BANKING AND MONEY CREATION

MODULE 25

THE MONETARY ROLE OF BANKS

• More than half of M1 consists of currency in circulation.

• The rest of M1 consists of bank deposits, which are a major component of the money supply.

• Although we are fascinated by large sums of currency, people use checkable deposits for most transactions.

• Most transaction accounts are “created” as a result of loans from banks or thrifts.

• The term bank will be used generically to apply to all depository institutions.

HISTORY OF FRACTIONAL RESERVE BANKING: THE GOLDSMITHS

• In the 16th century goldsmiths had safes for gold and precious metals, which they often kept for consumers and merchants. They issued receipts for these deposits.

• Receipts came to be used as money in place of gold because of their convenience, and goldsmiths became aware that much of the stored gold was never redeemed.

• Goldsmiths realized they could “loan” gold by issuing receipts to borrowers, who agreed to pay back gold plus interest.

HISTORY OF FRACTIONAL RESERVE BANKING: THE GOLDSMITHS

• Such loans began “fractional reserve banking,” because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold.

• Significance of fractional reserve banking:

1. Banks can create money by lending more than the original reserves on hand. (Note: Today gold is not used as reserves).

2. Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds. Also, the U.S. deposit insurance system prevents panics

WHAT DO BANKS DO?• Banks are financial intermediaries, that

use liquid assets in the form of bank deposits to finance the illiquid investments of borrowers.

• Banks are in business to make a profit like other firms. They earn profits primarily from interest on loans and securities they hold.

• Because not all of the depositors will want to withdraw all of their funds at the same time, a bank can provide these liquid assets yet still invest much of the investor’s funds in loans for illiquid assets, such as mortgages and business loans.

WHAT DO BANKS DO?• Banks cannot lend out all their funds,

because they need to have some on hand to satisfy any depositor that wants to withdraw their funds at any time.

• These required funds may be kept as currency in the bank’s vault, or as deposits held in the bank’s account at the Federal Reserve (this money can be converted into currency rapidly)

• These funds held in the vault or at the Fed are called bank reserves, and are not counted as part of the money supply, as they are not part of the currency in circulation.

A BANK’S BALANCE SHEET

• A balance sheet states the assets and claims of a bank at some point in time.

• All balance sheets must balance, that is, the value of assets must equal value of claims.

1. The bank owners’ claim is called net worth.

2. Non-owners’ claims are called liabilities.

3. Basic equation:

Assets = liabilities + net worth.

THE T-ACCOUNT• The T-account is a simple tool for

analyzing a bank’s financial position.• Just like the T-account for an ordinary

business, it summarizes a bank’s financial position by showing the banks assets and liabilities.

• The assets are on the left side and they represent the funds that those who have borrowed from the bank are expected to repay. The bank’s other assets are its reserves, either held in the bank’s vault or as deposits at the Fed.

THE T-ACCOUNT• The liabilities of the bank are shown on the

right side of the T-account. These are funds that must be repaid to depositors

• By law, banks are required to have their assets larger than their liabilities by a specific percentage.

• The fraction of bank deposits that a bank is required to hold as reserve is called its reserve ratio.

• The banking system sets a required reserve ratio, which is the smallest fraction of bank deposits a bank must hold.

• This required reserve acts as protection against a bank run.

WHAT IS A BANK RUN?• A bank can lend out most of the funds

deposited in it because only a small fraction of its depositors want to withdraw their funds at one time.

• If they did demand their money back at the same time, the bank would not be able to raise enough cash to meet those demands, because most of the depositor’s funds are converted into loans made to borrowers.

• That is how the banks earn revenue: by charging interest on loans.

WHAT IS A BANK RUN?• However, bank loans are illiquid, which

means that they cannot be easily converted into cash on short notice.

• Banks may be forced to sell off their loans quickly and cheaply in order to raise the funds demanded by depositors, which may lead to a bank failure, in which the bank would be unable to pay off its depositors in full.

• The fear of a bank failing may be a self-fulfilling prophecy, in which the rush itself cause the bank to fail.

WHAT IS A BANK RUN?• A bank run is a phenomenon in which

many of a bank’s depositors try to withdraw their funds due to fears of a bank failure.

• A run on a bank may be contagious and spread to other banks or even the whole banking system, as occurred in the 1930s in the United States.

• Modern governments have established a system of bank regulations that protect depositors and prevent most bank runs.

BANK REGULATION

• After the banking crisis of the 1930s, most countries put into place a system designed to protect depositors and the economy as a whole against bank runs.

• This protective system has three main components and a source of loans:

1. deposit insurance

2. capital requirements

3. reserve requirements

4. discount window

1. DEPOSIT INSURANCE

• The FDIC (Federal Deposit Insurance Corporation) provides deposit insurance, which is a guarantee that depositors will be paid even if the bank cannot come up with the funds.

• The maximum amount that the FDIC insures is $250,000 per account.

• This deposit insurance doesn’t only protect depositors if the bank fails, it also eliminates the main reason bank runs occur, because depositors will be assured of their funds and will not run to pull them out because of a rumor that the bank is in trouble.

2. CAPITAL REQUIREMENTS• Because the deposit insurance may create an incentive

problem: the depositors may feel safe and fail to monitor the bank’s financial health, and the bank may incur in risky investment behavior. They may make questionable loans at high interest rates because they stand to make a large profit, and if things go badly, the government will cover the losses through the deposit insurance.

• Regulators require banks to hold substantially more assets than the value of bank deposits, so that the bank will still have assets larger than their deposits even if some of its loans go bad, and these losses will reduce the bank owner’s assets and not the government.

• This excess of a bank’s assets over its bank deposits and other liabilities (debts) is called the bank’s capital.

3. RESERVE REQUIREMENTS• Another rule set by the Federal Reserve to reduce the

risk of a bank run is to establish reserve requirements, which establish the required reserve ratio (a fraction of the deposits) that a bank must keep on hand.

• The United States uses a 10% required reserve ratio for checkable bank deposits. This means that the banks must keep 10% of the value of the checkable deposits as cash on hand to meet the depositor’s needs.

• This required reserve may be kept as cash in the bank’s vaults or as reserves at the Fed, in the bank’s own account.

• Reserves are an asset to banks but a liability to the Federal Reserve Bank system, since now they are deposit claims by banks at the Fed.

3. RESERVE REQUIREMENTS• The reserves over and above the amount needed to

satisfy the minimum reserve ratio are called excess reserves.

• The reserves over and above the amount needed to satisfy the minimum reserve ratio are called excess reserves.

• Required reserves do not exist only to protect against bank runs. Required reserves are to give the Federal Reserve control over the amount of lending or deposits that banks can create.

• In other words, required reserves help the Fed control credit and money creation, because banks cannot loan beyond their fraction required reserves.

4. THE DISCOUNT WINDOW

• This final protection against bank runs is the fact that the Federal Reserve stands ready to lend money to banks, which is an arrangement known as the discount window.

• This ability to borrow money from the Fed means that a bank can avoid being forced to sell its assets at cheap prices in order to satisfy the demands of a sudden rush of depositors demanding their funds.

• A bank has the option of turning to the Federal Reserve to borrow the funds it needs to pay off depositors.

DETERMINING THE MONEY SUPPLY• If banks did not exist, there would be no checkable

deposits, and the quantity of currency in circulation would equal the money supply.

• Because there are banks, and they create checkable bank deposits, they affect the money supply in two ways:

1. Banks remove some currency from circulation because the currency sitting in bank vaults is not part of the money supply.

2. Banks create money by accepting deposits and making loans. That means that they make the money supply larger than just the value of currency in circulation.

• The monetary base is the sum of currency in circulation and bank reserves.

THE ENTIRE BANKING SYSTEM AND MULTIPLE DEPOSIT EXPANSION

• The entire banking system can create an amount of money which is a multiple of the system’s excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves.

• Three simplifying assumptions:

1. Required reserve ratio assumed to be 10 percent.

2. Initially banks have no excess reserves; they are “loaned up.”

3. When banks have excess reserves, they loan it all to one borrower, who writes check for entire amount to give to someone else, who deposits it at another bank. The check clears against original lender.

THE ENTIRE BANKING SYSTEM AND MULTIPLE DEPOSIT EXPANSION

Example of the system’s lending potential:

1. Suppose a junkyard owner finds a $100 bill and deposits it in Bank A. The system’s lending begins with Bank A having $90 in excess reserves, lending this amount, and having the borrower write an $90 check which is deposited in Bank B.

2. Bank B keeps 10% ($9) and can then lend out $81 it has in excess reserves, and the borrower writes out an $81 check, which is then deposited at Bank C.

3. Bank C then keeps $8.10, and lends out the other $72.90, and so on…

THE MONETARY MULTIPLIERThe formula for monetary or checkable deposit multiplier is:

Monetary multiplier = 1/required reserve ratio

m = 1/R

Maximum deposit expansion possible is equal to:

excess reserves x monetary multiplier

THE MONETARY MULTIPLIER• Modifications to simple monetary multiplier concept

reduce the final result and include complications due to “leakages.”

a. Currency drains (cash kept by customers) dampen M, because that money is not part of bank reserves so can’t be loaned out further.

b. Excess reserves kept on hand by banks also dampen M, because those reserves are not loaned out and therefore not expanded.

NEED FOR MONETARY CONTROL1. During prosperity, banks will lend as much as possible

and reserve requirements provide a limit to expansion of loans.

2. During recession, banks may cut lending, which can worsen recession. Federal Reserve has ways to encourage lending in such cases.

3. The conclusion is that profit-seeking bankers will be motivated to expand or contract loans that could worsen business cycle. The Federal Reserve uses monetary policy to counteract such results in order to prevent worsening recessions or inflation.