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How Banks Operate - A Toy Model

From a number of recent articles written by otherwise intelligent folks it seems many people have a model of banks that goes like this:

Banks have a shoebox full of cash/reserves. When you go to get a car loan for $10,000, the bank goes in the back and fishes $10,000 out of the shoe box and hands it to you! Let me tell you this - it does not work that way.

A Toy Model

Let us look at a simplified bank balance sheet:

Assets: Cash, Reserves, Loans

Liabilities: Deposits, Debt, Equity

Now, banks have to meet a variety of complex regulations, but vastly oversimplifying , for purposes of this toy model, I'll make up two rules:

Cash+Reserves/Deposits > 10%

Equity/ Loans > 5%

Now, let's say we start a bank with $1000 in Cash, which we deposit at the Fed as Reserves. Our initial balance sheet looks like this:

Assets: Cash and Reserves =$1000

Liabilities: Equity = $1000

OK? Now, say our first customer walks in and wants to borrow $5000 to buy a motorcycle. He has great credit. What do we say to him? I think a lot of people may think we have to say something like the following:

" Thanks for coming in. We just started our bank and don't have any deposits and only $1000 in cash, so please come back in a week or so by which time we will easily have more than $5000 in deposits and can make you the loan". Right? Wrong!!

What we do is sit the customer down. Have him sign a loan document for $5000 payable in 5 years at interest rate of 8%. Then we hand him a checkbook with an initial balance on his deposit of $5000. Our bank balance sheet now looks like this:

Assets: Cash and Reserves=$1000, Loans=$5000

Liabilities: Deposits=$5000, Equity=$1000

Do we meet our regulatory ratios? Let's see.

Cash+Reserves/Deposits=20% Check, easily meets the 10% minimum

Equity/Loans=20% Check easily meets the 5% minimum.

So- that's kind of how it works. Banks create loans and matching deposits simultaneously, subject to meeting certain regulatory ratios.

At the moment, our banks are swimming in excess reserves to the tune of $3 Trillion. So, that first ratio is a non-issue and banks don't need to pay any attention to their reserve ratios when deciding whether or not to make a loan. That second ratio is more important - banks need to worry about the riskiness of the loans and making sure they have adequate capital.

What was QE all about? In very rough numbers , this is kind of what happened over the past 5 years: The Govt ran a cumulative budget deficit of $3 Trillion and issued Treasuries to finance it. The banks bought the $3 Trillion in Treasuries and simultaneously increased their deposits by $3 trillion. Then the banks turned around and sold the $3 Trillion in Treasuries to the Fed in exchange for Reserves. Which is why the banks now have a huge amount of excess reserves.

You can now, read my other instablog titled "Fed to raise rates next year? Don't worry." for my thoughts on why this upcoming rate rise cycle will not be anything like in the past.