chosen rate, an influx of reserves (due, for instance, to government spending) or a reflux of reserves (due to tax payments) would cause the interest rate on short-term borrowing to deviate from target. In the case of reflux, final settlement of transactions might also be jeopardized.

The constraint on bank lending relates to profitability and bank capital, not reserves. Bank capital is the difference between the bank’s assets and liabilities. Bank assets include cash, government bonds and interest-bearing loans. Bank liabilities include customer deposits, debt and loan-loss reserves. The purpose of lending, from the bank’s perspective, is to make a profit. The risk is that loans might not be repaid. When there are too many bad loans, a bank will need to run down its capital to meet obligations. If necessary, it can borrow additional reserves from the central bank by supplying collateral in the form of government bonds.

The Bank of England paper sums it up as follows:

In the real world, banks provide financing through money creation. That is they create deposits of new money through lending, and in doing so are mainly constrained by profitability and solvency considerations. (emphasis added)

The cost of obtaining reserves will be factored in to a bank’s lending decision because it affects the profitability of the loan. But a shortage of reserves, in itself, will not prevent the loan since, if necessary, reserves can always be obtained at a price after the event.

The bank’s risk, as the quoted passage makes clear, is insolvency. A deposit is a bank’s promise to supply currency to the deposit holder, either on demand or after some agreed upon duration of time, as well as to have sufficient reserves or to obtain them as needed to facilitate final settlement of transactions undertaken by account holders.

Commercial banks cannot create currency or reserves. These originate from government. Government spending and central bank lending create reserves. Banks obtain currency in exchange for reserves. They obtain reserves, if possible, from other banks in the overnight market (with no need of collateral) or by borrowing from the central bank, in which case collateral is required, and comes out of the bank’s capital.

Making too many bad loans therefore leaves a bank exposed. Amid the losses from the bad loans, the bank still remains liable to its deposit holders to provide currency and/or facilitate final settlement of transactions. Depletion of the bank’s capital undermines its ability to obtain funds sufficient to meet its obligations.

Share

5 thoughts on “Banks are Capital Constrained, Not Reserve Constrained

  1. As usual, doing excellent work clearing up the many misconceptions that linger, in clear accessible language, thanks!
    I was trying to get back in touch with you but your twitter handle didn’t seem to be working. Just wanted to let you know that the book I mentioned to you a few months ago is live on Amazon. I am letting you know because your various posts on OMF and vertical and horizontal “money” were much of the impetus for the book! So thank you, first of all. I recommend heteconomist.com frequently for people trying to get a start on understanding real macro.

    Anyway, rather than trying to print/mail paper galley drafts of the forthcoming print book around the world, I have made a Kindle edition free to reviewers (and anyone else) who would like to give input or review the book (blog or amazon). I would love any input from you especially as your writing was an inspiration. At any rate, for anyone reading this, for the next 48 hours the Kindle edition is free to download at https://www.amazon.com/dp/B07PWRXTF2 or https://www.amazon.co.uk/dp/B07PWRXTF2 or the Australian site also.

    I hope you find it interesting and any input (from anyone here) is greatly appreciated.
    Kind regards,
    Clint
    (feel free to email me at cjballinger at gmail com (anyone) with any questions)

  2. Hi Clint. I no longer have twitter or facebook accounts. Congratulations on the new book, and thanks for the links. I will read it with interest along with the macro text by Mitchell, Wray and Watts that recently arrived in the mail.

  3. OMFG, where did you go?? I had THE BEST cat video to link to you on twitter just now … and POOF. How dare you stand me up like this?

    That’s it, I’m breaking up with you. Right here on your website for all the world to see. HAPPY now? Good job, Peter.

    ::stomps away::

  4. At the end of WWII my father and other young men came home. They were all children of the Great Depression, and they had seen the negative effects that government economic policies had forced on their lives, the lives of their parents, and the lives of their grandparents. Without realizing it, I was immersed in detailed oral histories about how the national government had failed generations of Americans—Americans I personally knew, who were my parents, my grandparents, and my great-grandparents.

    From the end of the war in 1945 until I went away to college in 1957. These young men, my heroes, discussed how the government had failed, and how, in the post-war years, it was continuing to fail its citizens, particularly those of the farming class. In the summer of 1949, the 100th anniversary of the California Gold Rush, these young men began to imagine what the world would be like if we discovered that the Rocky Mountains were made of pure gold. Over a period of years they constructed an imaginary world in which America had an unlimited supply of money. They pondered five questions with purpose and objectivity:

    Did the gold standard impose a limitation on our money supply? They decided that it did.

    Did this limited supply of money impose a limitation on economic growth? They decided that it did.

    Did disconnecting from the gold standard remove all limitations from our money supply? They decided that if we could control inflation our supply of money would be unlimited.

    Was there a way to control inflation? They decided that there was, and they designed it.

    What effect would our unlimited supply of money have on taxation? They decided that we would live tax-free lives.

    In effect, they were designing a new system of economics for America. When I went to college I majored in mathematics. In my freshman class in Finite Mathematics I was introduced to computers by my professor who was working as a consultant to IBM on programming languages and operating systems for IBM’s newest line of computers which began deliveries in 1965. I became a programmer and a designer of large scale systems of hardware and software for large enterprises. I realized that computers were the perfect tool to use in making the design of my father and his friends become real.

    In 1995 I retired, but continued to work on the design of a new system of economics. In 2004 I decided to work full time on the design of this new system as well as a new system of government for America.

    In 2004 I came upon MMT and its home site. I was delighted. I began to put forward my ideas on that site and was bitterly greeted by the old, NIH (Not Invented Here) syndrome which I had encountered many times in my working life. I defended my ideas and when I would not buckle under Randall Wray banned me from his site in a shower of insults. Okay.

    So, I wrote a book which describes my systems and includes a plan for implementing them. What is MMT’s plan?

    My reaction to MMT is that it is too timid. It does not do enough to solve our problems. The Jobs Guarantee is not nearly enough. My system does much better. My system… well, it is too much to go into here. But if you, by you I mean the principal of this site, want to read about it, I will be happy to instruct Amazon to send you a complimentary copy. All I need is an address to which Amazon can send a physical copy of the book.

    I think that MMT has done the nation a service by fighting its fight and I want our current systems of government and economics to be replaced. But I don’t want to squander the one chance that we may, I say “may” have before global warming shuts down everything.

    I guess that Wray and company are experts in economics, but that is not such a good thing. If you look at the world you can see that almost nothing of lasting value has been accomplished by economists. Engineers and scientists are the ones who build new things of lasting value and that is because they are the professions who are always working to achieve a positive result. Politicians, economists, religious leaders, banks, etc. etc. are not obliged to produce a real, positive result—they are part of the chattering class. Thus new systems of economics can never, will never, be designed and implemented by economists—it just won’t happen. I hope I am wrong…

Comments are closed.