Bank Lending and Reserves

The following scenario illustrates how the reserve ratio requirement relates to bank lending.  Suppose a bank has $100,000,000** in demand deposits and $10,000,000 in reserves, which is just enough to meet the reserve ratio of 10%.  The bank plans to issue mortgage loans totaling $5,000,000 for a new housing development.  Can it do so before it acquires more reserves?  [** The reserve ratio required for that amount of demand deposits is somewhat less than 10%, but we use that figure to keep the arithmetic simple.]

Capital Adequacy Requirement 

A bank's lending is ultimately limited by the amount of its own capital (assets minus liabilities).  The capital adequacy rule requires that the ratio of its capital to risk-weighted assets be at least 8%.  Mortgage loans have a risk weighting of 0.5 in contrast to ordinary loans which have a risk weighting of 1.0.  Since the bank plans to expand its balance sheet by $5,000,000, it must have excess capital of at least $5,000,000 x 0.5 x .08 = $200,000.  We will assume the bank satisfies this requirement. 

Borrowing Reserves when Needed 

Assume the first loan is for $1,000,000.  The immediate effect of the loan is to increase the bank's assets and liabilities by that amount, without affecting its reserves or capital.  When the borrower spends the $1,000,000, if the proceeds are deposited in other banks, the lending bank loses that much in reserves to other banks but it no longer has that deposit liability.  However the bank's original demand deposits of $100,000,000 have not changed, and they are now backed by only $9,000,000 in reserves.  The bank must therefore acquire $1,000,000 more in reserves to meet the 10% reserve requirement. 

Other banks now have $1,000,000 in new deposit liabilities, as well as new reserves of the same amount.  Since they only need $100,000 of those reserves to back their new deposits, they could use the remaining $900,000 to back additional lending of their own.  But let's assume they have no good lending opportunities at the time, and therefore offer to lend the excess reserves in the Fed funds market.  The lending bank could borrow the excess reserves, which would still leave it $100,000 short of what it needs.  Where will the extra funds come from? 

How the Fed Responds 

Other things equal, aggregate demand deposits of the banking system have increased by $1,000,000, but aggregate reserves remain unchanged.  The banking system will thus be short $100,000 of what is needed for all banks to meet their reserve requirements.  This shortage applies upward pressure on the Fed funds rate, which will bring a response from the Fed's open market operation.

The Fed will purchase $100,000 of Treasury securities from the public, thereby injecting what is needed to restore the balance and hold the Fed funds rate on target.  The full $1,000,000 that the bank needs will therefore be available to borrow in the Fed funds market, and at an interest rate close to the target Fed funds rate.  Of course the actual scenario is not as neat and precise as this, but we are only seeking to understand the principle. 

Issuing the Remaining Loans 

This process can be repeated with other borrowers to issue the $5,000,000 in new mortgage loans.  The Fed will then have added $500,000 to banking system reserves on its own initiative.  At no time has the reserve requirement been a constraint on the bank's lending.  Assuming it has a good credit rating, the bank can borrow the reserves as needed.  Indeed it can do so after each loan has been issued because reserves are figured as the average over successive fourteen day periods.  That allows a bank to be short of reserves on any given day. 

Maintaining Control of the Fed funds rate

We have assumed that the money loaned by the bank and spent by the borrowers has all remained in demand deposits around the banking system.  If instead some of that money gets parked in savings or term deposits for which reserves are not required, the banking system would likely have more reserves than it needed and would offer them in the Fed funds market.  In order to hold the Fed funds rate on target, the Fed would need to drain the excess reserves.  It would do so by selling Treasury securities from its own portfolio. 

Note that the whole system revolves around what must be done to control the Fed funds rate, the primary monetary policy tool of the Fed.  The Fed funds rate sets the upper limit on the cost to banks of borrowed funds, which in turn determines the interest rate banks charge on loans to the public.