Reply To: Fractional Reserve Banking Requirements


To be viable in a market economy, every business enterprise must be solvent and liquid. There are always two fundamental constraints on its activities as they affect its balance sheet. It must have sufficient capital as a buffer against a decline in the market value of its assets. It must also roughly match the time structure of its assets and liabilities. It must have sufficient short term assets to cover short term liabilities.

If a bank issues liabilities against itself that are due to be paid on demand at par (i.e., its customers’ checking accounts) against the assets of the loans it creates for those customers, then it would be illiquid since its assets (the loans) have some time before maturity. The only asset that perfectly matches an on demand at par liability in its time dimension is cash. Other assets the bank holds that are available to it on demand at par match imperfectly. These are reserves. A bank can be ruined financially by creating loans out of thin air and writing them into customers’ checking accounts if doing so makes them illiquid because they failed to acquire reserves to hold against their on demand at par liabilities.

Of course, a bank doesn’t need reserves in advance of creating credit out of thin air. But it needs to acquire and maintain reserves sufficient to make its balance sheet liquid just as it needs to acquire and maintain capital to make its balance sheet solvent.