Bank Lending and Bank Reserves

By Dan Kervick

Provoked partly by some recent posts by Paul Krugman, which seem to imply that understanding the institutional structure of the banking system is irrelevant to gauging the effectiveness of the monetary policies implemented by the central bank, questions have arisen again about the relationship between bank lending and bank reserves.  One of the issues raised can be framed by asking, “Do banks lend their reserves?”  And as with so many questions in economics, the answer to this question depends on disambiguating the question, clearly distinguishing parts from wholes, and avoiding fallacies of composition and division.

An individual bank certainly can lend out its reserves.  The total reserves of a Fed member bank consist of the balance in the bank’s reserve account at the Fed plus the sum of its vault cash.  When a bank customer borrows money from a bank, that borrower may ask for all or part of the loaned amount in cash.  If that happens, the bank will remove some cash from its vault and give it to the borrower.  Suppose the amount borrowed is $10,000 and it is all taken in cash.  Then the bank books a new loan asset worth $10,000, and concurrently books a $10,000 reduction in its cash assets.  The net balance sheet effect is zero.  (There are different ways in which the interest on the loan can be handled in the accounting, and so I’m leaving that out.)

But in most cases the borrower will take the borrowed funds on account.  The bank will credit the borrower’s account with $10,000, which in turn represents a liability of the bank.  Again, the bank will book a $10,000 loan asset, and so the total balance sheet effect will be zero.  In the first case the balance sheet effect was zero because a reduction in cash assets was offset by an increase in loan assets.  In this second case the balance sheet effect is zero because the increase in the bank’s loan assets is offset by a corresponding increase in the bank’s liabilities.

But even if the borrower takes the loan in the form of the deposit balance, as soon as the borrower begins spending the money in the account, some of the bank reserves will likely leave the bank.  It is possible that they would not leave the bank, if the borrower’s spending all goes to depositors at the same bank.  In that case, the result of the settlement and clearing of the payments will just be a reduction in the bank’s liability to the borrower and an increase in its liabilities to the payees.  But in most cases, many of the people the borrower pays will be depositors at other banks.  The settlement of these payments will thus require a settlement between the two banks, resulting in a Fedwire transfer of reserve funds from the borrower’s bank to the payee’s bank.

So yes, individual banks can lend their reserves.  But the more important question is what happens to the reserves of the banking system as a whole in response to expanded bank lending.  And in this case the answer to the question is that those reserves will not appreciably change.

Consider the first case, where the borrower has taken the loaned amount in cash.  As the borrower proceeds to spend the $10,000 in cash that was removed from the first bank’s vault at the time of the loan, the businesses who receive these cash payments will make routine deposits of their cash receipts at their own banks, at which point it goes back into the cash vaults in the banking system.  Similarly, if the borrower’s funds are in the form of a deposit account balance, then as the borrower makes payments by check, debit card or other instrument against that account, the clearing of the payments will result in reserve transfers from the borrower’s bank to the reserve accounts of other banks.

The end result is that an aggregate increase in commercial bank lending is unlikely to diminish in any appreciable way the total quantity of bank reserves; it just changes the pace at which those reserves circulate from bank to bank.  People sometimes look at the large current excess reserve holdings in the banking system, and say, “Why aren’t those banks lending their reserves out?”  But that question bespeaks a misunderstanding of the way the banking system functions.

If banks in the aggregate were not already carrying excess reserves prior to an expansion in bank lending, then we would see reserve balances going up, not down.  An increase in deposit account balances is going to mean an increased volume of interbank payments, and increased bank demand for reserve account liquidity to make those payments.  The added liquidity demand would prompt bank liquidity managers either to sell more Treasury securities to the Fed, or “loan” more securities via repurchase agreements, or (less profitably) borrow dollars from discount window.  Reserve balances would then go up.

If, however, banks are carrying abundant excess reserves, it is possible for the banks in the aggregate to expand their lending and create more deposit liabilities without acquiring any new reserves at all.  In that case, we would not see reserves decreasing; we would just see a decrease in the ratio of reserves to deposits and reserves to loans.

As it happens, though, we currently have a situation in which there are abundant excess reserves, and in which loans are increasing while reserves are also increasing.  This is due to QE, which consists of Fed purchases of treasury securities, agency debt and other mortgage backed securities.  We are therefore also seeing large injections of additional reserves along with reductions in bank holdings of treasury and agency securities.

Cross-posted from Rugged Egalitarianism

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44 responses to “Bank Lending and Bank Reserves

  1. “An increase in deposit account balances is going to mean an increased volume of interbank payments, … ”

    It’s also going to mean an increase in required reserve balances, even if reserves were still adequate for clearing needs.

  2. A loan creates an asset for the bank as well as a liability (assuming the bank wishes to grow its balance sheet and its profits) – end of story. Anything that happens after that is a different banking operation. Lets not confuse correlation with cause. Lots of things change a banks or the banking systems demands for reserve. Changes in customer portfolio of savings (moving time deposits to savings), liquidity preferences (holding more cash on hand), increased economic activity (spending down savings or just more spending/writing more checks) , etc… all increase the demand for reserves and in all cases the CB meets those demands. To think that the central bank on any individual level can figure out if the system is short reserves because someone issued a loan or a customer decided to take an a extra $100 out of his account is lunacy, but that the underlying lunacy of anyone who thinks that controlling base money readily translates into controlling the larger money suppy.

    Sorry just my rant after reading all these Krugman related posts.

    • “Anything that happens after that is a different banking operation. ” Right, so other than banks loaning reserves to other banks, isn’t it in fact more correct to say that banks do NOT loan their reserves. They make a loan (simultaneously creating an asset and a liability). THEN, reserves may or may not leave the bank in the process of settling of payments, which is the different banking operation.

      • If banks don’t lend reserves, what do they lend?

        • They lend claims against their assets, and if the borrower acts on that claim by ordering a withdrawal or payment, they use their cash and electronic reserves – one particular component of their assets – to settle the claim. But as these claims are settled, and the borrowers make purchases, reserves move from bank to bank, so in the aggregate they aren’t lent “out” of the banking system.

        • Banks don’t “lend out” anything. That’s what you and I do as non-banks. If I lend you $10 I have to forgo $10 of purchasing power.

          When a bank extends you credit it is making a promise to you to clear and settle any payment requests that many be generated by that loan. Those payment promises will be kept by changing account balances on its balance sheet and or leveraging its ability to clear and settle payments between banks. This process means that nobody had to forgo any purchasing power to extend the credit and the central bank stands by to ensure that there are always sufficient interbank clear capabilities – the only question is what is the cost of those transactions.

  3. “It’s also going to mean an increase in required reserve balances, even if reserves were still adequate for clearing needs.”

    It may do. So what. If you’re a competitive bank with a good salesforce then you can sell your loans fractionally higher than anybody else, that means you can offer deposit rates fractionally higher than anybody else.

    That makes the extra required reserves some other bank’s problem.

    Unless the central bank relieves that pressure very quickly they lose control of their policy rate as competition drives interest rates higher. If the central bank continues to maintain a tight discount window and keeps reserves short, then the interest rates will shoot up very quickly indeed and the transaction system would start to slow down (the easiest way to prevent reserves leaving is to slow down clearing or start using direct bank to bank lending agreements).

    This is what happened to interest rates in the 1980s during the Monetarist experiments. The central bank has to be prepared to cripple some bank in the system, shatter the transaction system, enforce overdrafts by refusal rather than penalty payment and let interest rates go where they will if it wishes to control the quantity of reserves.

    In the real world, it doesn’t work. Individual bank actions does not translate into individual consequences for that bank. It translates into a systemic problem. So you get a system collapse and uproar, and the central bank is told by the politicians to stop being an idiot and directed to change its behaviour.

    • I was talking about the aggregate.

      And the question is not whether the CB can do policy by restricting reserves to less than the regulatory requirement. It is where the money that banks lend comes from. It does not come from reserves. Reserves do not drop because banks have lent them out. On the contrary, reserves typically increase when banks lend, and the required level of reserves must increase when deposits increase.

  4. “… are increasing while reserves are also increasing. This is due to QE ….”

    Do you mean that the increase in loans is also due to QE? If so, what mechanism did you have in mind? Other things being equal, I would expect the reflux principle to apply here, resulting in part of the additional deposits created by QE being used to pay down debt.

    • No, I just meant that with excess reserves, it should be possible for loans to increase without any increase in reserves. So, to understand why reserves are also increasing even though there is no loan-driven demand for them, we need to look to QE.

  5. Pingback: Bank Lending and Bank Reserves | The Money Chro...

  6. Thornton Parker

    Dan, as I understand them, most MMT explanations say that banks normally create deposits when they create loans. Your discussion opens with this.

    But there appears to be another argument, that some of the biggest banks receive so much cash from depositors that they have “excess deposits.” This results in a loan-to-deposit ratio of substantially less than 1 (one) that MMT tends to stress. According to this explanation, the banks buy “safe” investments like Treasuries, which they carry on their balance sheets, but which they sell on the repro market to obtain cash that they can use for buying other assets. These purchases are putting banks into many businesses far removed from banking, like speculating on energy markets and owning city parking systems. This is discussed in the Public Banking article posted at

    You might want to look at that article and see how it relates to the much simpler MMT explanation.


  7. Not to be impolite, but the mechanism by which banks lend money is not important. Banks create credit when they issue a loan, and remove credit when the loan is repaid. More importantly, the government creates credit when they issue credit and spend and but can’t decide who should repay the issuer of the loan. Credit travels a circular path to be used for transactions. The more transactions, the greater the velocity of credit, the healthier the economy.

    My objection to the Coin is that it cancels the debt of those hoarding credit, credit which should be circulating and retired. It is the hoarding of credit that creates inequality. A majority of the austerity measures are designed to protect hoarded credit

  8. Gerry Spaulding

    I’m not sure what is gained on the way to understanding the money and banking system by putting in play the statement that ‘some’ banks can lend ‘some’ reserves. The fact that currency forms a part of a bank’s reserves is already confounding enough. And we’re far better off with an inflation-calming blanket understanding that banks cannot lend reserves, rather than that they can.

    The Krugman, etc. dialogue, for instance as here, ( ) is centered upon central bank policy which affects all banks. Moreover, there has been no dialogue to counter that says banks cannot lend the cash-reserve balances in their vaults. As the broader dialogue involves the implications of QE upon potential future inflationary effects, it therefore does not involve anything except non-cash reserves.

    For a broader understanding of the underlying socio-political mechanisms at play, I suggest a reading of German economist Joseph Huber’s recent clarifications of MMT’s positing the philosophy of the banking school in advancing its new understanding of our currency system.


    • I think it is always useful to be as complete an accurate as possible, Gerry. There is nothing confusing about the fact that vault cash is part of a bank’s reserves. It’s right there in every bank financial statement and every Fed report on conditions affecting reserves.

      When people make broad general statements that are subject to multiple interpretations, some of which can be refuted from obvious facts, they can undermine their own credibility. So I think it is important then to specify that the statement “banks don’t lend their reserves” is intended as a statement about banks in the aggregate, not a statement about individual banks.

    • The Huber paper is very interesting.

      Since banks create most of the money in the economy, and tend to be pro-cyclical, it must be up to government to use its much smaller money-creation powers to offset the banks’ tendency. That’s got to be hard to do. It didn’t stop the last two bubbles in time, but managed to persist beyond the bubbles to exacerbate the crashes.

      I suppose government could take over the banking system, and act as the monopolist to limit money creation. I have little confidence in their ability to do it properly, or in a timely manner. It could even be worse than the pro-cyclical banks, since the nature of the cycle is to reverse itself. Government would not have that tendency.

      Raising reserve requirements would be ineffective. Raising capital requirements could work, if the regulation were effective. Bank CEO’s willing to defraud their banks would be willing to lie to regulators just as well, I should think. Still, it might tend to dampen the cycle.

      Could there be some other novel control mechanism to offset the pro-cyclical nature of bank lending?

      • The Huber paper is very interesting.

        Most definitely (at least to me, a non-economist). I particularly liked this passage:

        (…)the currency school’s response to the real-bills doctrine was the thesis of the real-bills fallacy: the belief in ‘good bills’, ‘good uses’, ‘good bankers’, ‘perfect markets’ and other features of ideal-world economics does not apply to real-world banking. To put it differently, the banking-school rationale is based on the axiomatic classical belief in the ‘invisible hand’ of markets, i.e. the medieval Scholastic theo­lo­gem of God’s wise manus gubernatoris unfailingly creating a harmonia mundi unless distorted by evil machinations. In neoclassical economics, the latter are normally projected onto government interference.

        • Yes, he’s very glib and clever. Obviously, the so-called “law” of gravity doesn’t apply to the real world either. Anyone can see that a pound of lead falls faster than a pound of feathers.

    • I’d be curious to know what MMT experts would have to say in response to this from Gerry’s link:

      Confusingly enough, the original theory of chartalism, the state theory of money by G. Fr. Knapp 1905, does not really belong here, nor does today’s Modern Money Theory. The reason is that they reduce a state’s monetary prerogative to defining the national unit of account, while leaving issuance of the money and benefitting from the seigniorage thereof to the private banking industry. They do not recognize any problem of fractional reserve banking and the banks’ pro-active credit and deposit creation.[16] On balance, they represent banking theory rather than currency theory.

      • I’m not sure I understand the comment. MMT at least does not restrict the state’s role to simply defining the unit of account. The government issues both physical currency and bank reserve balances at the Fed. Nor does the government somehow need to obtain bank deposit money to carry out its operations. It chooses to accept drafts on bank deposits in payment of taxes because the settlement of those payments is carried out with bank reserve balances, which are a form of money that the government itself issues.

        I have argued in the past that many of the positive money folks have adopted a view that I have sometimes called “hyper-endogeneity” – that is, they systematically exaggerate the role of bank money in the system, treating the banks as, in effect, operating their own fiat printing presses. I tried to point out the errors in this approach in my post “Do Banks Create Money from Thin Air.” Banks deposits are debts of the bank. Those bank debts are negotiable, and so they function as a form of money in our economy. But the banks routinely have to make good on the debts they have incurred. They make good on those debts by making payment with a form of money that they, themselves do not issue. The payment assets they use are issued by government.

        Commercial banks don’t earn seigniorage, they make money by charging interest on lending, in the same way any of us could make money by charging interest in lending. Seigniorage is the profit earned by a money issuer consisting in the gap between the cost of creating the money and value of the assets that can be fetched for the money in markets. But when a bank creates a $10,000 deposit and exchanges it for a promissory note to pay $10,000 plus $500 of interest, their cost is $10,000, since that deposit balance is a genuine liability of the bank.

        • It makes more sense if you consider the Federal Reserve to be a private bank. Then it benefits from seigniorage, creating paper currency and government reserves from nothing.

          But he oversimplifies MMT’s position and ignores the pyramid of money.

  9. I thought it was Capital Ratios that constrain bank lending, that the bank must hold 3 to 10 % of risk weighted assets against their loan portfolio. I think QE is the long version of a buy the toxic asset plan to repair the balance sheets of the banks. The Fed gets to let the junk play out over time. The Fed also swapped long term treasuries and replaced them with much shorter terms. It seems all a process of balance sheet repair and maturity transformation.

    • I thought it was Capital Ratios that constrain bank lending, that the bank must hold 3 to 10 % of risk weighted assets against their loan portfolio.

      Yes, however, we know from real world evidence, that what “banks” present as capital (under Basel) is often fiction. Couple this with their wide discretion in the determination of what constitutes, reserves against non-performing loans etc., capital ratios offer weak assurance. So in theory, I suppose, you are correct.

      Why our Fundamental Approach to Banking Regulation is Inherently Unsound

      The underlying net financial assets which are being purchased by the central bank, would in my mind, determine their status as to “junk” or “toxic”.

      The purchase of risk free US treasuries is simply a swap of net financial assets of the private sector. Yes there may be a yield differential due to terms and monetary p0licy goals, however, there is no risk.

      If the central bank is indeed purchasing “toxic” (i.e. junk) at the sellers’ carrying value, then they are stepping into the shoes of the private sector owner, who, has effectively transferred their unrecognised loss to the central bank. Once again, this is a swap of private sector net financial assets, a balance sheet transaction, with no current income effect to the private sector.

      If indeed the central bank purchased junk, (assuming the carrying value did not represent the fmv) then yes, it directly repaired/fixed/remedied an unrecognised loss to the beneficiary. It is otherwise called, socializing the losses and privatizing the profits.

      • It’s not junk. The Fed has been earning a lot of money from its SOMA portfolio.

        • Mr. Kervick:

          I did not intend to imply that the targeted assets were junk. I have no such knowledge to make such a statement.

          I will only make note of the following, which I am sure you are well aware of.

          A portfolio in aggregate can realize a profit, while at the same time, some or even many, of the individual instruments that comprise that portfolio can produce a realized loss.

          I agree that in aggregate the SOMA portfolio is golden, however, it doesn’t necessarily follow that individual mortgages, packaged in various tranches of MBS (for example) are realizable in full.

          My apologies for drifting …..

          • I asked this question at the time, and got no definitive answer: if the securities the Fed bought that “bailed out” the banks were really worth their value on the banks’ books, and the Fed paid only that value for them, then what was the nature of the “bailout”? The banks should have been able to raise the same amount of capital by selling them on the open market, and would have been solvent, not needing any bailout.

            And if they were worth far less than book value, and the Fed paid market value for them, then again, where was the bailout? The banks could have sold them on the market for the same price the Fed paid, and the bank would be no more solvent than if it continued to hold the assets.

            It’s only a “bailout” if the Fed paid face value or book value or even just more than market value for assets that were, in fact, worth less: toxic assets backed mostly by non-performing loans. The Fed may well be earning some interest on those assets, if even one borrower continues to make payments; but they are never going to get their money back if they in fact “bailed out” the banks, and many of the loans ended up in default.

            • Seems to me the answer is that the market couldn’t price the securities and didn’t know whether they were junk or not, and so the firms that owned them couldn’t sell them or use them as collateral and use them to offset the liquidity crunch. So the government bought those mysterious high-risk securities for some zero-risk dollars, and assumed all the risk. As it turns out, the government mostly made money on the deals, but I haven’t seen a full accounting. Same with loans. It made loans and they were paid back.

              I think the bottom line is probably that that the bailout worked in that short-term sense. The problem is the moral hazard problem. How do we get financial firms to behave responsibly if the government will come in to assume the risk when things go sour.

              • If the government made money, then the loans were worth more than the government paid. Which means the banks weren’t bailed out, they were taken advantage of during the liquidity crunch. How did that make insolvent banks solvent?

                According to Bill Black, these loans and MBS were fraudulent. Junk. Toxic. Is that not true?

                I can’t reconcile the gov’t making money by buying fraudulent loans with the idea that the banks were bailed out in the process.

                Loans, I understand, it’ much more simple, especially for the likes of AIG. They lost $billions, borrowed $billions, and proceeded to earn profits using the borrowed money, enough to pay it back. Businesses borrow money and use it to make profits all the time. They’re just not usually bankrupt when they borrow.

  10. John Hermann

    Technically, even in those rare cases where a retail borrower demands receiving his/her bank loan in currency (cash), the reserves are not loaned out. The reason being that whenever that cash is received by the customer it ceases to be part of any bank’s stock of reserves and is transformed into being part of the money supply. It would only be correct to say that reserves are loaned if they remain as reserves (as recognized by the central bank) after the transaction has occurred. The real lending of reserves occurs in wholesale transactions between banking institutions (e.g. interbank lending).

  11. Robert Avila

    (There are different ways in which the interest on the loan can be handled in the accounting, and so I’m leaving that out.)
    Question: If all money is bank money and if all bank money comes from making loans , then there is interest as well as principal owed on all money in circulation. Thus the amount of money owed is in excess of the amount of money in circulation.

    Isn’t this an accounting problem that should be investigated?

    • Definitely. It’s just that addressing that further question wasn’t wasn’t relevant to the narrower point I was making in this short piece.

    • Based on your premise (“all money is bank money”), deficit spending by government, funded by increases in lending by banks to the government, provides additional money to the private sector ex-banks, so that the public normally also has increasing net financial assets. Since the government is monetarily sovereign, its increasing debt is not a problem for anyone. Money in circulation is greater, not less, than money owed by the private sector to banks.

      • Robert Avila

        On the other hand there is that nagging requirement to pay taxes, which contributes to the value of fiat money. If the budget were constantly balanced there would not be the money to pay the interest owed the banks. So it is only the deficit that does the trick

    • The government spends credit into circulation which can be earned to pay interest on bank loans. It becomes the deficit. In reality, interest on loans is simply a tax on credit, a tax received by the bank as unearned income.

    • Robert Avila: Quick answer – If I understand your question correctly, many have investigated it – see e.g. Wray’s comment at bottom of MMP Blog #15: Clearing and the Pyramid of Liabilities.

  12. I repeatedly see comments on this blog regarding interest requiring additional dollars to be put into the system if it is to be paid. I don’t understand why interest is so different from any other form of payment. Why doesn’t the sale of lollipops require additional money? It seems to me that what’s important isn’t whether someone is paying interest or buying lollipops. What is important is what anyone receiving payment does with the money. If they stuff it in a mattress or send it to China, that will have different consequences than if they buy more lollipops or invest in a lollipop factory. But whether that money came in the form of interest (i.e. bank revenue) or revenue from lollipop sales is irrelevant, at least AFAICT.

    • Increased sales of lollipops does require additional money, if that increase is part of a general increase in output and if prices are to remain stable. That’s why we have an “elastic” currency system. If the quantity of currency was fixed and output continually increases, then prices can only remain stable if velocity increases. Since there obvious are real-world limits on increases in velocity, then unless the quantity of currency increases, there will eventually be a deflation.

      • I guess my question is, why do some people seem to think there’s something so special about interest requiring new/additional money as opposed to any other thing? If I characterize a loan as being interest free, but always accompanied by the purchase of a lollipop (as opposed to the bank just giving me one, as they are wont to do), with the payment for that lollipop being made over time and contemporaneous with the payback of the loan, such that paying the loan back early relieves me of making any further lollipop payments, does that make it okay, since it’s no longer interest?

        • You’re right I think. If people borrowed 1000 lollipops and repaid a year later with 1050 lollipops we have the same question about where the additional lollipops come from. In the broadest sense, people in an economy are borrowing assets, and using some of them to invest in the production a new assets so that they create wealth, and are able to repay the borrowed asset plus get a return.

        • Lollipops are real assets. They can be created in the private sector, by using ingredients harvested from nature and by human labor.

          Ordinary humans cannot create money that way. Only the issuer of money creates it.

          The premise is that only banks create money, and all money is created by banks making loans. No matter how many lollipops you make, you need money to repay the loan. You can sell lollipops to someone to get money, but that someone got the money because he or someone else borrowed it from the bank.

          The bank cannot create money by spending, though, like government can do. The bank could buy your lollipop only using the interest you have paid. But if the bank buys enough lollipops from you that you can pay the interest, the bank has no money left over, and has not made any profit. And if it has other expenses, it is bankrupt.

          Another way some people say it is that although money is created by the loan, the loan creates no money to pay the interest. And in the aggregate, all the loans made by all the banks only create enough money to repay the principal, and none to pay the interest.

          • Well, what about if you borrow a tractor, some fertilizer and some seeds? Then you grow a bunch of corn. If you have done well, you can return the tractor plus a sufficient amount of corn to compensate for its depreciation and then some. And you can return the seeds, plus interest (more seeds). And you can repay for the fertilizer with corn of greater value than the fertilizer. And you keep any remaining corn for yourself. Wealth has been created, debts made and discharged, interest paid. – all without any money.

            But I agree that there is no tool for growing money, so if the total amount of money loaned requires a greater amount of money to be repaid, more money must be loaned to keep the cycle going. Thee hyper-endogenists think the banks can handle the whole cycle, by continually creating more deposits in amounts sufficient to pay off all the previous debts. But my claim is that since the bank money is a kind of debt for which the creditors often demand payment, and demand that payment in the form of currency or central bank balances, the banks have to keep acquiring more currency and central bank balances. So the commercial system is piggy-backed on the government system.

            • All true, in our current system. But the private sector accumulating debt with interest growing exponentially and no other inputs is not sustainable. In the old days, the new king would declare a “jubilee”, voiding all debts (to the prior king) and starting over. Today we have bankruptcies, and government deficits.

  13. But, if I’m reading Dan correctly, economic growth requires new money to be created, anyway. So what’s the big deal specifically with interest on loans in that regard? It’s unsustainable without other inputs, but we have the inputs, the same inputs that are required for everything else to work.

  14. It goes back to the premise: that all money is created by bank loans. No other inputs. And you’re right, those same “other” inputs are required for everything else to work, and the economy to grow sustainably.

    Without other inputs, the bankers end up with all the money, and eventually, all the real wealth.