| In the really olden days: reserves were physical gold or cash in your vault. (These days, it's a bit more complicated.) About loss absorbing capital: companies usually finance themselves from two sources equity and debt. (Normal companies get their debt from their bank, or they issue bonds. Banks get some of their debt in the form of deposits.) To give an example, supposed you have 2 billion dollars lying around, and you start a bank. You take another 8 billion dollars in debt (say as deposits), and you use that to make 10 billion dollars of loans and other investments. If you investments gain in money, you keep the profit. Your accountant will count it as an increase in your capital, from 2 billion to, say, 3 billion. Basically, capital is just what's left of your assets after you subtract all your debt. If your investments lose money, your capital shrinks. Say your investments are now worth only 9 billion dollars, but you still have 8 billion in deposits. Then you only have 9 - 8 = 1 billion in capital left. There's never any money in the vault, ie no reserves, in our example. When a depositor wants their money, you sell some of your investments to cover that. As long as your total investments are worth more than your total deposits, this is fine. (For convenience, real world banks keep some reserves around even when not legally required, so they can satisfy withdrawal requests directly, instead of having to sell some investments for every little withdrawal request.) Obviously, the more capital cushion your bank has the larger a decline in the value of your investments you can absorb as losses, before your depositors and other creditors need to get nervous. Back in Scotland's free banking era, when financial regulation was very light, banks over there routinely kept around a third of their total balance sheet as equity and two thirds as debt. Today because of all the regulation we have accumulated and especially the too-big-too-fail expectations, banks need to be forced to even keep around 8% of their balance sheet as equity. (It doesn't help that interest on debt can be paid with pre-tax money, but return on capital (ie dividends) comes largely out of post-tax money. So debt is cheaper.) |