Comment by jljljl | Hacker News Reader

Comment by jljljl | Hacker News Reader

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When a bank creates a loan, it also creates a deposit. Say they make a loan to Bob:

Loan -- an asset on the Bank's balance sheet. It's a promise that Bob will repay the bank a certain amount of money, plus interest

Deposit -- a liability on the Bank's balance sheet. It's an account that Bob can draw from at any time, and the Bank will promise to honor or pay the deposit.

These are created at the same time, and balance one another. The bank does not need the Fed to create the deposit at all, the create it out of thin air when issuing the loan.

When Bob comes to withdraw from his account, the Bank will pay him from it's *reserves*. The banks reserves are a pool of assets, cash, and deposits from other customers that the bank holds in excess of it's loans.

The bank can get these from a lot of places, not necessarily the Fed -- they could offer checking accounts to other customers, and hold some fraction of the assets in a customer's checking account in reserve. Banks offer all sorts of incentives to get people to deposit long term(CD, Savings Accounts, e.g.) for this reason, but they almost never have 100% of the money they are loaning out held in reserves. Their entire bet is that only a fraction of the deposits will be withdrawn at any time.

The Fed doesn't need to be present for any of this, but they provide an important stabilizing function, ensure liquidity, and can adjust the money supply through open market operations or banking regulations.

I should have been more specific and said "without deposits or reserves", but I was assuming that without a central bank account, reserves are moot. This is because the central bank determines reserve requirements for the commercial banks, so a bank without a fed account is limited in how much money they can 'create.'

If the Bank doesn't have enough reserves to give Bob money, they simply cannot give him a loan. If a commercial bank doesn't have enough reserves, they can take a temporary loan from the Fed at the cash rate and create money to their hearts (or their risk-teams) content.

If you don't have reserves, borrowing from the Fed would be your very last resort. The first thing you would do is borrow short term from other banks to meet your reserve needs. This is what the Overnight Federal Funds rate represents -- the rate that banks use to lend to other banks short term.

AS a very last resort, you might borrow from the Fed, but banks will generally avoid this as much as possible -- The Fed often charges a higher than market rate to discourage banks from using the discount window too much. Furthermore, borrowing from the Fed's discount window comes with a lot of stigma, since it implies you are unable to get funding from the market.

The most recent Odd Lots podcast episode has a great primer on the Fed Discount Window

> I was assuming that without a central bank account, reserves are moot

There are tons of ways to get reserves without a central bank account -- issuing stock, selling CDs or Bonds, selling liquid assets, etc.

> This is because the central bank determines reserve requirements for the commercial banks, so a bank without a fed account is limited in how much money they can 'create.'

FWIW, in the US the reserve requirements are currently 0%. They're also 0 in a lot of other countries (e.g., Canada)

> This is because the central bank determines reserve requirements for the commercial banks, [...]

Many countries don't have minimum reserve requirements.

However the gist of what you are saying is still true.

Mostly agreed.

> The Fed doesn't need to be present for any of this, but they provide an important stabilizing function [...]

Alas in practice they are more of an arsonist than a firefighter.

The Fed barely has any power other than to increase the interest rate.

The system is "pull based". The Fed can close the valve and not much else.

The Fed also sets eg interest on excess reserves. They are also involved in quite a bit of regulation these days.

They also don't really 'set' the interest rate (apart from the interest on excess reserves). They have an interest rate target, and then buy or sell bonds to reach that target. Instead of setting an interest rate target, they could also have other intermediate targets.

Eg they could directly target the TIPS spread, and buy/sell offsetting pairs of U.S. Treasury bonds and Treasury Inflation-Protected Securities (TIPS) to make the spread go where they wanted it. That might be a better way to implement their inflation target, too.

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