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If the reserve ratio is 0 (e.g. in Hong Kong), why isn't lending riskless for banks?

They effectively generate assets without creating a liability (even if the reserve ratio is > 0, they can lend and find reserves later, not generally constraining their ability to lend.)

This would seem to suggest banks should simply lend as much as possible, earning interest on the money they created which was lent to creditworthy borrowers and taking no real losses on defaults as the money that was lent was created ex-nihilo.

Why is this not the case?

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  • $\begingroup$ Loans are not riskless - if the customer fails to repay the principal and interest then the bank will usually lose money. When they lend, they create an asset and a liability; if the asset disappears, they will still have a liability $\endgroup$
    – Henry
    Aug 22, 2022 at 14:23

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They can't do that because even without reserve requirements they need hold cash/reserves/short-run liabilities to maintain sufficient liquidity, also they have to maintain certain capital ratio (BIS). Hence, they still have to have high liquidity and are even forced to get new capital if they lend too much which constrains their lending. If they would lend to anyone they would have low retained earnings due to too many defaults (meaning it would be more difficult to have enough capital for capital requirements) and next they would also have to get more cash/reserves etc to make sure their liquidity coverage ratio does not exceed 30 calendar days.

Making reserve requirement zero does not mean banks do not need them it just turn all reserves into excess reserves which constrains bank lending less than having required reserves but it does not allow bank to lend freely willy-nilly. Excess reserves are less restrictive than required reserves because required reserves cannot be counted towards bank liquidity coverage ratio.

Also, due to the reasons above it is not correct to say private banks create money ex nihilo. Following Freund and Rendahl (2019):

In recent years, some have claimed that banks create money ‘ex nihilo’. This column explains that banks do not create money out of thin air. 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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  • $\begingroup$ Maybe we should say that borrowers create private money by selling out their future :) $\endgroup$ Aug 22, 2022 at 15:07

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