Bank reserves for cash withdrawals
It seems impossible that the banks could lend out the money that has been deposited in accounts and yet still have it available for withdrawal by the depositors. However, as most things are bought and paid for with electronic transfers and cheques there is no problem, because the money never leaves the banking system.
There is a problem for true cash withdrawals (bank notes and coins) because the banks cannot create true cash by creating debt through loans, so it is impossible for banks to give true cash back to the depositor when it has been lent out to someone else.
To cover withdrawals of true cash the banks have to reserve sufficient of the money deposited to use for cash withdrawals, the rest they are free to lend. However, with most transactions performed as electronic transfers, the overall demand for withdrawals of true cash is usually only a few percent of the total transactions.
Just how much of the money that is deposited the banks choose to reserve for cash withdrawals is balanced between two opposing factors: the profit that they make from lending the money, and the risk of being unable to supply cash for cash withdrawals.
Banks make their profit from the interest that they charge on loans; the less money that a bank reserves from deposits for the purpose of covering cash withdrawals, the more money there is to lend to create money in the money creation cycle, and the more interest it gets from those loans. However, if the bank doesn't have enough cash for customers' withdrawals, confidence in the bank may be damaged causing a 'run' — a panic withdrawal by a large number of customers , which can cause the bank to collapse. There have been some economically disastrous 'runs' on banks, in which many people have lost all of their savings when the banks finally collapse.
The banks must strike a balance between profit and security when they choose the size of their reserves. The balance between the amount of money lent out and the amount reserved for cash withdrawals, and the consequent balance between profit and security looks like this:
There are things that banks can do to minimise the risk of having insufficient funds to cover cash withdrawals, which allow them to minimise the need to keep cash reserves, however, at least some reserves will be required.
Without the need to reserve some of the money deposited for cash withdrawals, the money creation cycle could create an unlimited amount of money, and its associated debt. The money that banks must reserve to cover cash withdrawals limits the amount of money that they can create by creating debt, as loans, in the money creation cycle.
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