How does a small business banker calculate the amount of money he can lend?

Question

Thank You.

Answer 1

A bank's ability to lend is governed by  Federal Reserve Bank reserve requirements.

Reserve requirements are the portion of deposits that banks may not lend and have to keep either on hand or on deposit at a Federal Reserve Bank

The Monetary Control Act (MCA) of 1980 authorizes the Fed's Board of Governors to impose a reserve requirement of 8% to 14% on transaction deposits (checking and other accounts from which transfers can be made to third parties) and of up to 9% on nonpersonal time deposits (those not held by an individual or sole proprietorship). The Fed may also impose a reserve requirement of any size on the amount depository institutions in the United States owe, on a net basis, to their foreign affiliates or to other foreign banks. Under the MCA, the Fed may not impose reserve requirements against personal time deposits except in extraordinary circumstances, after consultation with Congress, and by the affirmative vote of at least five of the seven members of the Board of Governors.

In order to lighten the reserve requirements on small banks, the MCA provided that the requirement in 1980 would be only 3% for the first $25 million of a bank's transaction accounts, and that the $25-million figure would be adjusted annually by a factor equal to 80% of the percentage change in total transaction accounts in the United States. An adjustment late in 2006 put the amount at $45.8 million. Similarly, the Garn-St. Germain Act of 1982 provided for a 0% reserve requirement for the first $2 million of a bank’s deposits. This level, too, rises each year as deposits grow, but it is not adjusted for declines in deposits. As of December 2006, that level is $8.5 million.

The transactions-account reserve requirement is applied to deposits over a two-week period: a bank's average reserves over the period ending every other Wednesday must equal the required percentage of its average deposits in the two-week period ending the Monday sixteen days earlier. Banks receive credit in one two-week period for small amounts of excess reserves they held in the previous period; similarly, a small deficiency in one period may be made up with excess reserves in the following period. Banks that fail to meet their reserve requirements can be subject to financial penalties.

Reserve Requirements and Money Creation

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.