Question

textbook theory argued that the ability of banks to create loans and deposits is constrained by the FED's 10% reserve requirement. Heterodox economists have long argued that large banks are not constrained by reserve requirements. The FED recently eliminated the 10% reserve requirement on demand deposits.

1. Explain why the loan creating ability of large banks is not constrained by reserve requirement.

2. What does constrain the loan creating ability of large banks?

Answer 1

1. To understand why reserve requirements do no constrain lending, one needs to understand how a bank operates. Banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share.

These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these horizontal transactions will not add the required reserves.

In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds. At the individual bank level, certainly the “price of reserves” may play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.

2. There are two broad considerations that may constrain bank's lending:

(a) banks are limited by profitability considerations; that is, given a certain demand for loans, banks base their lending decisions on their perception of the risk-return trade-offs, not reserve requirements.

(b) bank lending is somewhat also constrained by capital requirements, not reserve requirements. Since the government insures deposit accounts, the government tries to prevent excessive risk-taking by banks. For this reason, regulatory capital requirements have been implemented to ensure that banks maintain a certain ratio of capital to existing assets.

However, since capital requirements are specified as a ratio whose denominator consists of risk-weighted assets (RWAs), they are dependent on how risk is measured, which in turn is dependent on the subjective human judgment. Subjective judgment combined with ever-increasing profit-hungriness may lead some banks to underestimate the riskiness of their assets. Thus, even with regulatory capital requirements, there remains a significant amount of flexibility in the constraint imposed on banks’ ability to lend.