Banks lend out the money they receive as deposits, as part of the money creation cycle of lending, spending, earning, and saving; however, they must reserve some of that money for withdrawals of true cash (bank notes and coins.)  The less money that a bank reserves for cash withdrawals, the more money there is to lend, and the more interest it gets from loans.

The demand for cash withdrawals is highly variable, both in time and place. An individual bank may experience a large demand for cash withdrawals while at the same time another bank in a different location may experience a low demand for cash withdrawals; at different times the positions may be reversed. Any individual bank will need to keep sufficient cash reserves to cover the greatest expected momentary demand for cash withdrawals.

However, the banks are big organisations, with so many deposit accounts in so many branches that the amount of money that is withdrawn at any particular time tends to even out across all of the branches. In fact, all the banks work together so that the demand for withdrawals can be evened out across all of the banks. At the end of every working day the banks even out any excesses and shortfalls between each other by lending each other the necessary money in inter-bank loans. By working together this way, any variation of demand for true cash is spread across all of the banks, making the amount required for reserves much more predictable. This means that they can safely minimise their cash reserves and maximise the amount of money that they have available to lend out to make a profit from.

Even when all of the banks are working together to minimise the effect of variability in the demand for cash, it is still possible that cash withdrawal requirements could exceed the available reserves. In most countries the government guarantees to temporarily provide the necessary cash if the banks' reserves are exhausted; the government is then the "lender of last resort".

The need to minimise reserves is one of the reasons that banks love credit cards. Apart from giving the banks very high interest and yearly fees from the cardholders, and a percentage of sales from the retailers, credit cards also reduce the use of cash in transactions and therefore reduce the need for reserves to cover that cash when it is withdrawn from accounts. Currently, credit cards are mostly known as a form of electronic funds transfer, but not many years ago they were a form of paper transfer, like cheques, and in that form they greatly reduced the amount of cash transactions long before the EFTPOS system did.

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Bank reserves for cash withdrawals

How reserves limit the creation of money

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