More on Bank Reserves, and their Potential Meaninglessness

My post about bank reserves generated a lot of discussion. Well, I guess it was really more of an anonymous commenter trying to explain it to me than a discussion, but anyway, the comment thread is worth a read.  I also have two more reserves related links today (one of which is from David, another commenter in that thread).  I think it’s important for people to realize that 99% of Americans, me included, really have no idea how the banking system works.  We (we the ones who don’t understand) think that when we master the concept of fractional reserve lending (which, in itself, 90%+ of Americans probably don’t understand) that we have it figured out.  There’s a big problem though, in that fractional reserve lending really doesn’t illustrate how the system actually works anymore.  
You can check out a piece from John Hussman that’s a few years old for some more thoughts:
“Yes, during periods of crisis, the Fed has an important role to play in providing day-to-day liquidity so banks can meet depositor withdrawals. But aside from this short-term variation in the monetary base (which we saw, for example, around the “year 2000” turn), there is not even a slight relationship between bank reserves and total bank lending. Indeed, any remnant of that relationship was wiped out in the early 1990’s, when reserve requirements were removed on all bank deposits other than checking accounts.”
Note that the piece is from 2007.  
Billy Blog also took issue with people panicking about the potential removal of reserve requirements.
“At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.
So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.
The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.”
What’s probably most frustrating for readers, myself included, is the epiphany that banking doesn’t work like we think it does – it doesn’t work like the textbook fractional reserve banking example I gave in my prior post (where, with 10% reserves, a $100 deposit becomes a $90 loan, which is then re-deposited and becomes a new $81 loan, etc).  In our system, in reality, you don’t need deposits to lend.  I think that fact troubles and confuses a lot of readers.
-KD

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