Thus the Fed plays an essentially reactive role, providing the reserves as needed to hold the Fed funds rate on target. The answer is that every bank must also comply with an equity capital requirement. This is a complex formula that rates a bank s assets by risk and requires that its own capital exceed a certain fraction of its risk-weighted assets. A bank can get into trouble by creating too large an asset base through excessive lending. A bank with insufficient equity capital relative to its assets will be placed under supervision by its regulator who may then demand to approve any new lending.
Banks are in the business of selling credit.
If a creditworthy borrower is willing to pay the bank s rate, the bank will normally make the loan even if it must seek the required reserves after the fact. Thus the only defense against the creation of excessive credit money is for the Fed to increase the price of credit to the point that it slows net demand. But this is like a small rudder on a massive ship. It can take a long time before there is much response to the corrective action. The time lag in the credit market is usually a matter of many months.