Students Again

The Balance Sheet of a Commercial Bank: We’re going to be using a simplified T account in this chapter to describe how a bank works. Most of the examples in the chapter are fine – so the notes are not going to be exhaustive.

Prologue: The goldsmiths: The simply bank can be described as part of the founding of the old west. While many gold rush towns arose – people needed a safe place to store their gold while they were out prospecting. A wise person would buy a vault and move to town. He would charge a fee to hold the gold for them. Fractional reserve banking system: After a while, the vault owner found that whenever he released some gold so a person could buy a shovel, or food at the general store – he very soon after received the gold back from the store owner who now wanted to keep it in a safe place. The constant in and out of gold dust for measuring led to a certain amount of lost dust. To solve the problem, vault owners started issuing writs for gold – a piece of paper telling others that the holder of the note had a claim to a certain amount of gold at the vault. This eliminated the need to measure gold dust at the store – and kept the gold safe all the time.

After a while, the vault owner realized that since most people did not come for their gold that often – he could loan out a fraction of what he had in his vault to people who were willing to pay interest on the loan. Even if a person came in for his gold, the vault owner could give him anyone’s actual gold – as long as he eventually got the gold back.

Money creation and reserves: Now instead of just (let’s say) 100 pounds of gold in the vault supporting 100 pounds worth of economic activity – the number of notes (claims against the gold) could exceed the pounds of gold behind it. The Vault owner eventually found that he was able to loan out most of the gold – as long as everyone didn’t come to withdraw all at once.

Bank panics and regulation: Of course, occasionally, a lot of people did come in at once – or the largest depositor came in to move out of town. If the largest depositor had earned 100 pounds of gold (his original gold plus any claims he had acquired over time), and was leaving town – once he withdrew his gold, there would be none left in the bank. People seeing old Mr. Moneybags walking to the bank with empty suitcases would rush to get there first – taking out their 5 pounds before Mr. Moneybags withdrew his 100 pounds. Others would rush there as well – like the scene from “It’s a Wonderful Life”. This was known as a “bank panic” or a “run on a bank”. Those who got there too late lost everything, the bank would close and the town’s economy would collapse.

A Single Commercial Bank: let’s start with a one vault town.

Formation of a Commercial Bank: The bank has to establish itself – investors need to put their money in to buy property, hire labor and furnish the place (they need to buy a vault!)

Transaction 1: Creating a Bank:
Transaction 2: Acquiring Property and Equipment:

These two transactions are pretty self explanatory, but I put in a “T” account for them anyway. The basic premise of a “T” account is that the total in the left column must always equal the total in the right column. Other than that, we don’t need to delve into accounting any more than that. Our investor (vault owner) is going to invest $150,000 and use $100,000 of it to buy a vault and a building. The money invested (Capital Stock) is a liability to the firm – they owe it back to the investor. The cash and the building are going to be used to create money – so they are assets.

Transaction 3: Accepting Deposits

Here is our vault owner accepting gold into his vault. Let’s let him accept $100,000 worth of deposits. The deposits are his liabilities – he owes them to someone (the customers), but the cash in the vault is an asset to him (can be used to create money and profits).

Transaction 4: Depositing Reserves in a Federal Reserve Bank:

Next we have to add that a modern bank must keep reserves (some of the deposits) at the FED (Federal Reserve Bank) but in the old west – we could just say this is the cash kept in the vault in case someone wants to withdraw some of their money. He doesn’t need to keep all the gold in the vault since most people only come in occasionally.

Today, the FED requires banks to hold some of their cash as reserves at the FED (called Required Reserves). The proportion they must keep at the FED is known as the Required Reserve Ratio (RRR) – and we’ll assume that it’s 10%.

Excess Reserves: This is the cash available to be loaned out by the bank. It is there and is not required to be at the FED – therefore it can be loaned out. This is the $140,000 we were calling cash reserves.

Control: the FED does not require these reserves just to protect investors from bank panics – but it also allows the FED to control the size of the money supply.

Asset and Liability: the reserves at the FED are an asset to the bank – but a liability to the FED (they owe it back).

Transaction 5: Clearing a Check Drawn against a Bank:

If I wrote a check against my account (or gave my claim certificate to someone else in the old west), they could withdraw my money from the vault (bank). If they simply deposited it – then the bank doesn’t even need to have it on hand – they simply credit a second person’s account by moving my money to an account with their name. But if they deposit it in another bank – I have to send that money (gold) to the other bank.

The FED does this for us. If you write a check for $100 to Sam’s Club from your account at the Bank of Novi and Sam’s Club deposits it in the Bank of Arkansas – then your bank needs to send their bank $100. What actually happens is that the FED has an account for both of those banks. They take $100 out of the Bank of Novi’s reserve account and put it in the Bank of Arkansas’ reserve account. This is called clearing checks and it’s one of the duties of the FED.

Money-Creating Transactions of a Commercial Bank:

Transaction 6: Granting a Loan:

If I take out a loan from the bank (vault) for let’s say $20,000, I get an account with money in it to use as I see fit. Deposits rise by $20,000. That means that reserves have to increase too – to $12,000.

Perhaps I buy some property and a pan and tent and go prospecting for gold. I spend part of the money at the general store – hand him my claims to gold at the vault, and go  prospecting. The store owner brings his claim to the vault and deposits it. Even though the vault owner lent me money that wasn’t his – the money (gold) is still physically in the vault. But now there are more than $100,00 worth of claim tickets ($120,000 to be exact). $10,00 is still in the my hands (the loan money I have not spent yet), $10,000 in the hands of the store owner, and $100,000 worth of initial deposits. This step does not change the deposit number since the money comes from my deposit account to the store owner’s deposit account.

You see if you add the columns that the money in my bank has risen from $250,000 to $270,000 – even though no more actual money (gold) exists. If everyone came in for their  deposits today – The vault owner couldn’t possibly cash them all out. Granting loans based on fractional reserve banking creates money – but it also increases the risk.

If the store-owner takes his money to another vault (bank), then my reserves decrease when I cash it out. At that point I only need $11,000 in FED reserves, so I can pull $1,000 back from the FED.

Transaction 7: Repaying a Loan:

When I go back to the bank to re-pay my loan – the extra money disappears. I withdraw the $20,00 from my account and pay the bank back with it. Total deposits fall to just the original $100,000 as my account goes back to 0. Loans go to 0. The vault owner can again pull back some reserves since only 10,000 is now required. The money available can again cover the amount of deposits.

Transaction 8: Buying a Government Securities:

If the bank owner buys a stock, bond or other asset, that money comes from excess reserves and the asset is the security.

Less money is available to be loaned out – so there is less potential to create money.

BUT – if the money is re-deposited in the bank (the vault owner bought the bond from people in town), then they could deposit it back with the vault. If they do, deposits rise by that same amount ($10,000). Reserves have to be increased (by 10% of the new deposits = $1,000). The rest ($9,000) is available to be loaned out.

Profits Liquidity, and the Federal Funds Market:

Banks have two objectives -

• make a profit: to do this they need to make loans and charge interest, but that means fractional reserve banking and that’s risky.
• Be liquid: to do this they need to retain reserves in case people come to make a withdrawal – but that means less is available to be lent out, decreasing profits.

Banks have an incentive not to hold extra reserves at the FED since FED reserves earn no interest. If a bank guesses poorly how much reserves itr will nee – It can borrow from other banks looking to make some money off the extra they mistakenly left at the FED. The rate banks charge other banks for borrowing FED Reserves is called the Federal Funds Rate.

The Banking System: Multiple Deposit Expansion

So how much money can banks create? If they loaned out every dollar they had – there is no limit to how much money the banking system could create – but they would be running a very risky bank system. One person coming in would constitute a bank panic. If they loan out none – then they create none. The ability to create money depends on how much they loan out.

RRR – the required reserve ration (minimum reserve ratio set by the FED). The money set aside to meet this requirement is not on hand to be loaned out. The more the FED requires them to sdet aside – the less they have to loan out and the less money gets created.

Excess Reserves are the reserves a bank keeps over and above the minimum RRR. This is often referred to as Vault Cash.

RR = is the ratio of total reserves (required and excess) to deposits.

The Banking System’s Lending Potential

At a maximum, banks could create 1/RRR times the deposits worth of Money Supply. To do this, they would have to loan out every dollar they could (excess reserves = 0)

MS = 1/RRR * deposits

If the RR was 10% and there was $100 worth of gold in our gold rush town, we could have:

MS = (1/.10)*100 = 1000

The Money Multiplier: at a maximum it is 1/RRR – but if banks keep excess reserves, then it’s 1/RR.

Some Modifications: Other Leakages:

Currency Drains: the more people keep from re-depositing, the lower the multiplier.

Excess Reserves: the more excess reserves banks keep, the lower the multiplier.

Need for Monetary Control: One of the main problems with the banking system is that it is pro-cyclical. When times are good, they are willing to make riskier loans and the economy heats up (causing inflation). When times are bad, banks are more risk averse and they loan out less money (slowing the economy down even further). The government must use  Monetary Policy to counteract that tendency by banks to be pro-cyclical.