Of course, private banks cannot simply create money out of thin air without limit and still expect to stay in business. When the bank credits a borrower's account with the amount of his new loan, it is to be expected that the borrower will very soon want to spend part or all of the money he has borrowed. After the check the borrower writes is deposited in somebody else's account in another bank, the check will soon be presented for collection at the lending bank, and they will have to have the cash on hand to pay the other bank off at that time. The more dollars' worth of loans a bank has extended, the more cash it will have to have on hand in reserves to meet the daily flow of redemptions. Most or all of the check redemption demands coming in every day can normally be offset by the cash and checks drawn on other banks that the depositers and borrowers have brought in and deposited or paid that day, but an "unsound" bank that extends loans with reckless abandon sooner or later will find that the flow of checks presented to it for collection greatly exceeds the flow of outside checks and cash being brought in. Once the bank's vaults are empty and the cash reserves are gone, the management must quickly (overnight!) either borrow the necessary additional cash elsewhere (probably at high interest rates ) or else sell off some of the bank's assets (because of the haste, probably at fire-sale prices). When the troubled bank can no longer borrow and has no assets left that can be sold on short notice, it can no longer fulfill its ontractual guarantees to pay its obligations on demand and is therefore out of business with the banks owners and managers now subject to civil (and perhaps criminal) legal penalties (bankrupcy, suits for breach of contract, negligence, and fraud, indictments for fraud, embezzlement, etc.).
"Sound" banks limit the volume of the loans they extend so that they remain in a prudent proportional relationship to the amount of instantly liquid funds they have available in "reserves" (either as currency in the vault or as demand deposits in some other bank, such as the Federal Reserve ). But bankers face a difficult trade-off. The flow of checks that will be presented for payment and the volume of new deposits and loan repayments coming in every day cannot be predicted with 100% accuracy, so the higher the fraction of its total deposit obligations the bank holds ready in reserves, the safer or "sounder" the bank can be considered (and the more attractive the bank will seem to depositers and other potential business associates). However, reserves do not yield any interest income to the bank; only the funds that are tied up in loans to (solvent) borrowers can contribute directly and immediately to the bank's profitability. To maximize their profits , bank management must find the best way to strike a balance between the need to maintain their "reserve ratio" at a level high enough to limit their risks of becoming insolvent and the conflicting need to keep the highest feasible proportion of the bank's available funds loaned out at interest .
[See also: money stock , monetary policy , reserve requirement , Federal Reserve System ]