c hapter 26 money creation and the banking system

CChapter 26hapter 26Money Creation and Money Creation and the Banking Systemthe Banking System

Outline

• The fractional reserve system

• The legal reserve requirement

• A bank’s balance sheet, its assets and liabilities

• Demand deposits and bank loans

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Outline

•The potential money multiplier

•Bank failure

•The Federal Deposit Insurance Corporation (FDIC)

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How Banks Create MoneyHow Banks Create Money

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Fractional reserve system

•A banking system that provides people immediate access to their deposits but allows banks to hold only a fraction of those deposits in reserve.

How Banks Create MoneyHow Banks Create Money

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The fractional reserve system serves as the basis of all modern banking.

How Banks Create MoneyHow Banks Create Money

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If all depositors lost faith in the banking system and demanded their money back, banks would be unable to meet their demands.

How Banks Create MoneyHow Banks Create Money

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Balance sheet

• The bank’s statement of liabilities (what it owes) and assets (what it owns).

How Banks Create MoneyHow Banks Create Money

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Banks make a profit on the loans they provide, not on their deposits.

How Banks Create MoneyHow Banks Create Money

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Legal reserve requirement

• The percentage of demand deposits banks and other financial intermediaries are required to keep in cash reserves.

•In the example from the textbook, it is assumed 20%.

Balance Sheet

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Balance Sheet

• Bank makes loans for profit.• Example: Matt want to borrow money from

PFN for an investment project. PFN lends him $800 (max amount PFN can make under 20% reserve requirement. The bank then opens demand deposit account for him.

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Balance Sheet after Loans made

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The Interaction of Deposits and Loans

• Suppose Matt hires Charlie to work for him. This service will cost Matt $800. When the job is done, Matt writes out the check to Charlie for $800. Thus, the balance sheet of PFN becomes:

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The Interaction of Deposits and Loans

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• Suppose Charlie deposits the check in his bank, PSN.

• Below is the balance sheet of PSN.

The Interaction of Deposits and Loans

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• Now PSN makes loans to Betty for its max allowed amount $800*0.8=$640.

• Balance sheet of PSN is:

The Interaction of Deposits and Loans

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• Betty then pays her loan $640 to Forrest for his consulting service.

• Forrest deposits the check in the bank, PTN. Thus, the balance sheet of PSN is as below.

The Interaction of Deposits and Loans

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• In the meantime, the balance sheet of PTN becomes:

• This process can keep going on…

How Banks Create MoneyHow Banks Create Money

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Banks create money by repeating processes we discuss above. That is , we say bank serve as:

•Financial intermediaries

•Firms that accept deposits from savers and use those deposits to make loans to borrowers.

How Banks Create MoneyHow Banks Create Money

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• A fractional reserve system operating within financial intermediaries.

What three factors are needed for a banking system to create money?

How Banks Create MoneyHow Banks Create Money

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• A fractional reserve system operating within financial intermediaries.

• People willing to make demand deposits.

What three factors are needed for a banking system to create money?

How Banks Create MoneyHow Banks Create Money

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What three factors are needed for a banking system to create money?

• A fractional reserve system operating within financial intermediaries.

• People willing to make demand deposits.

• Borrows prepared to take out loans.

How Banks Create MoneyHow Banks Create Money

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Potential money multiplier

• The increase in the money supply that is potentially generated by a change in demand deposits.

How Banks Create MoneyHow Banks Create Money

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How Banks Create MoneyHow Banks Create Money

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If the legal reserve requirement is 10 percent, what is the potential money multiplier?• The potential money multiplier “m” = 1/(legal reserve requirement) = 1/0.1 = 10.

How Banks Create MoneyHow Banks Create Money

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• M = ID/LRR.

If the legal reserve requirement (LRR) is 20 percent and the initial demand deposit (ID) is $1,000, then what is the maximum potential increase in the money supply (M)?

How Banks Create MoneyHow Banks Create Money

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If the legal reserve requirement (LRR) is 20 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)?

• M = $1,000/.20 = $5,000.

How Banks Create MoneyHow Banks Create Money

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Why might the actual increase in the money supply be less than the maximum potential increase in the money supply?• Because there may not be a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system.

How Banks Create MoneyHow Banks Create Money

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Excess reserves

• The quantity of reserves held by a bank in excess of the legally required amount.

Excess reserves

• Suppose now PFN only makes loans amounted to $400, then its balance sheet eventually will be just:

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How Banks Create MoneyHow Banks Create Money

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If there is not a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system, then the banking system will end up holding excess reserves.

How Banks Create MoneyHow Banks Create Money

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• Required reserves are 0.2 × ($100,000) = $20,000.

Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess?

How Banks Create MoneyHow Banks Create Money

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• Excess reserves = (total reserves) - (required reserves).

Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess?

How Banks Create MoneyHow Banks Create Money

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Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess?• Excess reserves = $35,000 - $20,000 = $15,000.

Reversing the Money Creation Reversing the Money Creation ProcessProcess

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• Some excess reserves that may have otherwise been loaned out will instead be converted to required reserves.

1. What will happen if the Federal Reserve increased the legal reserve requirement for banks?

Reversing the Money Creation Reversing the Money Creation ProcessProcess

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• Banks with no excess reserves will have to borrow reserves until enough loans are repaid or enough new deposits are made.

1. What will happen if the Federal Reserve increased the legal reserve requirement for banks?

Reversing the Money Creation Reversing the Money Creation ProcessProcess

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1. What will happen if the Federal Reserve increased the legal reserve requirement for banks?• Either way, increasing the legal reserve requirement will reduce loanable reserves in the banking system, and thus reduce the money supply.

Why Banks Sometimes FailWhy Banks Sometimes Fail

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1. What will happen if too many borrowers are unable to repay their loans?

• A bank may fail.

Why Banks Sometimes FailWhy Banks Sometimes Fail

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2. If a bank fails, what will happen to the depositors?• If deposits are not insured by the federal government, then depositors may lose their money.

Why Banks Sometimes FailWhy Banks Sometimes Fail

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• Fearing that they may lose their money, and having lost confidence in the banking system, some depositors will demand their money back from their deposits.

3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?

Why Banks Sometimes FailWhy Banks Sometimes Fail

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• Many people will lose their money, loanable funds for investment will be eliminated, and a recession may result.

3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?

Why Banks Sometimes FailWhy Banks Sometimes Fail

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•To prevent the spreading of panics, the government should step in.

• On way is to pay depositors up to the maximum insurable amount.

Safeguarding the SystemSafeguarding the System

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Federal Deposit Insurance Corporation (FDIC)

• A government insurance agency that provides depositors in FDIC-participating banks 100 percent coverage on their first $250,000 of deposits.

FDIC Historical insurance limits

• 1934 - $2,500

• 1935 - $5,000

• 1950 - $10,000

• 1966 - $15,000

• 1969 - $20,000

• 1974 - $40,000

• 1980 - $100,000

• 2008 - $250,000

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Safeguarding the SystemSafeguarding the System

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Banks participating in the FDIC insurance program must pay insurance premiums in return for FDIC protection.

Federal Deposit Insurance and Federal Deposit Insurance and Moral HazardMoral Hazard

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Fully insuring deposits leads to a costly side effect known as moral hazard.

Federal Deposit Insurance and Federal Deposit Insurance and Moral HazardMoral Hazard

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Once a bank is insured, it has an incentive to take on more risky loans than it otherwise would if it were not insured.

Safeguarding the SystemSafeguarding the System

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In addition to deposit insurance, the FDIC also audits banks to make sure that they use sound banking practices.

Safeguarding the SystemSafeguarding the System

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Despite these safeguards, banks still fail each year.

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EXHIBIT 1 BANK FAILURES: 1930–2000

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EXHIBIT 2 BANK FAILURES, SELECTED STATES: 1987–89

Source: Federal Deposit Insurance Corporation, Annual Report, 1989 (Washington, D.C., 1989), p. 11.

Safeguarding the SystemSafeguarding the System

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During the 1970s, high farm commodity prices inflated the price of farmland, and high oil prices inflated the value of property in Texas and Oklahoma.

Safeguarding the SystemSafeguarding the System

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Banks made loans with inflated property values as collateral.

Safeguarding The SystemSafeguarding The System

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When farm commodity prices and oil prices collapsed in the recession of the early 1980s, many farms and businesses failed, and were unable to repay their loans.

Safeguarding the SystemSafeguarding the System

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Banks were left holding collateral —land, buildings, and other capital—that was worth less than the amount of the loan.

Safeguarding the SystemSafeguarding the System

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Consequently, many banks failed, particularly in farm states and in Texas and Oklahoma.