The government has specific rules set which all banks especially need to follow to maintain the basic cash reserve ratio. This can only be done when money is lent out at specific rates of interest after creating a deposit account with the same in the name of the borrower. While it may ideally and apparently seem like the bank is lending out the money from its reserves but in reality, it is creating an asset from its own money.
Without going very deep into the matter it can be said that giving out loans the banks build assets which is much greater than the deposit liability created.
Way it is done
The way the banks create such assets can be best explained with the help of a hypothetical case. Typically, in most of the circumstances, the ban will require a net worth of 10% fee directly out of the loan amount provided. Please note that since this is a hypothetical example, the percentage is taken to be 10% to make calculations and understandings easier. In reality, this amount is much lower.
- This means when a bank provides a loan of $100, it deducts a fee of $10 making the actual deposit to be just $90. It also means that the reserve requirement of the bank is reduced by $1 due to this accounting.
- Apart from that, this process creates a $119 of liability for the bank which includes $9 reserve requirement and a $10 capital requirement.
Taking a closer look
Now the question is how can the meet with the additional requirement of $9 for reserves? Well, the bank may call for a new customer to deposit a minimum of $10 dollars. That means it will create a liability of $10 for the bank as well as a $10 cash balance which is the asset of the bank.
The bank, in turn, will require on $1 dollar of this new deposit to use as a reserve for it leaving the rest $9 as a reserve for the loan account created earlier. The fact that there is no capital requirement for cash assets makes things simpler and easy for the reserve requirement which is only one application in such cases.
When you go through different websites such as or any other you may come across a term called ‘interbank loans.’
- This is the process by which a bank can borrow from another bank for its reserves. In the Fed Funds market, the bank providing the loan enjoys the rights of a money lender and the bank borrowing becomes the legally liable debtor.
- In such cases, the banks that have excess money as reserves lend money to other banks that have a shortfall in its reserves that is fixed by the government. This is an unsecured overnight lending market but is very helpful to maintain the reserve requirements by the banks.
Going back to the above example, the bank with a reserve deficit may not require a new deposit to create a reserve. Instead, it can borrow the deficit money and make up the $9 shortfall.
The benefit of interbank loans is the low amount of interest that such loans carry. Currently, the Federal Reserve controls this interbank lending market and has fixed the rate of interest on such loans as low as 0 and 0.25%. That means acquiring the $9 of reserve on a loan is easy and inexpensive.
Use of the loan amount
The amount of loan sitting in the loan account of the borrower will also have a considerable effect on the bank’s financial management when it is used. This is a very complex scenario.
- The borrower will write a check for this purpose on his account.
- The amount mentioned on the check will be transferred to the account of the payee and suppose the entire $90 is paid. This amount is transferred through the specific payment system of the Federal Reserve.
- The bank, however, may not have this $90. All it may have is the $9 borrowed for reserves through interbank lending and a $10 as retained earnings.
- The bank cannot use the $10 retained earnings however as it is required to be retained as the capital requirement of the bank.
- Withdrawal of $90 from the bank account will revoke the liability of reserve requirement by the bank against the deposit but the loan will still remain outstanding. That means in turn that the capital requirement will still remain in place.
Therefore, the bank will need a further $81 to deposit from some other depositors or the interbank market or through money market funds against some collateral as required. In this case the only collateral the bank has is the initial loan amount given by it which was worth $100. This means when this collateral is given, raising $81 is not much of a problem.
The significance of the capital requirement
It is during this time that the significance of capital requirements is felt. The capital requirement will do its job when it was funded by the bank that created the deposit. It is due to the fact that the bank has successfully lent out $90 and in the process has created a capital reserve of $10 effectively while giving a loan of $100; it will be able to borrow money from a collateralized market. It will be able to account for its liability when the deposit thereby created by the loan is drawn.
With all these complex calculation and nuances created by the capital requirement, the bank can now easily borrow the required $90 to satiate its reserve requirements as well as its loan withdrawal liability. At the same time, the bank can enjoy a handsome steep discount. This will result in making a profit by the bank on the entire spread.
That means it is all about the origination fee and its effects that enabled the bank to create a capital requirement by selling a $10 worth of equity. In turn, the bank has successfully and effectively created a $100 asset, a $100 liability, a $10 reserve requirement and a $10 capital requirement.