For the purpose of discussion here, we should probably simplify the banking operation and agree that we will be discussing simple banks that are (a) started with a certain dollar amount of capital, (b) accept deposits and (c) make loans secured by collateral in the form of pledged wealth and income of the borrower. That means we will not discuss "securities" because a government bond, for instance, must be handled quite differently than a home mortgage as far as the "reserves" are concerned.
1) According to U.S. law all U.S. banks must maintain a certain amount of reserves to cover the banks' obligations to customers who have deposited their money in the bank. Whether or not these reserves serve any real purpose is a matter of debate we can leave for another time. The fact is that these requirements are part of banking laws and they must be observed.
2) The following reserve requirement ratios are prescribed for all banks. The numbers come from § 204.9 (e) of << http://www.fdic.gov/regulations/laws/rules/7500-500.html >>, a federal law. Scroll down to the links under “regulations” § 204.9 for “Reserve requirement ratios”.
3) “Net Transaction Accounts” is basically the dollar value of all customer’s deposits and accounts receivable on the bank’s books. The precise definition of transaction account comes from § “202 Definitions” of the URL immediately above: (scroll down at the URL to the links under “regulations” § 204.2 --”definitions”) it is reproduced directly below at 4) below.
4) “(e) Transaction account means a deposit or account from which the depositor or account holder is permitted to make transfers or withdrawals by negotiable or transferable instrument, payment order of withdrawal, telephone transfer, or other similar device for the purpose of making payments or transfers to third persons or others or from which the depositor may make third party payments at an automated teller machine (“ATM”) or a remote service unit, or other electronic device, including by debit card ... “
5) The following reserve requirement ratios are prescribed for all depository institutions, banking Edge and agreement corporations, and United States branches and agencies of foreign banks:
8) In other words, if a bank has a total of $50 million of (a) customer’s deposits and (b) loans to borrowers on its books, it must have $1,648,000 as a reserve [$1,038,000 + $610,000 (10% of $6,100,000)].
9) That $1,648,000 is about 3.3% of the $50 million. That means such a bank can lend about 30 times as much money as it has in “net accounts”.
10) Note that the bank needs zero reserves if it has up to $9 million dollars in loans out to customers. In other words, if a bank has none of its own money (capital) in the bank -- it can still lend out up to $9 million.
11) The above material does not make it clear that the bank owners' investment (capital) in the bank also serves as a "reserve". In other words, when a bank opens its doors on the first day of business -- it has no deposits and no loans to customers -- therefor no "transaction accounts". It has only its invested capital. But at that precise moment it can lend money based on its invested capital. It must be that it is a common operating practice that the banks capital is counted as a transaction account. I am assuming that preceding statement is a fact. If it is not, I would appreciate hearing from a bank operating officer who can give me the contrary details.Martycarbone
12) If the above is correct and a bank opens with say one million dollars of invested capital ( or ANY lesser amount) -- that means the bank can immediately lend $9.3 million. If this is not correct, please post contrary information with substantiating references.Martycarbone
NOTE -- In reality, Banks do not need “reserves” -- they make money out of thin air as explained below.
a) When a bank makes a loan to a customer, it immediately records that loan as an asset on the bank’s books.
b) That “asset” immediately increases the “Transaction Accounts” (see #2 to 4 above) by the dollar amount of the loan and it also increases the bank's "Reserves" by the amount of the loan.
c) Therefor it can be truthfully said that “all loans create their own reserves”.
d) That logically leads to the conclusion that banks can lend out an infinite amount of money.
e) We hesitate putting that (d) conclusion here because most people can’t accept that as being true -- because we all “know” that there can’t be an “infinite amount of money”. The statement boggles the minds of most of us and we are unable to rationally consider any further discussion of the subject.
f) The problem is that the word “reserve” is a rhetorical trap when used in this context.
g) Here is a common definition of “reserve” when used as a verb, from my computer’s dictionary -- “refrain from using or disposing of (something); retain for future use : roll out half the dough and reserve the other half”. That “other half” is usually called a “reserve” -- the noun form of the word.
h) If such a definition is applied to a loan from a bank, it would be logical to assume the bank has a certain amount of money and it is lending the customer some of that money -- keeping some in “reserve”.
i) But that is not what actually happens. In reality, when a bank makes a loan -- it truly creates that money on the spot. In other words “it creates the money out of thin air”. Those 8 words are not swallowed easily. There is something inside us that will not accept anything being made out of “thin air”. But, in realty, every abstract thing is always made out of thin air. Love, dreams, beauty, joy, a joke, a story and the law are all parts of the theoretically infinite abstract world that is, figuratively, “made out of thin air”. We know this is a little mind boggling. Because of the laws of physics, we all tend to think you can’t make something from nothing, therefor, you can’t “make money out of thin air”. But that thinking is fallacious. In fact, laws of physics teach that Matter and Energy can neither be created nor destroyed -- but they can be made to change form. Fractional reserve banking essentially allows money to change form. A farmer can turn money into turnips and back again to more money if that farmer uses borrowed money to buy seed and grow turnips that he sells for more money than he borrowed. Doesn’t that make sense? Even if this little explanation makes no sense to you -- remember, abstract things are always made of thin air.
j) It is important that we all understand this. Without that understanding, it is impossible to understand how money works.
k) The difficulty in understanding this point is because the money we are most consciously familiar with exists as (1) a physical thing we can hold in our hands and put in our pocket -- but it is ALSO (b) an abstract thing that has no physical reality (it is figuratively made of thin air). That dual nature of “money” makes it hard to logically wrap our minds around the word.
If, after reading all this, you still can’t grasp the concept that our banking system does not need reserves, it probably is because you think the “reserves” were designed to protect either the system the government, the general public, the borrowers or the lender banks. That may be a fallacy.
I can’t figure out how the “reserves” protect any person or any thing. Think about this. Who is protected by the reserves? Most of us intuitively think that the reserves stop the banks from either (a) lending so much as to cause inflation or (b) running out of money to lend or use in the future. Neither is true.
In the case of (a) above, sensible lending can’t cause inflation because all the lent money is not a permanent increase in the money supply that is not balanced by an increase in wealth. Every sensible loan should create enough wealth to easily offset the dollar amount of the loan and/or it should be paid back by the borrower.
How then, you might ask, are the banks restricted from making loans that are not sensible and which will not be paid back? Consider the following 3-step (a, b, c) scenario for a bank operating on a 10 to 1 reserve requirement, where $10 of loans is supported by $1 of reserves: (a) If a loan is are not paid back, the bank's reserves will be reduced by the amount of the loss, (b) the bank will then have to reduce its loans by $10 for every dollar of loss and (c) will lose the interest income from the $10. That is the leveraged downside of fractional reserve banking. It is very expensive for the bank.
Further restrictions should be built into prudent banking laws and bank charters. If a given bank makes a significant amount of loans that are not paid back, the bank that makes those loans should wind up bankrupt and will thereby automatically remove itself as a bank -- or it should be terminated as a bank under appropriate laws. The public and the system needs no more protection than that.
The recent (early 2009) banking problems can primarily be traced to banks not being held accountable for bad loans. They were allowed to sell off their loans to Freddie Mac and Fannie Mae and thus escape the penalties normally incurred by a lender. Those sold loans were later turned into the "toxic securities" that threatened to extinguish our entire economy.
In the case of (b) above, the bank will never run out of money to lend -- because it can create the money it needs for that purpose. See the discussion above about "making money out of this air".