Why Deposits? Banks Do Not Need Funds to Lend But to Ensure the Lent Money Is Fungible

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Banks are in the business of offering loans. Borrowed money is mostly considered to be only useful only if it is fungible, i. e. it can be transferred to other parties. Thus, just as important as the credit industry extending loans are the attendant settlement services. These are the two pillars of banks. 

All payments among banks are controlled by the central bank in that settlement is achieved by making entries in special accounts that only banks have with the central bank. Should there be problems, the central bank can always either help a troubled bank by extending a loan of the missing settlement units (reserves) or, if it lets the bank go belly up, it will make sure that the failed bank does not leave unsatisfied payees (deposit insurance) behind.

Settlement among banks is conducted at the central bank in a special currency that is only available to the central bank and the banks, but to nobody else.  This currency is called "reserves at the central bank" or "bank reserves" or "reserves".

When Bank A needs to transfer money from the account of its client X to the account of the client Y of another bank, Bank B, the only way it can do it is by having a positive credit balance ("Guthaben") in its reserve account at the central bank to begin with. If Bank A has a sufficiently large positive credit balance at the central bank, settlement between Bank A and Bank B can proceed by debiting the central bank account of Bank A and crediting the central bank account of Bank B. Say, the sum in question is $ 10,000 — thus, Bank A's reserves will diminish by US $ 10,000 while the reserves of Bank B at the central bank will increase by $ 10,000. Settlement accomplished.

What this tells us is that to extend loans that make sense, i. e. that result in deposits from which the credit user can make payments to other parties, a bank must be able to participate in the settlement system maintained at the central bank. This in turn requires the bank to receive from or transfer to other banks reserves held with the central bank.

And this is the part where the need for lending institutions to fund themselves comes in.

It is misleading to suggest that banks need to finance the loans that they make. Unfortunately this phrasing is regularly used. In fact, banks can extend loans without having to finance them, rather they are capable of creating them ex nihilo (subject to certain constraints of which I shall be writing in posts to come).

What they do have to finance are bank reserves. And these are needed if their loans are to be fungible, i. e. being loans capable of financing/supporting payments to clients of any bank that is part of the system.

In our above example, Bank A requires a positive credit balance at its account with the central bank of at least $ 10,000. Where does the bank get this money from? It could borrow it from other banks or the central bank, or it could use some of the deposits of its clients. (As for the latter, it may use term deposits (that can be drawn upon only after a certain period of time, say three months). Or maybe it uses cheaper demand deposits that can be instantly replenished using long-term deposits if a client withdraws money from her account.)

Banks like to use deposits for reserve purposes (and therefore seek deposits from clients) because they tend to be rather a cheap, perhaps even the cheapest kind of funds.

But banks could finance their ability to ensure loan fungibility with any other kind of funds that are cheap enough for the purpose.

Take the case of securities. A bank would typically hold a portfolio of bonds which it can sell to the central bank if need be. On accepting the bonds, the bank's account with the central bank is credited with the sales price of the bonds. Now, the bank has central bank reserves of at least the value of the sales price of the bonds, say $ 10,000. 

Back to our initial example: Bank A needs to transfer $ 10,000 to Bank B. Say, at present, Bank A has a zero credit balance at its reserve account with the central bank. So to fund the transfer to achieve settlement it could either sell bonds worth $ 10,000 to the central bank, borrow that sum from other banks or divert for that purpose deposits to the tune of $ 10,000 held by its clients.

If Bank A pays a smaller interest rate on deposits of its own clients than on money borrowed from other banks or the central bank, deposits become an attractive funding proposition, which they have historically been — hence banks have been interested in maintaining large contingents of deposits.

See also here and here.