The Mechanics of Banking: Take 3

Kid Dynamite submits:
Believe me - it's not that I really enjoy talking about the mundane theoretical mechanics of the banking system - it's just that it's driving me crazy. So I'll try to get my questions answered here. Let's put aside reserves for a second - for the purposes of the questions in this post, let's simplify and pretend that reserve requirements do not exist - they are zero. There are frequently repeated mantras from "those who understand." The first of these mantras is "banks don't need deposits to make loans." What I still haven't been able to get a good answer to, is, "If I open up the Bank of Kid Dynamite, how do I give my loan customers the money that I loan them if I don't have any deposits?" I still have to give them (the borrower) the money. So, does it come out of my equity - my startup capital? OR, do I borrow (the loan amount - not reserves, remember) it from the Fed, using my equity as collateral? [my guess would be that it comes out of my equity] In essence, the Fed would become a depositor at my bank? [my guess would be NO, but it seems like this is certainly possible at some point - WHEN is that point? I think the whole cycle is actually easier to understand if I DO borrow the money from the Fed, who lends to me based on my equity as collateral - I hope that's how it works!] If I find $100MM in the street and open up a bank, refusing to take in any customer deposits at first - how many loans can I make? $100MM? Some amount slightly less, like $90MM, due to regulatory capital requirements (NOT due to reserve requirements!)? [My guess would be $90MM, assuming RegCap requirements of 10%. But wait - maybe it's $1,000,000,000 - the Fed will lend me $1billion, and my $100MM would be collateral - RegCap requirements?]. Would I be borrowing any money from the Fed or the interbank market in this scenario? [my guess would be NO, but it's quite clear that I don't know the answer!] Expanding the question, what if I had $100MM in equity, and I also took in $100MM in deposits? How many loans can I make now, and would I be borrowing any money from the Fed/interbank market? [my guess would be that I can loan out the $100MM in deposits - remember, we have no reserve requirements - and I can also loan out $90MM of my equity capital - but I'm not super confident in that answer.] The second mantra is "loans create deposits." HOW? Someone please explain this to me. Look - I certainly understand the theory that if the Bank of Kid Dynamite lends $100k to MikeMortgage so that MM can buy a house, and MM takes that $100k and buys a house from HarryHomeseller, then HH will hopefully deposit that money in the bank. BUT - HH doesn't need to deposit that money at the Bank of Kid Dynamite - he might bring it to another bank. So, how does making loans at the Bank of Kid Dynamite create deposits at the Bank of Kid Dynamite? EDIT: I think I may have just had a "loans create deposits" epiphany: When the Bank of KD loans money to someone, like MikeMortgage, even if that money doesn't end up getting deposited back in my bank, it hopefully (theoretically) gets deposited SOMEWHERE, say Bank of Anonymous. Then, Bank of Anon lends it's excess deposits back to me, Bank of KD... right? Essentially, I get a deposit (aka: I borrow) from the Bank of Anon. In an effort to keep it simple, I'll leave it there...Complete Story »