Bank Reserves and Loans: The Fed is Pushing On a String
The money multiplier effect no longer works.
As you (hopefully) know, we live in a fractional reserve banking system: if the bank is required to have $1 in cash reserves for every $10 in loans, it means the bank creates $10 of new money when it issues a $10 loan. When the $10 loan is paid off, that money vanishes from the system.
At that point, the bank is insolvent, i,e, its losses exceed its assets.The problem with fractional reserve lending is the leverage. A 10-to-1 reserve ratio means that if the bank issues a $10 loan, the borrower defaults and the borrower’s collateral (home, auto, etc.) only fetches $8 on the open market, the bank lost $2, which is more than the bank’s cash reserves ($1).
In credit bubbles, the reserve requirements may reach absurd levels of leverage. At a reserve ratio of 100-to-1, a $2 loss of value in a $100 loan will push the bank into insolvency, as it only held $1 in cash as reserves against the $100 loan.
Reserve requirements and leverage are one set of constraints on new loans; the other constraint is the income, creditworthiness and willingness of the borrower.If households and businesses decide not to borrow more, regardless of the interest rate, then raising or lowering the reserve requirements will have no effect.
This is where the Federal Reserve finds itself today. The Fed is anxious to spark more lending/borrowing, and it has lowered interest rates to near-zero and made it easy for banks to build reserves–two things that in previous eras would have sparked increased borrowing.
But in our debt-saturated, stagnant-income era, the Fed is pushing on a string.Frequent contributor Dave P. explains why with the aid of two of his charts:
Banks can create new money, but only within the limits of the reserve requirements set by the Fed.
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