PEG 2.0: Honest question on no-reserve banking
Some people are saying that even though most people think we live under a fractional reserve banking system, we really live under a no reserve banking regime—bank lending is unconstrained by, and unrelated to, reserves.
I’m open to the idea (after all, in theory, banks can create an infinite…
The focus on reserves is kind of a relic of an earlier time, when people held a lot more cash and shifts between bank deposits and cash were volatile and, potentially, destabilising to the financial system. Nowadays, thanks not least to deposit insurance, households (and small businesses) are happy to keep most of their liquid holdings in the form of bank deposits. Reserve requirements are pretty small and don’t really bind banks, since they can get what they need on the wholesale funds market or, as a last resort, from the Fed’s discount window.
What really binds bank lending, or should, is capital requirements. Banks may always have access to the immediate resources (in the form of reserves) to make loans, but each loan has to be backed by capital, and more capital is needed the riskier the loan gets. And Basel III will increase the amount of capital banks have to hold. The other factor, which will be introduced with Basel III, is liquidity requirements - banks will have to maintain enough liquid assets to match their liquid liabilities. These constraints will, or should, get incorporated into the loan officer’s approval process at some level. It’s not fully clear yet how the financial system will work when both of these are in place, but at least in theory both of them will put a ceiling on banks’ ability to lend ad infinitum.
strangebloombergheadlines knows more than headlines! Even dumber question: aren’t reserves capital, though? (Or, at least, a kind of capital, for the purposes of capital requirements?) Or am I completely clueless?
Think of a bank that has reserves (R) and makes loans (L), financed by deposits (D) and bonds (B). Its capital is essentially K=R+L-D-B. Traditionally, a bank would start with a chunk of equity contributed by its owners or partners, then use that as reserves, while it funded its loans from deposits and bond issues. So you roughy had R=K. Nowadays of course banks are much more complicated. The bank’s reserve ratio is R/D, its capital ratio is K/aL (where a is a factor determined by the riskiness of its loans), its leverage ratio is K/(R+L), and its liquidity ratio is (R+sL)/(dD+bB) where s, d and b reflect the short-term portion of its loans, deposits (ie expected withdrawals) and bonds. Which one of these is binding depends on its business model. So much for banking regulation 101 …
