Loans Create Deposits -- how banks actually work

I used to believe that banks lent out deposits. So, you deposit money in a bank, and the bank turns around and loans that money out to someone. "Fractional reserve accounting" meant that the bank could lend out more money than it had on deposit, which seemed fishy. As the bank usually made long term loans funded by short term deposits (mismatched maturity) they were always at risk of a bank run, which is where FDIC insurance came in.

I was wrong.

At a macro level, banks create deposits by extending loans. At an individual level they do the same thing, but also need to manage reserve accounts. This is how it works:

Loans create deposits

Banks do not loan out deposits. When you deposit money in a bank, you are not putting it "hard at work" in any way. It is not funding factories, houses, or anything else. Saving money in a bank is the same as putting it under the mattress.

When an individual bank (bank A) makes a loan, it creates (credits) an asset (receivable). To make its books balance, it debits its reserve account at the Fed (also an asset) by the same amount. The loan creates a deposit, say in a different bank (bank B). That bank credits the deposit on the liability side, and credits its reserve account at the Fed. The reserve account debit made by bank A is exactly matched by the reserve account credit made by bank B. While the total amount of reserves in the system is unchanged, bank A is now short reserves, and bank B is long (assuming they had the correct amount of reserves in the first place).

Bank lending is not reserve constrained

So, what will bank A now do, since it is short reserves? It can try to win over bank B customers and get them to move their deposits over, this transferring the reserve account assets bank B has to itself. If bank A fails to do this, then it simply borrows the reserves it needs overnight from... bank B. The overnight lending market is designed to do exactly this. Bank B, in this case, happens to have exactly the quantity of reserves bank a needs, and since reserves earn no interest, is happy to lend to bank A at the federal funds rate, which is the overnight interbank lending rate.

Suppose the system as a whole is short of reserves? In this case, the banks who are short on reserves borrow directly from the Fed's discount window.

Suppose the system as a whole has excess reserves? In this case, the Fed sells treasury securities, which enable banks to transfer assets from their reserve accounts (at the Fed) to their treasury accounts (also at the Fed). The Fed sells treasuries not to "finance" the deficit, but to drain the system of excess reserves, so there will be overnight lending, and thus, a non-zero interest rate. If the Fed did not drain extra reserves from the system, banks would not lend, and the overnight lending rate would be zero.

Again, loans create deposits

So, at an individual bank level, banks make loans as they like, and then either borrow the reserves they need at the discount window or overnight market, OR the grow their deposit base to meet their reserve requirements. But the banks make the loans first, and then do whatever to hit their reserve target at the end of the day.

At a macro level, the banking system makes loans, which in turn create deposits.

Note to Austrians: the problem is not maturity mismatching, the problem is private sector credit extension

You'll note that individuals cannot make loans the way banks can. We do not have the facilities they have at the Fed. Austrians think that it is maturity mismatching that enables banks to lend money, but they are wrong (although maturity mismatching has it's own problems), the issue is private sector credit extension. Private sector credit extension expands private sector balance sheets, can it can do this to whatever level it can get away with.

Capital requirements constrain bank lending

So, if reserve requirements don't limit bank lending, what does? Answer: capital requirements. Bank balance sheets must rest on a certain core of paid-in equity, but unfortunately, regulators frequently fudge, ignore, or otherwise enable banks to ignore those rules and leverage themselves to calamitous levels, getting paid obscenely in the process.

I leave you with one of the most remarkably ignorant posts I've seen on this topic, notable only because the individual actually works within the banking system! On a comment forum in Econlog, he stated

The point here is that a particular bank cannot be sure where any disbursed loan funds may end up and can only count on a small proportion returning. This means that they cannot simply inflate their balance sheet by making loans and counting on the funds to come back as deposits. Additionally, if they did this their liquidity ratios (one of the key measures of any bank's soundness) would steadily deteriorate, restricting their ability to make further loans. Their capital ratios would also steadily deteriorate, reducing their ability to raise funds.

Ozrisk does not seem to realize that making loans reduces a bank's ability to make further loans, which is exactly how capital requirements are supposed to work, and their whole point.