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9.2: The Banking System and Money Creation

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  • Learning Objectives

    1. Explain what banks are, what their balance sheets look like, and what is meant by a fractional reserve banking system.
    2. Describe the process of money creation (destruction), using the concept of the deposit multiplier.
    3. Describe how and why banks are regulated and insured.

    Where does money come from? How is its quantity increased or decreased? The answer to these questions suggests that money has an almost magical quality: money is created by banks when they issue loans. In effect, money is created by the stroke of a pen or the click of a computer key.

    We will begin by examining the operation of banks and the banking system. We will find that, like money itself, the nature of banking is experiencing rapid change.

    Banks and Other Financial Intermediaries

    An institution that amasses funds from one group and makes them available to another is called a financial intermediary. A pension fund is an example of a financial intermediary. Workers and firms place earnings in the fund for their retirement; the fund earns income by lending money to firms or by purchasing their stock. The fund thus makes retirement saving available for other spending. Insurance companies are also financial intermediaries, because they lend some of the premiums paid by their customers to firms for investment. Mutual funds make money available to firms and other institutions by purchasing their initial offerings of stocks or bonds.

    Banks play a particularly important role as financial intermediaries. Banks accept depositors’ money and lend it to borrowers. With the interest they earn on their loans, banks are able to pay interest to their depositors, cover their own operating costs, and earn a profit, all the while maintaining the ability of the original depositors to spend the funds when they desire to do so. One key characteristic of banks is that they offer their customers the opportunity to open checking accounts, thus creating checkable deposits. These functions define a bank, which is a financial intermediary that accepts deposits, makes loans, and offers checking accounts.

    Over time, some nonbank financial intermediaries have become more and more like banks. For example, brokerage firms usually offer customers interest-earning accounts and make loans. They now allow their customers to write checks on their accounts.

    The fact that banks account for a declining share of U.S. financial assets alarms some observers. We will see that banks are more tightly regulated than are other financial institutions; one reason for that regulation is to maintain control over the money supply. Other financial intermediaries do not face the same regulatory restrictions as banks. Indeed, their relative freedom from regulation is one reason they have grown so rapidly. As other financial intermediaries become more important, central authorities begin to lose control over the money supply.

    The declining share of financial assets controlled by “banks” began to change in 2008. Many of the nation’s largest investment banks—financial institutions that provided services to firms but were not regulated as commercial banks—began having serious financial difficulties as a result of their investments tied to home mortgage loans. As home prices in the United States began falling, many of those mortgage loans went into default. Investment banks that had made substantial purchases of securities whose value was ultimately based on those mortgage loans themselves began failing. Bear Stearns, one of the largest investment banks in the United States, required federal funds to remain solvent. Another large investment bank, Lehman Brothers, failed. In an effort to avoid a similar fate, several other investment banks applied for status as ordinary commercial banks subject to the stringent regulation those institutions face. One result of the terrible financial crisis that crippled the U.S. and other economies in 2008 may be greater control of the money supply by the Fed.

    Bank Finance and a Fractional Reserve System

    Bank finance lies at the heart of the process through which money is created. To understand money creation, we need to understand some of the basics of bank finance.

    Banks accept deposits and issue checks to the owners of those deposits. Banks use the money collected from depositors to make loans. The bank’s financial picture at a given time can be depicted using a simplified balance sheet, which is a financial statement showing assets, liabilities, and net worth. Assets are anything of value. Liabilities are obligations to other parties. Net worth equals assets less liabilities. All these are given dollar values in a firm’s balance sheet. The sum of liabilities plus net worth therefore must equal the sum of all assets. On a balance sheet, assets are listed on the left, liabilities and net worth on the right.

    The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected—to companies seeking to expand their operations, to people buying cars or homes, and so on. Banks keep only a fraction of their deposits as cash in their vaults and in deposits with the Fed. These assets are called reserves. Banks lend out the rest of their deposits. A system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves is called a fractional reserve banking system.

    Table 9.1 “The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012” shows a consolidated balance sheet for commercial banks in the United States for January 2012. Banks hold reserves against the liabilities represented by their checkable deposits. Notice that these reserves were a small fraction of total deposit liabilities of that month. Most bank assets are in the form of loans.

    Table 9.1 The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012

    Assets Liabilities and Net Worth
    Reserves $1,592.9 Checkable deposits $8,517.9
    Other assets $1,316.2 Borrowings 1,588.1
    Loans $7,042.0 Other liabilities 1,049.4
    Securities $2,546.1
    Total assets $12,497.2 Total liabilities $11,155.4
    Net worth $1,341.8

    This balance sheet for all commercial banks in the United States shows their financial situation in billions of dollars, seasonally adjusted, in January 2012.

    Source: Federal Reserve Statistical Release H.8 (February 17, 2012).

    In the next section, we will learn that money is created when banks issue loans.

    Money Creation

    To understand the process of money creation today, let us create a hypothetical system of banks. We will focus on three banks in this system: Acme Bank, Bellville Bank, and Clarkston Bank. Assume that all banks are required to hold reserves equal to 10% of their checkable deposits. The quantity of reserves banks are required to hold is called required reserves. The reserve requirement is expressed as a required reserve ratio; it specifies the ratio of reserves to checkable deposits a bank must maintain. Banks may hold reserves in excess of the required level; such reserves are called excess reserves. Excess reserves plus required reserves equal total reserves.

    Because banks earn relatively little interest on their reserves held on deposit with the Federal Reserve, we shall assume that they seek to hold no excess reserves. When a bank’s excess reserves equal zero, it is loaned up. Finally, we shall ignore assets other than reserves and loans and deposits other than checkable deposits. To simplify the analysis further, we shall suppose that banks have no net worth; their assets are equal to their liabilities.

    Let us suppose that every bank in our imaginary system begins with $1,000 in reserves, $9,000 in loans outstanding, and $10,000 in checkable deposit balances held by customers. The balance sheet for one of these banks, Acme Bank, is shown in Table 9.2 “A Balance Sheet for Acme Bank”. The required reserve ratio is 0.1: Each bank must have reserves equal to 10% of its checkable deposits. Because reserves equal required reserves, excess reserves equal zero. Each bank is loaned up.

    Table 9.2 A Balance Sheet for Acme Bank

    Acme Bank
    Assets Liabilities
    Reserves $1,000 Deposits $10,000
    Loans $9,000

    We assume that all banks in a hypothetical system of banks have $1,000 in reserves, $10,000 in checkable deposits, and $9,000 in loans. With a 10% reserve requirement, each bank is loaned up; it has zero excess reserves.

    Acme Bank, like every other bank in our hypothetical system, initially holds reserves equal to the level of required reserves. Now suppose one of Acme Bank’s customers deposits $1,000 in cash in a checking account. The money goes into the bank’s vault and thus adds to reserves. The customer now has an additional $1,000 in his or her account. Two versions of Acme’s balance sheet are given here. The first shows the changes brought by the customer’s deposit: reserves and checkable deposits rise by $1,000. The second shows how these changes affect Acme’s balances. Reserves now equal $2,000 and checkable deposits equal $11,000. With checkable deposits of $11,000 and a 10% reserve requirement, Acme is required to hold reserves of $1,100. With reserves equaling $2,000, Acme has $900 in excess reserves.

    At this stage, there has been no change in the money supply. When the customer brought in the $1,000 and Acme put the money in the vault, currency in circulation fell by $1,000. At the same time, the $1,000 was added to the customer’s checking account balance, so the money supply did not change.

    Figure 9.2

    Because Acme earns only a low interest rate on its excess reserves, we assume it will try to loan them out. Suppose Acme lends the $900 to one of its customers. It will make the loan by crediting the customer’s checking account with $900. Acme’s outstanding loans and checkable deposits rise by $900. The $900 in checkable deposits is new money; Acme created it when it issued the $900 loan. Now you know where money comes from—it is created when a bank issues a loan.

    Figure 9.3

    Presumably, the customer who borrowed the $900 did so in order to spend it. That customer will write a check to someone else, who is likely to bank at some other bank. Suppose that Acme’s borrower writes a check to a firm with an account at Bellville Bank. In this set of transactions, Acme’s checkable deposits fall by $900. The firm that receives the check deposits it in its account at Bellville Bank, increasing that bank’s checkable deposits by $900. Bellville Bank now has a check written on an Acme account. Bellville will submit the check to the Fed, which will reduce Acme’s deposits with the Fed—its reserves—by $900 and increase Bellville’s reserves by $900.

    Figure 9.4

    Notice that Acme Bank emerges from this round of transactions with $11,000 in checkable deposits and $1,100 in reserves. It has eliminated its excess reserves by issuing the loan for $900; Acme is now loaned up. Notice also that from Acme’s point of view, it has not created any money! It merely took in a $1,000 deposit and emerged from the process with $1,000 in additional checkable deposits.

    The $900 in new money Acme created when it issued a loan has not vanished—it is now in an account in Bellville Bank. Like the magician who shows the audience that the hat from which the rabbit appeared was empty, Acme can report that it has not created any money. There is a wonderful irony in the magic of money creation: banks create money when they issue loans, but no one bank ever seems to keep the money it creates. That is because money is created within the banking system, not by a single bank.

    The process of money creation will not end there. Let us go back to Bellville Bank. Its deposits and reserves rose by $900 when the Acme check was deposited in a Bellville account. The $900 deposit required an increase in required reserves of $90. Because Bellville’s reserves rose by $900, it now has $810 in excess reserves. Just as Acme lent the amount of its excess reserves, we can expect Bellville to lend this $810. The next set of balance sheets shows this transaction. Bellville’s loans and checkable deposits rise by $810.

    Figure 9.5

    The $810 that Bellville lent will be spent. Let us suppose it ends up with a customer who banks at Clarkston Bank. Bellville’s checkable deposits fall by $810; Clarkston’s rise by the same amount. Clarkston submits the check to the Fed, which transfers the money from Bellville’s reserve account to Clarkston’s. Notice that Clarkston’s deposits rise by $810; Clarkston must increase its reserves by $81. But its reserves have risen by $810, so it has excess reserves of $729.

    Figure 9.6

    Notice that Bellville is now loaned up. And notice that it can report that it has not created any money either! It took in a $900 deposit, and its checkable deposits have risen by that same $900. The $810 it created when it issued a loan is now at Clarkston Bank.

    The process will not end there. Clarkston will lend the $729 it now has in excess reserves, and the money that has been created will end up at some other bank, which will then have excess reserves—and create still more money. And that process will just keep going as long as there are excess reserves to pass through the banking system in the form of loans. How much will ultimately be created by the system as a whole? With a 10% reserve requirement, each dollar in reserves backs up $10 in checkable deposits. The $1,000 in cash that Acme’s customer brought in adds $1,000 in reserves to the banking system. It can therefore back up an additional $10,000! In just the three banks we have shown, checkable deposits have risen by $2,710 ($1,000 at Acme, $900 at Bellville, and $810 at Clarkston). Additional banks in the system will continue to create money, up to a maximum of $7,290 among them. Subtracting the original $1,000 that had been a part of currency in circulation, we see that the money supply could rise by as much as $9,000.

    Heads Up!

    Notice that when the banks received new deposits, they could make new loans only up to the amount of their excess reserves, not up to the amount of their deposits and total reserve increases. For example, with the new deposit of $1,000, Acme Bank was able to make additional loans of $900. If instead it made new loans equal to its increase in total reserves, then after the customers who received new loans wrote checks to others, its reserves would be less than the required amount. In the case of Acme, had it lent out an additional $1,000, after checks were written against the new loans, it would have been left with only $1,000 in reserves against $11,000 in deposits, for a reserve ratio of only 0.09, which is less than the required reserve ratio of 0.1 in the example.