Loans create deposits, banks "are not reserve constrained"?

Question

It is often said that banks are not "reserve constrained" when it comes to lending, and that loans create deposits (and therefore commercial banks create money). I have some doubts about the actual mechanics.

Imagine a simplified banking system with two banks: Bank A and Bank B. If a customer takes out a loan at Bank A, that bank creates a loan on the asset side of it's books and a matching deposit on the liabilities side. It is for this reason it is often said that "loans create deposits". Bank A has created a deposit out of thin air to match the loan. Most examples I've read stop here and show how the bank has effectively created money from nothing - but how is that deposit considered money if it cannot be withdrawn due to lack of actual money at Bank A?

Bank A creates a loan and matching deposit:

assets	liabilities
+500K Loan	+500K Deposit

Naturally, someone takes out a loan because the intend to make a purchase. What happens when Bank A's customer decides to withdraw their deposit, for example to buy a house from a customer of Bank B?

Bank A honors customer withdraw, wiring money to bank B

assets	liabilities
+500K Loan	-500K Deposit
-500K Reserves*

*Bank A is "reserve constrained" if they do not have reserves/cash sufficient to meet this deposit withdraw.

Bank B receives wire from Bank A, credits customer's deposit account

assets	liabilities
+500K Reserves	+500K Deposit

If Bank A does not have reserves to fund this withdraw, they would need to borrow from another Bank in the fed funds market (or some other form of borrowing). If the banking system as a whole did not have reserves/cash equal to the deposits created by the loans, then money could not move between them. Does this not refute the claim that banks are not reserve constrained? Additionally, why is it said that commercial banks create money with loans (which create deposits, or "money" in these examples) if that money is meaningless without cash behind it? Creating loans/deposits does nothing to the amount of non-deposit cash in the system (e.g. fed reserves and circulating notes), and without cash those deposits can't be withdrawn.

The implication here is that while loans create deposits dollar for dollar, those deposits must be backed in full by some form of reserves + cash (in the aggregate banking system) otherwise there would be now way to fund deposit withdraws. I know there is something wrong with my understanding because you can plainly see that total loans as well as total deposits far exceed federal reserve balances. Is the difference simply some form of borrowing outside of the federal reserve system? What am I missing here?

Answer 1

First of all your example is incorrect. This is how the process of money creation looks like on the balance sheet of a bank (see McLeay et al 2014):

So it is simply not correct that when banks create new money they just create asset loan and liability deposit with equivalent amounts.

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Most examples I've read stop here and show how the bank has effectively created money from nothing

I do not know what sources you read, but careful researchers would not say that private bank can create money from nothing. That is something that only central bank can do. Some people misinterpret the current excess reserve situation as private banks being given the same privilege central bank has but that is wrong interpretation. Careful scholars, such as Rendahl & Freund (2019) still argue private banks can't do it from nothing despite of the excess reserves in the system.

Citing from their article:

From an economic viewpoint, commercial banks create private money by transforming an illiquid asset (the borrower’s future ability to repay) into a liquid one (bank deposits); they would quickly be insolvent otherwise. In addition to bank solvency representing a constraint on private money creation, banks require access to liquid reserves in order to be able to engage in money creation.

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but how is that deposit considered money if it cannot be withdrawn due to lack of actual money at Bank A?

Money is not cash in circulation. Money includes even things such as treasury bills, bonds other liquid assets. Deposit account is money, by definition of money in economics.

In economics money is everything that fulfils (to a considerable degree) the following three roles:

1. Medium of exchange
2. Unit of account
3. Store of value

The deposit account clearly can serve as a medium of exchange, people, generally will sell you stuff even if you just transfer them money.

Next, the deposit account is denominated in your local currency (e.g. if you live in Euro-zone it will show how many euros you have) which is generally agreed upon unit of account since sellers and buyers quote their prices in euros not in terms of pies or berries or something else.

Finally, you can use your deposit as a store of value. If your deposit account has some money in it then it will be valuable in future (despite inflation it will keep at least considerable amount of its original value).

Hence deposits are money by definition since they tick 1, 2 and 3 requirement reasonably well.

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Does this not refute the claim that banks are not reserve constrained?

You seem to have some personal definition of being reserve constrained that does not correspond to its regular use in economics.

For bank to be reserve constrained the amount of lending they can do has to be limited by their reserves. When serious economists say banks are not reserve constrained, they do not mean to say banks can lend money without having reserves, they mean by that the system has so much excess reserves that for all practical purposes supply of reserves is unconstrained.

If bank can always get extra reserves from central bank or other private banks no question asked then it is valid to say the banks are not constrained by reserves.

Before 2008 banks typically were reserve constrained because there were almost no excess reserves (see FRED data), that is reserves in excess of what bank has to have by law (e.g. with reserve requirement of 10% for every \$100 deposit bank has to keep \$10 as a reserve and with rest can do as it pleases). Banks kept small insignificant buffer but whenever they wanted to lend more they would have to get more reserves somehow (e.g. get more deposits, inject its own capital or beg the Fed for more - which in past used to carry bit of a stigma for a bank). However, after 2008, due to changes in Fed policy, US banks started to drown with excess reserves. The situation was similar elsewhere.

When banks literally drown in so much reserves that bank can satisfy virtually any (realistic) demand for loans then the banks can be said to not be constrained by reserves. However, if the reserve requirements are in place they still have to have reserves, there is just so many of them that they are not constraining bank lending decisions.

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Additionally, why is it said that commercial banks create money with loans (which create deposits, or "money" in these examples) if that money is meaningless without cash behind it?

Money is not meaningless without cash. Total cash in the US economy is now about 10% of all money in the economy (see FRED data on total cash and M2). Yet people still can go on and do commerce without that cash, just transferring money digitally from one account to another.

Even though it is impossible for everyone to withdraw the money from their deposit accounts (this is why bank panics sometimes happen and why fractional reserve system can be sometimes fragile), the digital currency in form of your account is still money equivalent to cash (except I suppose cash is more useful for black market as its harder to track).

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What am I missing here?

What you are missing is that deposits do not have to be fully backed by cash reserves. If reserve requirement is 10% then even with \$100 cash economy could end up with as much as \$1000 of money. There is no need for banks having enough cash for every single person if most people just keep their money in their account and transfer them around.

Furthermore, nowadays also reserves are not just cash, but also digital accounts at the central bank. Central banks don't just store piles of cash, although they can always order more cash to be printed (in case of ECB directly in case of Fed indirectly through the treasury).

Answer 2

I think you've got the order the wrong way around.

Firstly, you're correct in your understanding of the process by which banks create money (by extending credit).

But your conclusionary question

but how is that deposit considered money if it cannot be withdrawn due to lack of actual money at Bank A?

is not the issue you think it is.

You seem to be thinking that a commercial bank's reserves determine the deposit liabilities it can hold on its balance sheet. This is true when reserves are scarce but the reality is that the bank's reserves are effectively determined by their deposit liabilities because banks have ready sources of reserve funds.

In essence, because the classical view of reserve-constrained bank lending is false (in the fractional reserve banking way, see Paul Sheard 2013), the primary causation is effectively reversed. Within banks' other legal and commercial constraints, banks can create as much credit as they can afford (or is demanded) and the reserves to back resulting outflows are a secondary consequence of this. By that, I mean banks readily borrow reserves from other banks to settle outflow payments as well as borrow from the central bank. Their reserve level therefore follows deposits rather than the other way round. Reserve levels of a particular bank could still determine how many loans they are willing to make but it's not the strict deposit following reserves rule as you think.

When a bank creates a loan-deposit asset-liability pair on its balance sheet and the deposit holder wishes to buy a real asset with it, like a house, it will debit the deposit and instruct the central bank to debit its reserve balance by the same amount. If the commercial bank doesn't have enough reserves to settle this payment (what you implied was the constraint), it has three main options:

1. Borrow reserves on the interbank market at a given interest rate, or
2. Borrow reserves directly from the central bank at a given interest rate, or
3. Sell assets such as government bonds on their balance sheets to gain new reserves.

The point is that the commercial bank will never be limited in its ability to access the reserves it needs to settle payments. Ultimately, this is because the central bank is capable of always being the "lender of last resort" and will make reserves available on demand if the banking system needs it.

In a wider sense, the central bank undergoes QE and QT open market operations in part to address reserve requirements of the bank system.

So to your central query: banks do indeed create new money when loans are created (in fact ~97% of all broad money is bank deposits), and they have no economic, practical, or legal reserve constraint in doing so, or in settling withdrawals. They do have regulatory (eg. Capital requirements) and commercial (they must compete for funds with other banks so attract customers via high saving rates and low loan rates - this squeezes the rate spread which they derive their profit from resulting in a profitability limit in credit creation) constraints though but not the strict reserve constraint implied in your question.

Finally, I would say that the term cash is usually reserved for describing paper and coin currency. Currency is the more inclusive term which catches all physical cash as well as central bank reserves. Combined, this is base money, or liabilities of the central bank/government Treasury.

But deposits are just as legitimate a form of money as cash since goods and services can be and are transacted solely using deposit debits and credits (with reserve settlements with the central bank) everyday.

Edit: see this Bank of England paper establishing how money creation operates in the real world with respect to commercial bank credit creation and reserve dependencies (or not as it happens).