What happens behind the loan? What limits total bank loan amounts? What role do bank reserves play in the process of loans and money creation?

What sets the limits for loans?

Deposits

The amount of bank deposits determine the fundamental limit on the amount of loans that a bank can make.

In the traditional model of banking, customers deposit a money commodity with the bank. The bank holds the money commodity deposited in reserve. The bank enters a liability on its books to reflect the amount of the deposit. That liability, which we refer to as a "deposit," amounts to an IOU from the bank to the depositor. (This IOU now becomes money.) (Note: The reader should keep in mind that this traditional model does not fully match how banks operated today. We no longer have a commodity money in our system.)

Some of the customer deposits (bank IOUs) come from the proceeds of loans made to them by the bank.

Bank Loans

When banks make loans, they in essence exchange IOUs with the borrower. In exchange for the borrower's promise to pay the loan amount at some specified time in the future the bank gives its promise to pay current money to the borrower.

But what sets the limit to the bank promises?

The amount of available money held in reserve determines the lending potential of the bank.

Bank Reserves

Historically banks held, as reserves to accommodate withdrawals, the same economic good (usually gold) that served as money. A person presenting a check drawn on that bank could ask to receive the money good in payment. Today depositors cannot receive the good that banks hold as reserves; they can only receive currency (an IOU from the Federal Reserve) or an IOU from that, or another, bank.

NOTE: To signify reserve dollars, which the public cannot hold, I have colored them blue in the following examples. Also, I will discuss what "backs" currency and bank reserves in the discussion about the Federal Reserve.

Because depositors typically don't all ask for their money at the same time, banks maintain only a portion of the deposits they receive as reserves. They hold only a fraction of the amount of their deposit liability…