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ignores the fact that central bank reserves cannot be lent to non-banks (and that cash is never lent directly but only withdrawn against deposits that have first been created through lending).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.