Banks are Not Reserve Constrained
Modern banks are not “reserve constrained” as in “fractional reserve banking”, which is an effectively obsolete term. (Note: China, whose government owns the Chinese banking system, still uses variable reserve rates to implement the banking component of its fiscal policy.) Today “reserves” are held as paper banknotes and electronic reserve balances that are created by central banks with no physical limits and made readily available to commercial banks which can put up whatever scant threadbare “collateral” against them. This “collateral” could be a no income verification, no down payment, interest only, liar’s loan of $600k made to a homeless bum to buy a McMansion. This was sufficient “security” for the Fed to provide the originating bank whatever reserves it needed to back up the new $600k it had created. (Note: the ECB (European Central Bank), not to be outdone by the damn Yankees, bought Greek government bonds from its commercial banks at face value).
Then one of the three mighty and all seeing rating agencies would stamp AAA on packages of these junk loans that were bundled up by Wall Street investment banks and sold to unwary investors who were not unexpectedly deceived by the rating agencies’ stamps of “investment grade” approval. Then the bum is given several credit cards which he maxes out furnishing his new McMansion. And automakers compete to give him a new $zero down car. Then he gets a home equity line of credit to build his swimming pool and take a much needed vacation after the exertion of getting all those loans and spending all that money.
All of these latter loans are likewise packaged up by Wall St into collateralized debt obligations (CDOs), stamped AAA, and sold as ‘investments’ to the unwary who are attracted by the high interest the bum has agreed to pay on all his loans. Of course the bum never had any ability (and perhaps no intention) of ever making any of the principal repayments, let alone paying attractively high interest, so these misty fantasies of outsized returns ultimately condensed into the acrid smogs of default.
Banks are Capital Constrained
Banks are no longer reserves constrained because their central banks will provide them with all the “cash” they need. (Exception – at least temporarily – the Eurozone nations gave up their independent national central banks and their national currencies and are now at the mercy of the financiers who have taken control of printing euros and operating the euro money system.) Banks are now “capital constrained”. A bank balance sheet looks like this:
A = K + L
Assets = capital + liabilities.
Simple. This brings to mind John Kenneth Galbraith’s quip from his 1975 book simply titled, “Money”:
“The process by which banks create money is so simple that the mind is repelled. Where something so important is involved, a deeper mystery seems only decent.”
Indeed, bank money creation is so simple that most people simply can’t believe it. This “incredibility factor” is probably the primary cause of our culture’s almost universal ignorance about the magnificently simple mechanics of our money systems. You tell people the simple truth that banks create our money by lending it to us. They don’t believe you. So they remain ignorant.
Risk Free Money
The bank’s own money that the bank’s owners ultimately pledge against the eventuality of catastrophic loan losses, is the limiting factor in the balance sheet equation (bank capital, K in the equation above). Under Basel Accords, a bank can only purchase assets (i.e. make loans against collateral) and create liabilities against itself (i.e. create deposits), as a “risk adjusted” multiple of its capital. By convention both the U.S. and the Eurozone have decided that government debt (bonds, etc.) are zero risk for capital adequacy calculations, which means there is no limit to how much bonds banks can buy and hold.
“A Gaze Blank and Pitiless as the Sun”
So bank purchases of government debt are limited neither by reserve constraints nor by capital constraints. Our banks can create money to buy unlimited quantities of our governments’ debts, and thus collect unlimited interest payments from the poor debt-serf taxpayer upon whose weary shoulders the entire debt-built edifice perches, its “gaze blank and pitiless as the sun” (William Butler Yeats, “The Second Coming”) as it preys upon the next dollar of his “taxable earnings”.
In the run up to the recent bubble collapse “volatility”, the primary component of “risk” measurement, was declining, so the Basel “risk adjustment” ratio was likewise declining and capital could increase its multiple of asset purchases. Thus banks could create more loans to fund asset price inflation and provide debt grist to the Wall Street securitization mill.
Of course this proved in hindsight to be merely a procyclical acceleration of the fatal trend, which heterodox macro economists of the Hyman Minsky “instability” persuasion could clearly see and warned us about. William White, Head of the Monetary and Economic Department at the BIS at this time, was increasingly strident in his annual warnings to central bankers of a runaway train of accelerating global bank leverage.