Wednesday, February 29, 2012
Banks don't lend their reserves. Even if they could, it would be stupid.
The common story line we have been hearing for the past four years is that the Fed has "printed" all this money and reserves have grown exponentially so they will soon be "lent out" into the economy and that will create inflation.
Or what about this: Lawmakers wringing their hands over the fact that the gov't (Fed) gave the banks all this money and now they should be making loans.
It's wrong. All wrong.
First of all we need to understand that banks create loans by merely creating an accounting entry on their books. That's it. That's all there is to it. That's the power you have, granted to you by the government once you have a commercial bank charter. You create loans literally out of thin air. The only thing constraining your ability to do that is your capital. Nothing more than some capital and a blessing from the government and you're in business to "create money" (credit money) out of thin air. No reserves, no taking from Peter to lend to Paul. Nothing of the sort.
The point I am making is, if a bank needs nothing more than some capital and a book keeping system to make a loan, why would they lend out their reserves? From a business standpoint it would be really, really, dumb.
Don't forget, reserves earn interest for banks. Even if the interest rate is very low, the interest earned adds up. It's something. It flows to the banks' bottom line. More importantly, it's a no-risk stream of income and for a businesss that is fraught with risk (banking), that's a very precious thing. You don't want to play around with that.
So the obvious question is, why would a bank lend out its reserves and forego that risk free income when it's not even necessary? Again, the loan is just an entry on the banks' books. They can make that happen at will AND let the reserves sit there earning income at the same time.
Indeed, I'm not even sure if the banks are legally allowed to make loans with those reerves. I believe reserves can only be invested in things specified by the regulatory authorities and that mostly inlcudes government securities.
Therefore, no lending of reserves. Not necessary. Stupid, even.