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Why Full Reserve Banking Is A Bad Idea

LETeller
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4/29/2015 11:09:21 PM
Posted: 1 year ago
(Iceland brings this to mind):

The idea is that time deposits could actually be loaned out, and demand deposits could not be. Demand deposits would require that a storage fee be charged to the depositor, time deposits would pay interest. Proponents argue that it would make banking safer and force banks to be more responsible. The reverse is true, in both cases.

Deposits are bank liabilities, of course, and can't actually be loaned out. Since most deposits aren't cash, but are electronic or check, the assets that banks received can't be loaned out, either. What banks do is create deposits for borrowers and create balances in them that depositors can use. It has to be this way, there simply is no other way for a bank to account for a loan.

Some full reserve advocates understand this (most, I suspect), and propose that the central bank essentially lend banks money in order for banks to be able to make loans, with the "credit limit" of the bank being established by the total value of its time deposits.

This puts underwriting decisions in the hands of some central committee at the central bank.

What full reserve advocates typically don't understand is that reserves currently have nothing to do with loans. "Fractional reserve banking" is a misnomer.

It's based on the idea that banks lend deposits. But if banks lent deposits, and since when banks lend they create deposits for borrowers, this becomes an endless circle - once a bank lends money to a borrower and creates a deposit for him, that deposit looks exactly like any other deposit.

There's no way to distinguish a deposit created by a loan from a deposit created by grandma's weekly savings. Banks could, then, by lending deposits, create more deposits, which means they magically have more money to lend, in an infinite loop.

That infinite loop doesn't exist.

Banks create money based on their capital, that is the assets they have in excess of their liabilities (remembering deposits are liabilities for a bank). Absent regulation to the contrary, they can create as many loans as they can service with their available capital - so there is a limit to what they can lend. It's fuzzy, but it's there. Practically, we take the fuzziness out of that and regulate banks to allow them to lend some specific multiple of their available capital.

Essentially, banks are allowed to lend now based on their financial strength (it's arguable whether the existing regulations really assure that, but those regulations ARE based on the financial strength of a bank - its capital). The proposal for full reserve banking essentially divorces a bank's ability to lend from its financial strength (which is necessary to protect the bank's depositors and investors), and rests it on the bank's ability to assume liabilities (that is, to attract depositors, who are really creditors of the bank). In other words, under a full reserve system, the more indebted a bank is, the more it can lend.

I think that's foolish. One of our big problems right now is (private) debt. Why would we want to, on the one hand restrict credit to the control of a central committee, and on the other grant the most indebted banks the greatest right to make loans? Passing a law which encourages banks to leverage themselves even more seems backwards to the goal of safe, responsible banking.

It's important to understand that full reserve banking proposals are not a "tightening up" of what we have now. We currently have no reserve constraint on lending. Lending is capital constrained (as I mentioned above).

Reserve constraints apply to demand deposits, not loans. The reason for that is that reserves do not exist to protect depositors, reserves cannot be loaned to borrowers, nor can they be leveraged into loans for borrowers.

They are the scorekeeping mechanisms banks use to settle interbank transactions. When your paycheck clears, it clears because the Fed took reserves from your employer's bank, and gave reserves to your bank. Banks are the currency of the payments system which processes our checking and ATM transactions. They have no connection to lending, and tying them to lending for the first time, as "full reserve" advocates propose to do just introduces the probability that lending operations will now interfere with the check clearing and ATM processing operations which are the financial lifeblood of the average American.

To tie the payments system to lending seems a risky and pointless thing to do. It accomplishes nothing, and throws obstacles in the way of your paycheck clearing. Rather than reducing systemic risk, it increases that risk by tying other people's loans to your ability to use the money in your checking account. That's not responsible, it's insane.
Chang29
Posts: 732
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4/30/2015 12:32:09 AM
Posted: 1 year ago
At 4/29/2015 11:09:21 PM, LETeller wrote:
(Iceland brings this to mind):

The idea is that time deposits could actually be loaned out, and demand deposits could not be. Demand deposits would require that a storage fee be charged to the depositor, time deposits would pay interest. Proponents argue that it would make banking safer and force banks to be more responsible. The reverse is true, in both cases.

Deposits are bank liabilities, of course, and can't actually be loaned out. Since most deposits aren't cash, but are electronic or check, the assets that banks received can't be loaned out, either. What banks do is create deposits for borrowers and create balances in them that depositors can use. It has to be this way, there simply is no other way for a bank to account for a loan.

Some full reserve advocates understand this (most, I suspect), and propose that the central bank essentially lend banks money in order for banks to be able to make loans, with the "credit limit" of the bank being established by the total value of its time deposits.

This puts underwriting decisions in the hands of some central committee at the central bank.

What full reserve advocates typically don't understand is that reserves currently have nothing to do with loans. "Fractional reserve banking" is a misnomer.

It's based on the idea that banks lend deposits. But if banks lent deposits, and since when banks lend they create deposits for borrowers, this becomes an endless circle - once a bank lends money to a borrower and creates a deposit for him, that deposit looks exactly like any other deposit.

There's no way to distinguish a deposit created by a loan from a deposit created by grandma's weekly savings. Banks could, then, by lending deposits, create more deposits, which means they magically have more money to lend, in an infinite loop.

That infinite loop doesn't exist.

Banks create money based on their capital, that is the assets they have in excess of their liabilities (remembering deposits are liabilities for a bank). Absent regulation to the contrary, they can create as many loans as they can service with their available capital - so there is a limit to what they can lend. It's fuzzy, but it's there. Practically, we take the fuzziness out of that and regulate banks to allow them to lend some specific multiple of their available capital.

Essentially, banks are allowed to lend now based on their financial strength (it's arguable whether the existing regulations really assure that, but those regulations ARE based on the financial strength of a bank - its capital). The proposal for full reserve banking essentially divorces a bank's ability to lend from its financial strength (which is necessary to protect the bank's depositors and investors), and rests it on the bank's ability to assume liabilities (that is, to attract depositors, who are really creditors of the bank). In other words, under a full reserve system, the more indebted a bank is, the more it can lend.

I think that's foolish. One of our big problems right now is (private) debt. Why would we want to, on the one hand restrict credit to the control of a central committee, and on the other grant the most indebted banks the greatest right to make loans? Passing a law which encourages banks to leverage themselves even more seems backwards to the goal of safe, responsible banking.

It's important to understand that full reserve banking proposals are not a "tightening up" of what we have now. We currently have no reserve constraint on lending. Lending is capital constrained (as I mentioned above).

Reserve constraints apply to demand deposits, not loans. The reason for that is that reserves do not exist to protect depositors, reserves cannot be loaned to borrowers, nor can they be leveraged into loans for borrowers.

They are the scorekeeping mechanisms banks use to settle interbank transactions. When your paycheck clears, it clears because the Fed took reserves from your employer's bank, and gave reserves to your bank. Banks are the currency of the payments system which processes our checking and ATM transactions. They have no connection to lending, and tying them to lending for the first time, as "full reserve" advocates propose to do just introduces the probability that lending operations will now interfere with the check clearing and ATM processing operations which are the financial lifeblood of the average American.

To tie the payments system to lending seems a risky and pointless thing to do. It accomplishes nothing, and throws obstacles in the way of your paycheck clearing. Rather than reducing systemic risk, it increases that risk by tying other people's loans to your ability to use the money in your checking account. That's not responsible, it's insane.

Lets do some simple accounting (Assets = Liabilities + Owner's Equity):
A deposit of a $100 is recorded as on the asset side of the equation as Cash Dr $100 and on the liability side as accounts payable Cr $100, accounting equation is balanced at $100

Then a $90 loan is issued which is the highest Fed required reserve of 10%:
Two accounting entries required both on asset side: Loan issued Cash Cr $90, and Loan Receivable Dr $90. Since both entries are on the asset side of the equation it is still balanced at $100.

Now looking at account balances:
Cash $100-$90= $10
Loan issued = $90
Loan receivable = $90
Account payable = $100

The original depositor withdraws the $20!
The bank's cash account is at $10! The bank is insolvent!

The bank has followed all regulatory guidance, yet owes $10 that the bank does not have, and the proponent of 100% reserve banking are the insane ones.
A free market anti-capitalist

If it can be de-centralized, it will be de-centralized.
Chang29
Posts: 732
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4/30/2015 12:34:38 AM
Posted: 1 year ago
At 4/29/2015 11:09:21 PM, LETeller wrote:
(Iceland brings this to mind):

The idea is that time deposits could actually be loaned out, and demand deposits could not be. Demand deposits would require that a storage fee be charged to the depositor, time deposits would pay interest. Proponents argue that it would make banking safer and force banks to be more responsible. The reverse is true, in both cases.

Deposits are bank liabilities, of course, and can't actually be loaned out. Since most deposits aren't cash, but are electronic or check, the assets that banks received can't be loaned out, either. What banks do is create deposits for borrowers and create balances in them that depositors can use. It has to be this way, there simply is no other way for a bank to account for a loan.

Some full reserve advocates understand this (most, I suspect), and propose that the central bank essentially lend banks money in order for banks to be able to make loans, with the "credit limit" of the bank being established by the total value of its time deposits.

This puts underwriting decisions in the hands of some central committee at the central bank.

What full reserve advocates typically don't understand is that reserves currently have nothing to do with loans. "Fractional reserve banking" is a misnomer.

It's based on the idea that banks lend deposits. But if banks lent deposits, and since when banks lend they create deposits for borrowers, this becomes an endless circle - once a bank lends money to a borrower and creates a deposit for him, that deposit looks exactly like any other deposit.

There's no way to distinguish a deposit created by a loan from a deposit created by grandma's weekly savings. Banks could, then, by lending deposits, create more deposits, which means they magically have more money to lend, in an infinite loop.

That infinite loop doesn't exist.

Banks create money based on their capital, that is the assets they have in excess of their liabilities (remembering deposits are liabilities for a bank). Absent regulation to the contrary, they can create as many loans as they can service with their available capital - so there is a limit to what they can lend. It's fuzzy, but it's there. Practically, we take the fuzziness out of that and regulate banks to allow them to lend some specific multiple of their available capital.

Essentially, banks are allowed to lend now based on their financial strength (it's arguable whether the existing regulations really assure that, but those regulations ARE based on the financial strength of a bank - its capital). The proposal for full reserve banking essentially divorces a bank's ability to lend from its financial strength (which is necessary to protect the bank's depositors and investors), and rests it on the bank's ability to assume liabilities (that is, to attract depositors, who are really creditors of the bank). In other words, under a full reserve system, the more indebted a bank is, the more it can lend.

I think that's foolish. One of our big problems right now is (private) debt. Why would we want to, on the one hand restrict credit to the control of a central committee, and on the other grant the most indebted banks the greatest right to make loans? Passing a law which encourages banks to leverage themselves even more seems backwards to the goal of safe, responsible banking.

It's important to understand that full reserve banking proposals are not a "tightening up" of what we have now. We currently have no reserve constraint on lending. Lending is capital constrained (as I mentioned above).

Reserve constraints apply to demand deposits, not loans. The reason for that is that reserves do not exist to protect depositors, reserves cannot be loaned to borrowers, nor can they be leveraged into loans for borrowers.

They are the scorekeeping mechanisms banks use to settle interbank transactions. When your paycheck clears, it clears because the Fed took reserves from your employer's bank, and gave reserves to your bank. Banks are the currency of the payments system which processes our checking and ATM transactions. They have no connection to lending, and tying them to lending for the first time, as "full reserve" advocates propose to do just introduces the probability that lending operations will now interfere with the check clearing and ATM processing operations which are the financial lifeblood of the average American.

To tie the payments system to lending seems a risky and pointless thing to do. It accomplishes nothing, and throws obstacles in the way of your paycheck clearing. Rather than reducing systemic risk, it increases that risk by tying other people's loans to your ability to use the money in your checking account. That's not responsible, it's insane.

Lets do some simple accounting (Assets = Liabilities + Owner's Equity):
A deposit of a $100 is recorded as on the asset side of the equation as Cash Dr $100 and on the liability side as accounts payable Cr $100, accounting equation is balanced at $100

Then a $90 loan is issued which is the highest Fed required reserve of 10%:
Two accounting entries required both on asset side: Loan issued Cash Cr $90, and Loan Receivable Dr $90. Since both entries are on the asset side of the equation it is still balanced at $100.

Now looking at account balances:
Cash $100-$90= $10
Loan issued = $90
Loan receivable = $90
Account payable = $100

The original depositor withdraws only $20!
The bank's cash account is at $10! The bank is insolvent!

The bank has followed all regulatory guidance, yet owes $10 that the bank does not have, and the proponent of 100% reserve banking are the insane ones.
A free market anti-capitalist

If it can be de-centralized, it will be de-centralized.
LETeller
Posts: 47
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4/30/2015 1:25:22 AM
Posted: 1 year ago
Lets do some simple accounting (Assets = Liabilities + Owner's Equity):
A deposit of a $100 is recorded as on the asset side of the equation as Cash Dr $100 and on the liability side as accounts payable Cr $100, accounting equation is balanced at $100

Then a $90 loan is issued which is the highest Fed required reserve of 10%:
Two accounting entries required both on asset side: Loan issued Cash Cr $90, and Loan Receivable Dr $90. Since both entries are on the asset side of the equation it is still balanced at $100.

Now looking at account balances:
Cash $100-$90= $10
Loan issued = $90
Loan receivable = $90
Account payable = $100

The original depositor withdraws only $20!
The bank's cash account is at $10! The bank is insolvent!

The bank has followed all regulatory guidance, yet owes $10 that the bank does not have, and the proponent of 100% reserve banking are the insane ones.

- Let's look at your balance sheet first. Where's the depositor's deposit? It's not an "account payable". It's a deposit.

You're a typical example of what I'm talking about.

Asset
Cash $100-$90= $10
Loan receivable = $90

Loan issued = $90
Account payable = $100 - should be deposit

You have a $90 imbalance between your assets and liabilities. What happened there?

You have just illustrated why banks have to create deposits for borrowers. Notice how your books don't balance? ;)

Okay, so where do reserves come into play here?

I don't see them on your balance sheet. Any ideas about how reserves are accounted for?

Then a $90 loan is issued which is the highest Fed required reserve of 10%:

- This is a total misunderstanding of reserves, of what they are and what they do.

Banks don't "hold back" anything out of deposits as "reserves".

Let me help you. Let's run through some transactions and you can see how it really works.

Let's start with the most typical transactions a bank has, checking deposits and withdrawals, and go through them step by step. Then we can walk through a loan, and hopefully you'll get a better idea of how it works.

Let's start with you depositing your paycheck.

When you deposit your paycheck, the banks credits your account with the amount of your paycheck.

The bank now has an asset (the check) and a liability (your deposit)

Asset......................................Liability
+ Check..................................+ deposit

At posting time, the Fed will credit your bank's reserve account with a balance equal to your paycheck

Asset......................................Liability
Check....................................deposit
-Check
+Reserves

That's where reserves come from. They come from the Fed. In this case, the Fed also took reserves in equal amount from your employer's bank, and that bank reduced your employer's deposit. Your bank's balance sheet has expanded, and the other bank's balance sheet has contracted.

Okay, so you make a payment, say you write a check to your landlord. Your bank gets a notice that your landlord has deposited a check, which results in the following transaction.

Asset......................................Liability
Reserves................................deposit
-Reserves..............................-deposit

Now if you notice, your bank has received 100% of the value of its deposits in reserves.

It doesn't need that - it just needs to keep 10% of that value in its checking account. Over time, as long as a bank is doing business with checks, 90% of its reserves will be excess reserves. So unless its cash deposits are nine times as large as its check deposits, it really doesn't have to worry about reserves. What your bank would probably do is buy Treasuries from the Fed with those reserves - they pay better interest. But let's slip that now, and do a cash deposit.

You bring some cash in and deposit it:

Asset......................................Liability
Reserves................................deposit
+Cash....................................+deposit

There is no issue with reserves. The bank has plenty. They can count the cash if they want to reduce their reserve requirement, but cash itself is not reserves - it just can be used to offset a reserve balance requirement.

Okay, now let's make a loan.

You want to borrow money in order to buy a car. Here's how the bank does it.

Asset......................................Liability
Reserves................................deposit
Cash...................................................
+ Loan Receivable..............+deposit

See how that balances? We can't get an imbalance if we do it like this. And we ALWAYS do it like this. Your bank has created a deposit for you.

The ability of a bank to lend has nothing to do with reserves. It has to do with capital, which we're not chowing on this balance sheet, because it doesn't change throughout these operations, all of which are simple balance sheet expansions and contractions.

The bank has other assets - paid in capital, a trading portfolio, Treasuries, and other assets, some of which are going to be in excess of liabilities, creating equity (or the FDIC will shut them down). It is that capital which they leverage into loans, not reserves.

You gave a little example (which you bungled by not keeping balanced) without including those other assets. Banks aren't lending their deposits. As you can see, the vast majority of deposits don't give them any asset they can lend, or are deposits created for borrowers, which also don't give them assets they can lend.

A reserve constraint on lending makes zero sense.

Just to slake your curiosity, lets see what happens if the bank is short of cash to meet demand at the teller window. They go to the Fed and buy cash. Remember how they always seem to end up with excess reserves? Your bank cannot go insolvent from the transactions you posted. Here's what they do:

Asset......................................Liability
Reserves................................deposit
-Reserves...........................................
Cash...................................................
+Cash.................................................
Loan Receivable...............................

- Now they can cheerfully give you the cash you want.
Chang29
Posts: 732
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4/30/2015 1:54:06 AM
Posted: 1 year ago
At 4/30/2015 1:25:22 AM, LETeller wrote:
Lets do some simple accounting (Assets = Liabilities + Owner's Equity):
A deposit of a $100 is recorded as on the asset side of the equation as Cash Dr $100 and on the liability side as accounts payable Cr $100, accounting equation is balanced at $100

Then a $90 loan is issued which is the highest Fed required reserve of 10%:
Two accounting entries required both on asset side: Loan issued Cash Cr $90, and Loan Receivable Dr $90. Since both entries are on the asset side of the equation it is still balanced at $100.

Now looking at account balances:
Cash $100-$90= $10
Loan issued = $90
Loan receivable = $90
Account payable = $100

The original depositor withdraws only $20!
The bank's cash account is at $10! The bank is insolvent!

The bank has followed all regulatory guidance, yet owes $10 that the bank does not have, and the proponent of 100% reserve banking are the insane ones.

- Let's look at your balance sheet first. Where's the depositor's deposit? It's not an "account payable". It's a deposit.

You're a typical example of what I'm talking about.

Asset
Cash $100-$90= $10
Loan receivable = $90


Loan issued = $90
Account payable = $100 - should be deposit

You have a $90 imbalance between your assets and liabilities. What happened there?

You have just illustrated why banks have to create deposits for borrowers. Notice how your books don't balance? ;)

Okay, so where do reserves come into play here?

I don't see them on your balance sheet. Any ideas about how reserves are accounted for?

Then a $90 loan is issued which is the highest Fed required reserve of 10%:

- This is a total misunderstanding of reserves, of what they are and what they do.

Banks don't "hold back" anything out of deposits as "reserves".

Let me help you. Let's run through some transactions and you can see how it really works.

Let's start with the most typical transactions a bank has, checking deposits and withdrawals, and go through them step by step. Then we can walk through a loan, and hopefully you'll get a better idea of how it works.

Let's start with you depositing your paycheck.

When you deposit your paycheck, the banks credits your account with the amount of your paycheck.

The bank now has an asset (the check) and a liability (your deposit)

Asset......................................Liability
+ Check..................................+ deposit

At posting time, the Fed will credit your bank's reserve account with a balance equal to your paycheck

Asset......................................Liability
Check....................................deposit
-Check
+Reserves

That's where reserves come from. They come from the Fed. In this case, the Fed also took reserves in equal amount from your employer's bank, and that bank reduced your employer's deposit. Your bank's balance sheet has expanded, and the other bank's balance sheet has contracted.

Okay, so you make a payment, say you write a check to your landlord. Your bank gets a notice that your landlord has deposited a check, which results in the following transaction.

Asset......................................Liability
Reserves................................deposit
-Reserves..............................-deposit

Now if you notice, your bank has received 100% of the value of its deposits in reserves.

It doesn't need that - it just needs to keep 10% of that value in its checking account. Over time, as long as a bank is doing business with checks, 90% of its reserves will be excess reserves. So unless its cash deposits are nine times as large as its check deposits, it really doesn't have to worry about reserves. What your bank would probably do is buy Treasuries from the Fed with those reserves - they pay better interest. But let's slip that now, and do a cash deposit.

You bring some cash in and deposit it:

Asset......................................Liability
Reserves................................deposit
+Cash....................................+deposit

There is no issue with reserves. The bank has plenty. They can count the cash if they want to reduce their reserve requirement, but cash itself is not reserves - it just can be used to offset a reserve balance requirement.

Okay, now let's make a loan.

You want to borrow money in order to buy a car. Here's how the bank does it.

Asset......................................Liability
Reserves................................deposit
Cash...................................................
+ Loan Receivable..............+deposit

See how that balances? We can't get an imbalance if we do it like this. And we ALWAYS do it like this. Your bank has created a deposit for you.

The ability of a bank to lend has nothing to do with reserves. It has to do with capital, which we're not chowing on this balance sheet, because it doesn't change throughout these operations, all of which are simple balance sheet expansions and contractions.

The bank has other assets - paid in capital, a trading portfolio, Treasuries, and other assets, some of which are going to be in excess of liabilities, creating equity (or the FDIC will shut them down). It is that capital which they leverage into loans, not reserves.

You gave a little example (which you bungled by not keeping balanced) without including those other assets. Banks aren't lending their deposits. As you can see, the vast majority of deposits don't give them any asset they can lend, or are deposits created for borrowers, which also don't give them assets they can lend.

A reserve constraint on lending makes zero sense.

Just to slake your curiosity, lets see what happens if the bank is short of cash to meet demand at the teller window. They go to the Fed and buy cash. Remember how they always seem to end up with excess reserves? Your bank cannot go insolvent from the transactions you posted. Here's what they do:

Asset......................................Liability
Reserves................................deposit
-Reserves...........................................
Cash...................................................
+Cash.................................................
Loan Receivable...............................

- Now they can cheerfully give you the cash you want.

Since banks do not need a person's deposits to make loans, banks competing for deposit customers must be pointless. Banks are still advertising for more deposit consumers and maintaining access points for deposits and dispensing cash, they must also be insane.

In the small example, that bank is only solvent due to actions of another party's questionable activity. The Fed created money from nothing for the bank's reserve account, that can not end well. If anyone else, other than the Fed engaged in this activity it would be counterfeiting.
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If it can be de-centralized, it will be de-centralized.
LETeller
Posts: 47
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4/30/2015 6:44:13 AM
Posted: 1 year ago
Chang29, deposits make banks money in several ways. First, banks need to accept deposits in order to be Fed members, which enables them access to the payments system, which is necessary to all those transactions I described above.

Accepting deposits allows banks to be full service lenders, rather than just loan originators.

Depositors also use services - check cards and credit cards, all of which make money as retail services.

The idea that banks are intermediaries which accept the deposits of patient savers and lend them to impatient borrowers is an ancient conceptual model which hasn't been true in our lifetimes, although it is still a model that is widely taught and believed.

It is only if you believe that model that accepting deposits seems pointless if deposits are not being loaned. What you miss there is that banks create deposits as their technique of creating loans for borrowers. This is what enables banks to leverage their capital.

The example you gave, in which you claimed your bank became insolvent after issuing its first loan, was an example of full reserve banking. The bank was only lending based on deposits it actually had on hand, but that didn't prevent you from claiming that a bank which complied with the full reserve rules you prefer from becoming "insolvent" (in your view) immediately.

In your example, cash is the only currency. Bank deposits are not money (you mistakenly called them accounts payable), and your bank was restricted to lending deposits.

In other words, there is no creation of credit at all in the system you propose. You can see that there is no possibility of it, no leverage at all. In order to create leverage, banks MUST create loans as deposits. They cannot simply take in cash and put it in somebody else's hands.

So the acceptance of deposits is necessary to the creation of deposits. Reserves themselves don't enable loans to be made, but the accepting of deposits is what enables banks to create deposits in order to leverage their capital.
Chang29
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4/30/2015 8:20:32 AM
Posted: 1 year ago
At 4/30/2015 6:44:13 AM, LETeller wrote:
Chang29, deposits make banks money in several ways. First, banks need to accept deposits in order to be Fed members, which enables them access to the payments system, which is necessary to all those transactions I described above.

Accepting deposits allows banks to be full service lenders, rather than just loan originators.

Depositors also use services - check cards and credit cards, all of which make money as retail services.

The idea that banks are intermediaries which accept the deposits of patient savers and lend them to impatient borrowers is an ancient conceptual model which hasn't been true in our lifetimes, although it is still a model that is widely taught and believed.

It is only if you believe that model that accepting deposits seems pointless if deposits are not being loaned. What you miss there is that banks create deposits as their technique of creating loans for borrowers. This is what enables banks to leverage their capital.

The example you gave, in which you claimed your bank became insolvent after issuing its first loan, was an example of full reserve banking. The bank was only lending based on deposits it actually had on hand, but that didn't prevent you from claiming that a bank which complied with the full reserve rules you prefer from becoming "insolvent" (in your view) immediately.

In your example, cash is the only currency. Bank deposits are not money (you mistakenly called them accounts payable), and your bank was restricted to lending deposits.

In other words, there is no creation of credit at all in the system you propose. You can see that there is no possibility of it, no leverage at all. In order to create leverage, banks MUST create loans as deposits. They cannot simply take in cash and put it in somebody else's hands.

So the acceptance of deposits is necessary to the creation of deposits. Reserves themselves don't enable loans to be made, but the accepting of deposits is what enables banks to create deposits in order to leverage their capital.

No matter how you frame it, the system you describe creates currency from nothing. That system is an economy based on debt, not wealth.

In a 100% reserve banking system, banks simply store money or match lenders to borrowers. Very little need for financial oversight sight banks are not levered up against assets that have value based on debt.
A free market anti-capitalist

If it can be de-centralized, it will be de-centralized.
Diqiucun_Cunmin
Posts: 2,710
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4/30/2015 11:40:06 AM
Posted: 1 year ago
Sorry if this sounds clueless, but I'm trying to understand what you wrote.
At 4/29/2015 11:09:21 PM, LETeller wrote:
(Iceland brings this to mind):

The idea is that time deposits could actually be loaned out, and demand deposits could not be. Demand deposits would require that a storage fee be charged to the depositor, time deposits would pay interest. Proponents argue that it would make banking safer and force banks to be more responsible. The reverse is true, in both cases.

Deposits are bank liabilities, of course, and can't actually be loaned out. Since most deposits aren't cash, but are electronic or check, the assets that banks received can't be loaned out, either. What banks do is create deposits for borrowers and create balances in them that depositors can use. It has to be this way, there simply is no other way for a bank to account for a loan.

Some full reserve advocates understand this (most, I suspect), and propose that the central bank essentially lend banks money in order for banks to be able to make loans, with the "credit limit" of the bank being established by the total value of its time deposits.

This puts underwriting decisions in the hands of some central committee at the central bank.

What full reserve advocates typically don't understand is that reserves currently have nothing to do with loans. "Fractional reserve banking" is a misnomer.

It's based on the idea that banks lend deposits. But if banks lent deposits, and since when banks lend they create deposits for borrowers, this becomes an endless circle - once a bank lends money to a borrower and creates a deposit for him, that deposit looks exactly like any other deposit.

There's no way to distinguish a deposit created by a loan from a deposit created by grandma's weekly savings. Banks could, then, by lending deposits, create more deposits, which means they magically have more money to lend, in an infinite loop.
Mathematically it isn't infinite though; it can't get more than reserves * maximum banking multiplier, unless the required reserve ratio is 0%.
That infinite loop doesn't exist.

Banks create money based on their capital, that is the assets they have in excess of their liabilities (remembering deposits are liabilities for a bank). Absent regulation to the contrary, they can create as many loans as they can service with their available capital - so there is a limit to what they can lend. It's fuzzy, but it's there. Practically, we take the fuzziness out of that and regulate banks to allow them to lend some specific multiple of their available capital.
When you mean their capital, do you mean the reserves they borrow from the inter-bank market, or the reserves they gain from the central bank's OMO purchases of bonds, or other stuff? The capital they raise from issuing shares/debentures?
Essentially, banks are allowed to lend now based on their financial strength (it's arguable whether the existing regulations really assure that, but those regulations ARE based on the financial strength of a bank - its capital). The proposal for full reserve banking essentially divorces a bank's ability to lend from its financial strength (which is necessary to protect the bank's depositors and investors), and rests it on the bank's ability to assume liabilities (that is, to attract depositors, who are really creditors of the bank). In other words, under a full reserve system, the more indebted a bank is, the more it can lend.
Basically, you're saying that what regular Joes (like me) think banks do, banks actually don't do, and wouldn't do except at 100% rrr? I don't understand the connection between 100% rrr and the lending ability of the bank depending on its loans, though... Wouldn't deposits have no impact on lending ability when they can't loan out a penny of the reserves gained from people depositing?
I think that's foolish. One of our big problems right now is (private) debt. Why would we want to, on the one hand restrict credit to the control of a central committee, and on the other grant the most indebted banks the greatest right to make loans? Passing a law which encourages banks to leverage themselves even more seems backwards to the goal of safe, responsible banking.

It's important to understand that full reserve banking proposals are not a "tightening up" of what we have now. We currently have no reserve constraint on lending. Lending is capital constrained (as I mentioned above).

Reserve constraints apply to demand deposits, not loans. The reason for that is that reserves do not exist to protect depositors, reserves cannot be loaned to borrowers, nor can they be leveraged into loans for borrowers.

They are the scorekeeping mechanisms banks use to settle interbank transactions. When your paycheck clears, it clears because the Fed took reserves from your employer's bank, and gave reserves to your bank. Banks are the currency of the payments system which processes our checking and ATM transactions. They have no connection to lending, and tying them to lending for the first time, as "full reserve" advocates propose to do just introduces the probability that lending operations will now interfere with the check clearing and ATM processing operations which are the financial lifeblood of the average American.
So the purpose of reserves is to provide numbers for the clearing house? They have nothing to do with loans?
To tie the payments system to lending seems a risky and pointless thing to do. It accomplishes nothing, and throws obstacles in the way of your paycheck clearing. Rather than reducing systemic risk, it increases that risk by tying other people's loans to your ability to use the money in your checking account. That's not responsible, it's insane.
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LETeller
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4/30/2015 10:49:44 PM
Posted: 1 year ago
There's no way to distinguish a deposit created by a loan from a deposit created by grandma's weekly savings. Banks could, then, by lending deposits, create more deposits, which means they magically have more money to lend, in an infinite loop.

Mathematically it isn't infinite though; it can't get more than reserves * maximum banking multiplier, unless the required reserve ratio is 0%.

- Correct, It approaches, but is not infinite. The numbers can be very high, though. Poetic license.

When you mean their capital, do you mean the reserves they borrow from the inter-bank market, or the reserves they gain from the central bank's OMO purchases of bonds, or other stuff? The capital they raise from issuing shares/debentures?

- Central bank reserves are not counted as capital. Capital is defined by regulation specific to banks, and is divided into Tiers. Under the current regulation, Basel III, Tier 1 capital is equity arising from common stock, preferred stock, retained earnings, stuff like that. Tier 1 capital is not risk weighted, that is, it is valuated normally. Capital which falls outside of the Tier 1 definition is risk weighted, reducing its value as capital. Some assets can be counted as capital if they give the bank resilience, but they are heavily risk weighted.

Tier 1 capital is required to be 4.5% of risk weighted assets (assets are risk-weighted by amounts depending on type, performance, and so on), with an additional 2.5% buffer under normal operations, for a subtotal of 7% Tier 1 capital. When the buffer is broached, some bank operations are restricted (like they cannot pay dividends, may have lending restricted, etc). There is an additional buffer that may be required at the regulator's option, bank by bank. Total capital minimum as a percentage of risk-weighted assets is 8%. This is the bank's constraint on lending.

Central bank reserves don't count as capital, nor do they count as assets - they do not affect the bank's position on either side of the capital adequacy ratio.

It is important to understand that central bank reserves are not reserves in any normal accounting sense of the word. They aren't used to set anything aside for contingent liabilities. They are settlement funds and, in most companies are called something like "settlement funds". They are a scorekeeping system for making interbank payments, and do neither contribute to nor detract from a bank's financial strength.

Basically, you're saying that what regular Joes (like me) think banks do, banks actually don't do, and wouldn't do except at 100% rrr? I don't understand the connection between 100% rrr and the lending ability of the bank depending on its loans, though... Wouldn't deposits have no impact on lending ability when they can't loan out a penny of the reserves gained from people depositing?

- You have it figured out. Here's the problem. We're talking about double-entry bookkeeping every step of the way.

The goal of full reserve banking is to protect depositors. The idea is that banks would take people's money who made checking deposits and essentially stuff it in the vault, so that the assets people gave the bank would actually be available if everyone showed up at once to withdraw all of their money. The obvious problem is that I don't want them to give me my paycheck back. I either want them to honor my checks or give me cash. I gave them my paycheck, which doesn't allow them to do that. We settle checking transactions at the Fed (not all, many are settled privately, but it's a representative example) using transfers of reserves, or settlement funds. As long as we're all passing around checks or ATM transactions, that's fine. We never have to have any tangible money.

But if everyone showed up and wanted to withdraw in cash, the bank would have to have enough cash on hand to pay us, for the system to work. That's obviously impractical, because any cash they had on hand would be an amount of reserves they didn't have, which would mean they couldn't honor our checks and ATM transactions. Those can't feasibly be settled in cash.

So no matter what you do, there is no way to have checking deposits that are all accessible in cash and able to process checks at the same time.

The full reserve guys then sat that time deposits (CDs, savings accounts, etc) should be the only "funds" that banks could lend to customers. If it's in checking, it's off limits, so that people can demand their money promptly. If it's in savings, banks can lend it, because the depositors have already agreed to wait for their money.

But the problem is, if I deposit a check in savings, the bank still has nothing it can use to make a loan. It can't lend my check. So generally, the reserve guys have a system where the bank can go ahead and make a deposit for the borrower, as they do now, but they have to borrow the 100% reserves from the central bank to "back" the new loan deposit. They generally propose some sort of central bank underwriting review system to restrain credit which essentially would decide whether the central bank would be willing to underwrite the loan by providing reserves. That's a process to which I object.

So the purpose of reserves is to provide numbers for the clearing house? They have nothing to do with loans?

A fable makes it easier. You and I are banks. We want to be able to clear each others' checks. We start by agreeing that every time we accept each others' checks, we'll send a courier across town to trade the check for cash.

We realize that we could just wait to the end of the day, then each of us total the checks we had cashed for the other, and whoever cashed more checks would be owed a net amount, the difference between the two. We'd send the courier once a day, at posting time, with one bag of cash to settle. Much more efficient.

We get really smart, and realize that it seems like the courier is bringing a bag one direction one day, and the other the next. Rather than simple netting, we could net even further. We agree that we'll each open a deposit account at each others' banks, and the deficit bank will just credit the deposit of the surplus bank with the net, on a daily basis. More efficient still, and as long as it's just the two of us banks, it works great. This is what was done prior to the Fed.

To make it more efficient when there are lots of banks, we might all agree to open up deposit accounts with the largest bank, which would serve as a central bank for our clearing operations. That way we don't all have to have bank accounts with each other.

We smaller banks can all get together and create a clearinghouse which does nothing but keep running totals of our interbank transactions, and calculate net numbers at the end of each day - every bank will owe a net number to all banks in the system, or be owed a net number by all other banks in the system. These numbers ideally total to zero.

The clearinghouse gives its list to the central bank at the end of each day, and the central bank credits or debits the reserve account of each surplus or deficit bank. Because we're netting, there's no transfer of reserves. The reserve payment you get is a lump sum which represents what all other banks owe to you, less what you owed to all other banks, but it simulates perfectly as if you had settled every transaction individually with every other bank. At this point, the CB is just creating and destroying reserves at will to keep track of who owes who what. There's no actual "transfer" of funds anywhere in the system. It's a simple accounting exercise, other than at the teller window.

Since all the central bank is doing is making net debit and credit adjustments, there's no need to use actual money to do this. It's just scorekeeping. If the central bank wants to ensure that member banks always have settlement funds on hand to complete these operations, it will impose a minimum reserve requirement.
LETeller
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4/30/2015 11:31:58 PM
Posted: 1 year ago
So yes, they have nothing to do with loans directly, but there is another aspect to the system. I told a little white lie: reserve requirements aren't really to ensure that banks have enough reserves to settle interbank payments. I was just running out of space.

Here's the real deal on reserve requirements.

Before we get into this, it might occur to you "hey, wait a minute! If banks create deposits to make loans, those deposits have a reserve requirement! So there IS a reserve constraint on lending!" No. It makes sense, but it doesn't work that way.

The payments system is a critical central bank function, but the CB also has policy goals which Congress gives it. Currently, the governing law is the 1978 Humphrey Hawkins bill, which imposes the "dual mandate": the CB is supposed to conduct policy operations to keep prices stable, and to minimize unemployment. The Fed hasn't paid too much attention to the second, but it is serious about the first.

After experimenting with several methods to control inflation, the Fed has decided that the right way to do that is to control interest rates.

The Fed does not have the authority to set interest rates that banks can charge (they did have some prior to 1983, but that was taken from them).

Prior to QE, the Fed's thinking on controlling interest rates had to do with the term structure of interest rates, which is a theory that the longer the term of a loan, the greater the rate of interest (which seems to make sense, but defies all attempts to describe why it is so with any accuracy). Interest rates for loans of all different maturities are thought to be related, due to arbitrage. That is, if the interest rate is a little more profitable for 30-day loans than for 1-year loans, then lenders will prefer the shorter term, and the increased competition for borrowers in the 30-day market will tend to drive the interest rate down for those loans, until they are equally as profitable as 1-year loans.

The resulting curve is the term structure, and all maturities should be affected by the movement of any maturity, through arbitrage. So theoretically, if somebody were to raise the interest rate of one type of loan of any maturity, then the interest rate on all loans would rise.

The Fed needed, therefore, to create a lending market in which it could control the interest rate. If they could control one interest rate, they could influence all interest rates - theoretically.

Since banks settle their interbank payments in a "currency" wholly issued by the Fed, it seemed logical that a way should be found to force banks to have to borrow reserves from each other. If the Fed could control the supply of reserves, then they would be able to set the price at which banks loaned reserves to each other by adding or draining reserves until that interest rate hit the Fed's sweet spot.

By creating a requirement for minimum reserve balances, banks who were short of reserves could be forced to borrow from each other, and the Fed would be able to influence interest rates throughout the economy - theoretically. This is the real reason for reserve requirements (pre QE). They enable the Fed to control an interest rate, which enables them to do their job of keeping inflation under control. Again, theoretically.

The market in which banks lend each other reserves is called the fed funds market. These are overnight, unsecured loans - so they are at the origin in the term structure.

When a bank receives a check, it is awarded reserves in the full amount of the check, so meeting any minimum reserve requirement is never a problem for a bank.

The Fed had to find a way, therefore, to induce banks to create their own shortages of reserves, to give them an incentive to play the reserve game close to the bone, where they would frequently find themselves in the position of having to borrow reserves.

The Fed had to give banks something they could buy with reserves that was attractive to banks. Pre-QE, the Fed did not pay interest on reserves, so banks would always jump at the chance to use them to make money. Since reserves are a sort of Fed funny money, banks just didn't have those sorts of opportunities in the real market. They couldn't go buy stocks with them or anything like that.

The Fed, then, established the system of selling Treasuries at auction through primary dealers, which are banks. Banks were offered the opportunity to swap their reserves, which earned nothing, for Treasuries, which paid 2 or 3%. That encouraged banks to buy as many Treasuries as their reserve positions would allow, getting rid of all of the excess reserves they could.

Banks therefore cut themselves to the bone on reserves, keeping just enough to meet reserve requirements, preferring to hold interest-bearing Treasuries instead.

The Fed could then alter the supply of reserves to control the fed funds rate (ffr) by keeping a portfolio of Treasuries which it could offer to sell to any bank on a daily basis, or it could buy Treasuries daily from banks. Since reserves were being swapped for Treasuries, a sale of Treasuries would drain reserves from the system, driving up the ffr, and the Fed's purchase of Treasuries would inject reserves, driving the ffr down.

(they actually used a hybrid method for daily operations - rather than selling or buying, they used a loan called "repo" or "reverse repo". A repo is a sale with an agreement to repurchase a like item later. In the US, whoever is "borrowing" money is said to be "doing repo", whoever is "lending" is "doing reverse". That convention is not universal to all countries.)

So how does this relate to lending?

When banks create loans, they do indeed create deposits, and those deposits have reserve requirements, probably. This is not a constraint on lending, however. First, reserve requirements are counted in arrears. A bank doesn't have to have reserves to create a deposit, it just has to have them two weeks later. That gives them time to find reserves if they need them.

So the question is, how hard is it for banks to find reserves? Are they hard enough to find that they will restrain bank lending? The answer is no.

The Fed needs to control the ffr, so it is important that they be flexible in adding or draining reserves as needed to maintain that interest rate.

If a bank makes a bunch of loans and needs reserves to cover its deposits later, it will always be able to get them. If the bank had trouble getting them, then it would offer to pay more for them, which would increase the ffr.

As the Fed saw the ffr rising, they would automatically buy Treasuries to add reserves to the system, in order to drive the ffr back down to where it needed to be.

That would free up reserves, making reserves available to our profligate bank.

Banks know this, so they simply don't worry about reserves when making decisions about their loan portfolios. Reserves will always become available if needed - the Fed has to provide them, or lose control over interest rates.
LETeller
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4/30/2015 11:40:16 PM
Posted: 1 year ago
Obviously, the things I mention (reserve requirements, Treasury sales, etc) were not invented specifically for this purpose.

Prior to our current fiat money system, those systems existed, but they have been adapted to accommodate our current monetary system.

As an example, the discount window was at one time a policy tool used by the Fed (it used discount window rates to create, then solve, the 1920 "Forgotten Depression", for example. The depression was created to cool off postwar inflation.

The discount window rate is no longer used as a policy tool. The fed funds market has taken its place (discount lending still exists, but it is a tiny fraction of what goes on in the fed funds market).
LETeller
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4/30/2015 11:45:01 PM
Posted: 1 year ago
Post-QE, the system I described has largely changed, as well.

Since QE created massive amounts of excess reserves, and a shortage of Treasuries for banks, the fed can no longer control the ffr with little adjustments in reserve quantities.

Beginning in 2008, it began to pay interest on reserves, and now it pays interest on both required and excess reserves.

That's how they control the ffr now. That's why they began paying interest on reserves. Interest on reserves creates an opportunity cost for banks to lending out reserves, assuring that the ffr does not fall to zero.

When Yellin threatens to raise interest rates, it is likely that will be done by increasing the interest paid on reserves, which is a policy that would have been unheard of in the US prior to 2008.
Diqiucun_Cunmin
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5/2/2015 11:35:15 AM
Posted: 1 year ago
Thanks for the explanations ^^
At 4/30/2015 10:49:44 PM, LETeller wrote:: - Central bank reserves are not counted as capital. Capital is defined by regulation specific to banks, and is divided into Tiers. Under the current regulation, Basel III, Tier 1 capital is equity arising from common stock, preferred stock, retained earnings, stuff like that. Tier 1 capital is not risk weighted, that is, it is valuated normally. Capital which falls outside of the Tier 1 definition is risk weighted, reducing its value as capital. Some assets can be counted as capital if they give the bank resilience, but they are heavily risk weighted.

Tier 1 capital is required to be 4.5% of risk weighted assets (assets are risk-weighted by amounts depending on type, performance, and so on), with an additional 2.5% buffer under normal operations, for a subtotal of 7% Tier 1 capital. When the buffer is broached, some bank operations are restricted (like they cannot pay dividends, may have lending restricted, etc). There is an additional buffer that may be required at the regulator's option, bank by bank. Total capital minimum as a percentage of risk-weighted assets is 8%. This is the bank's constraint on lending.
Okay, I get it. I'm not from the US, so the system should be a little different here, but I see what you mean by 'capital', and how it affects lending.

Basically, you're saying that what regular Joes (like me) think banks do, banks actually don't do, and wouldn't do except at 100% rrr? I don't understand the connection between 100% rrr and the lending ability of the bank depending on its loans, though... Wouldn't deposits have no impact on lending ability when they can't loan out a penny of the reserves gained from people depositing?

- You have it figured out. Here's the problem. We're talking about double-entry bookkeeping every step of the way.

The goal of full reserve banking is to protect depositors. The idea is that banks would take people's money who made checking deposits and essentially stuff it in the vault, so that the assets people gave the bank would actually be available if everyone showed up at once to withdraw all of their money. The obvious problem is that I don't want them to give me my paycheck back. I either want them to honor my checks or give me cash. I gave them my paycheck, which doesn't allow them to do that. We settle checking transactions at the Fed (not all, many are settled privately, but it's a representative example) using transfers of reserves, or settlement funds. As long as we're all passing around checks or ATM transactions, that's fine. We never have to have any tangible money.

But if everyone showed up and wanted to withdraw in cash, the bank would have to have enough cash on hand to pay us, for the system to work. That's obviously impractical, because any cash they had on hand would be an amount of reserves they didn't have, which would mean they couldn't honor our checks and ATM transactions. Those can't feasibly be settled in cash.
Okay, that makes sense, since banks only exchange the net amount at the clearing house.
So no matter what you do, there is no way to have checking deposits that are all accessible in cash and able to process checks at the same time.

The full reserve guys then sat that time deposits (CDs, savings accounts, etc) should be the only "funds" that banks could lend to customers. If it's in checking, it's off limits, so that people can demand their money promptly. If it's in savings, banks can lend it, because the depositors have already agreed to wait for their money.
Are NCDs and savings regarded as types of time deposits in the US? :O I'm asking because they are considered three separate things here.
But the problem is, if I deposit a check in savings, the bank still has nothing it can use to make a loan. It can't lend my check. So generally, the reserve guys have a system where the bank can go ahead and make a deposit for the borrower, as they do now, but they have to borrow the 100% reserves from the central bank to "back" the new loan deposit. They generally propose some sort of central bank underwriting review system to restrain credit which essentially would decide whether the central bank would be willing to underwrite the loan by providing reserves. That's a process to which I object.
All right, I get it.
So the purpose of reserves is to provide numbers for the clearing house? They have nothing to do with loans?
[Some content removed to get more characters]
We smaller banks can all get together and create a clearinghouse which does nothing but keep running totals of our interbank transactions, and calculate net numbers at the end of each day - every bank will owe a net number to all banks in the system, or be owed a net number by all other banks in the system. These numbers ideally total to zero.

The clearinghouse gives its list to the central bank at the end of each day, and the central bank credits or debits the reserve account of each surplus or deficit bank. Because we're netting, there's no transfer of reserves. The reserve payment you get is a lump sum which represents what all other banks owe to you, less what you owed to all other banks, but it simulates perfectly as if you had settled every transaction individually with every other bank. At this point, the CB is just creating and destroying reserves at will to keep track of who owes who what. There's no actual "transfer" of funds anywhere in the system. It's a simple accounting exercise, other than at the teller window.

Since all the central bank is doing is making net debit and credit adjustments, there's no need to use actual money to do this. It's just scorekeeping. If the central bank wants to ensure that member banks always have settlemen
Okay, so minimum reserve requirements exist to ensure the banks have enough for settling that stuff. I see.
The thing is, I hate relativism. I hate relativism more than I hate everything else, excepting, maybe, fibreglass powerboats... What it overlooks, to put it briefly and crudely, is the fixed structure of human nature. - Jerry Fodor

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LETeller
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5/2/2015 4:18:56 PM
Posted: 1 year ago
Okay, I get it. I'm not from the US, so the system should be a little different here, but I see what you mean by 'capital', and how it affects lending.

- HKMA requirements are basically the same as the Fed's. They both get those requirements by treaty, the Basel III Accords.

Okay, that makes sense, since banks only exchange the net amount at the clearing house.

- It depends on the clearinghouse, but yes. We have different clearing systems, where we use real time gross settlement for large transactions, and net settlement for most transactions. If you are familiar with Hong Kong, I think all settlements are gross and real time.

Are NCDs and savings regarded as types of time deposits in the US?
O I'm asking because they are considered three separate things here.

They're different. Most savings are considered demand deposits.