The amount of First Bank’s reserves limits its ability to create new deposit liabilities; and the amount of First Bank’s capital limits its ability to acquire notes. Since First Bank uses deposit liabilities to acquire notes, these limitations become interactive. Thus, the amount of First Bank’s excess reserves can limit its note acquisitions and the amount of First Bank’s capital can limit its deposit liability creation.

This interactive relationship has become significantly important with the recent extreme expansion of bank reserves. Based solely on their high level of excess reserves banks have an almost unlimited capability of creating new deposit liabilities. It would seem from this that they would also have the capability of acquiring an almost unlimited volume of notes. So, why don’t banks make more loans?

The the relatively slim current capital ratios, however, severely limit the amount of notes banks can acquire. That coupled with potential risk from existing loans makes banks highly reluctant to make new loans — particularly risker loans. This provides an answer to that often asked question of, "Why don't banks make more loans?" Even though banks have massive amounts of bank reserves, they do not have massive amounts of capital to support note acquisition.

Note: I contend that with the reduction of bank reserve requirements and the immediate access to time deposits — making them virtually indistinguishable from demand deposits — the reserve requirements have lost their ability to limit deposit expansion and thereby monetary expansion. As a result, the interactive limitation resulting from the levels of bank capital has provided the primary limitation on deposit liability growth. Over the last couple of decades monetary expansion (MZM) has progressed at roughly 7 1/2% per annum, which I suspect parallels the expansion of bank capital through earnings. Monetary expansion of that same period has a relatively low correlation to the growth in bank reserves.