At the point I make a loan, 2 things happen on my balance sheet: I have a new liability to you (the increased balance in your account), and I have a new asset (the loan that you’re expected to pay back). They cancel each other out and it therefore seems as if I’m creating money out of thin air.
However, the moment you actually use that money (eg to buy something), the money leaves the bank (unless the other account is also at this bank, but let’s keep it simple). Liabilities on the balance sheet shrink, so assets need to follow. That needs to come from reserves because the loan asset keeps its original value.
The reserve comes from the bank, not from you. Added layer here: Banks can borrow money from each other or central banks if their cash reserves runs low.
Finally: it tends to be the case that the limit on lending is not the reserves, but on the capital constraints. Banks need to retain capital for each loan they make. This is weighed against the risk of these loans. For example: you could lend a lot more in mortgages than in business loans without collateral. Ask your favorite LLM to explain RWAs and Basel III for more.
> However, the moment you actually use that money (eg to buy something), the money leaves the bank (unless the other account is also at this bank, but let’s keep it simple). Liabilities on the balance sheet shrink, so assets need to follow. That needs to come from reserves because the loan asset keeps its original value.
"Everything should be made as simple as possible but no simpler."
You're omitting the thing that causes the money to be created out of thin air. If the other account is at the same bank, now that customer has money in their account that didn't previously exist. And the same thing happens even if the money goes to a customer at another bank -- then that bank's customer has money in their account that didn't previously exist. Even if some reserves are transferred from one bank to another, the total reserves across the whole banking system haven't changed, but the total amount of money on deposit has. And the transfers into and out of the average bank are going to net to zero.
The created money gets destroyed when the loan is paid back, but the total amount of debt generally increases over time so the amount of debt-created money goes up over time as banks make new loans faster than borrowers pay them back.
Your loan is loan+interest;
when your loan is created, we do not create the interest-part on it - the interest-part is the rest that you have to pull from someone else, since bank gives you loan X - but asks loan X + interest Y back from you -> thats the reason why there needs to be another fool somewhere else who is then again taking a loan.
its one of the main architectural choices of our money architecture :-D
>>
The reserve comes from the bank, not from you. Added layer here: Banks can borrow money from each other or central banks if their cash reserves runs low.
<<
Not correct: it can be both - on your central banking account, you can receive money from other banks (lending on the "interbanking market") _or_ customers (when they send money to your bank).
Yes, they do not need customer deposits to create loans and increase their balance sheet, there are just some guys like you and me, putting the amount in the balance sheet and clicking save (simply put)
But yes, they need to have at least some customer deposists to make payments happen, since if they do not have any deposits, their central banking account would be empty, therefore none of your loans could actually leave your bank since the transaction wont happen.
(i'm talking from perspective of TARGET2 / ECB / EURO system)
That is exactly what happens. Reserve ratio used to be 10%, same as your example. The reserve ratio is currently zero, lowered in 2020 during pandemics. But banks still can't lend out more than deposits.
> The reserve ratio is currently zero, lowered in 2020 during pandemics.
I saw this during the pandemic, and it bewildered me how little coverage of it there was. How is this not going to cause another financial catastrophe? And if we're so sure it isn't, then what makes people think they under economics so well, given that they clearly thought a minimum was necessary just a few years ago?
> I saw this during the pandemic, and it bewildered me how little coverage of it there was. How is this not going to cause another financial catastrophe?
The banks in Australia, Canada, etc have had zero reserve requirements for thirty years:
The US had reserve requirements leading up to the 2008 GFC which started off with mortgages/loans, and yet those requirement didn't stop the disaster. Canada et al did not have requirements, and yet it didn't have a financial meltdown (not itself, only as 'collateral damage' to what happened in the US).
Because what matters is _Capital_ requirements, which differ by the _risk_ of the loan. A bank's Capital is what limits their ability to lend. Reserve requirements are irrelevant in the modern banking system.
the do lend out more than they have _currently_ as deposits on their central banking accounts, you have to care about "duration transformation" - JPM has billions of loans and deposits, though most of the deposits may be currently "out of the house" (borrowed)
Now, for sure could JPM increase the balance sheet even more by another loan, if they still meet whatever balance-sheet-restrictions and if they have enough money on their central banking account.
(sure, if the loan is for a customer within the same institution, then there is no difference)
It’s a bit more complicated than that.
At the point I make a loan, 2 things happen on my balance sheet: I have a new liability to you (the increased balance in your account), and I have a new asset (the loan that you’re expected to pay back). They cancel each other out and it therefore seems as if I’m creating money out of thin air.
However, the moment you actually use that money (eg to buy something), the money leaves the bank (unless the other account is also at this bank, but let’s keep it simple). Liabilities on the balance sheet shrink, so assets need to follow. That needs to come from reserves because the loan asset keeps its original value.
The reserve comes from the bank, not from you. Added layer here: Banks can borrow money from each other or central banks if their cash reserves runs low.
Finally: it tends to be the case that the limit on lending is not the reserves, but on the capital constraints. Banks need to retain capital for each loan they make. This is weighed against the risk of these loans. For example: you could lend a lot more in mortgages than in business loans without collateral. Ask your favorite LLM to explain RWAs and Basel III for more.
> However, the moment you actually use that money (eg to buy something), the money leaves the bank (unless the other account is also at this bank, but let’s keep it simple). Liabilities on the balance sheet shrink, so assets need to follow. That needs to come from reserves because the loan asset keeps its original value.
"Everything should be made as simple as possible but no simpler."
You're omitting the thing that causes the money to be created out of thin air. If the other account is at the same bank, now that customer has money in their account that didn't previously exist. And the same thing happens even if the money goes to a customer at another bank -- then that bank's customer has money in their account that didn't previously exist. Even if some reserves are transferred from one bank to another, the total reserves across the whole banking system haven't changed, but the total amount of money on deposit has. And the transfers into and out of the average bank are going to net to zero.
The created money gets destroyed when the loan is paid back, but the total amount of debt generally increases over time so the amount of debt-created money goes up over time as banks make new loans faster than borrowers pay them back.
Not correct:
Your loan is loan+interest; when your loan is created, we do not create the interest-part on it - the interest-part is the rest that you have to pull from someone else, since bank gives you loan X - but asks loan X + interest Y back from you -> thats the reason why there needs to be another fool somewhere else who is then again taking a loan.
its one of the main architectural choices of our money architecture :-D
1 reply →
>> The reserve comes from the bank, not from you. Added layer here: Banks can borrow money from each other or central banks if their cash reserves runs low. << Not correct: it can be both - on your central banking account, you can receive money from other banks (lending on the "interbanking market") _or_ customers (when they send money to your bank).
The bank could also sell the loan instead of borrowing if they are in need of capital.
> So for every $1 deposited, I can lend $0.90 but must hold $0.10 as my reserve?
The GP is completely wrong on how modern finance works. Banks do not lend out deposits. This was called the "Old View" by Tobin in 1963:
* https://elischolar.library.yale.edu/cowles-discussion-paper-...
The Bank of England has a good explainer on how money is created:
* https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/m...
See also Cullen Roche:
* https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1905625
* https://rationalreminder.ca/podcast/132
Partially untrue:
Yes, they do not need customer deposits to create loans and increase their balance sheet, there are just some guys like you and me, putting the amount in the balance sheet and clicking save (simply put)
But yes, they need to have at least some customer deposists to make payments happen, since if they do not have any deposits, their central banking account would be empty, therefore none of your loans could actually leave your bank since the transaction wont happen. (i'm talking from perspective of TARGET2 / ECB / EURO system)
That is exactly what happens. Reserve ratio used to be 10%, same as your example. The reserve ratio is currently zero, lowered in 2020 during pandemics. But banks still can't lend out more than deposits.
> The reserve ratio is currently zero, lowered in 2020 during pandemics.
I saw this during the pandemic, and it bewildered me how little coverage of it there was. How is this not going to cause another financial catastrophe? And if we're so sure it isn't, then what makes people think they under economics so well, given that they clearly thought a minimum was necessary just a few years ago?
> I saw this during the pandemic, and it bewildered me how little coverage of it there was. How is this not going to cause another financial catastrophe?
The banks in Australia, Canada, etc have had zero reserve requirements for thirty years:
* https://en.wikipedia.org/wiki/Reserve_requirement#Countries_...
The US had reserve requirements leading up to the 2008 GFC which started off with mortgages/loans, and yet those requirement didn't stop the disaster. Canada et al did not have requirements, and yet it didn't have a financial meltdown (not itself, only as 'collateral damage' to what happened in the US).
Many central banks like the Bank of England don't even have a reserve requirement and rely on the bank rate to control it instead.
The equivalent for the USA would be the Federal Funds Rate, I suppose. The reserve requirement is just one tool among many.
Because what matters is _Capital_ requirements, which differ by the _risk_ of the loan. A bank's Capital is what limits their ability to lend. Reserve requirements are irrelevant in the modern banking system.
Technicaly not accurate:
the do lend out more than they have _currently_ as deposits on their central banking accounts, you have to care about "duration transformation" - JPM has billions of loans and deposits, though most of the deposits may be currently "out of the house" (borrowed) Now, for sure could JPM increase the balance sheet even more by another loan, if they still meet whatever balance-sheet-restrictions and if they have enough money on their central banking account. (sure, if the loan is for a customer within the same institution, then there is no difference)
Deposits≥Loans is a tautology since every time loans increase, so do deposits. It doesn't mean anything or provide any insight.
Even deposit liabilities matched by deposit assets in other banks are essentially inter-bank loans. That is, deposits=loans in all cases.
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Fortunately, loans create deposits, so they are always in balance.