How Banks and Thrifts Create Money

How Banks and Thrifts Create Money • Most transactions are “created” as a result of loans from banks or thrifts. • Chapter demonstrates the money-creating abilities of a single bank or thrift and then looks at the system as a whole.

How Banks and Thrifts Create Money • This chapter the term “bank” is used generically and applies to all depository institutions.

Balance Sheet • A Balance sheets summarize the financial position of the bank at a certain time. • The value of assets must equal the value of claims • Claims on a balance sheet are divided into two groups: • The bank owners’ claim is called net worth • Non-owners’ claims are called liabilities • Equation: Assets=Liabilities + Net Worth

Fractional Reserve System • Type of system the U.S. has in which only a fraction of the total money supply is held in reserve as currency.

Goldsmiths • In the 16th century goldsmiths had safes for gold and precious metals, where they kept for consumers and merchants • Receipts for these deposits were issued. • Receipts were used as money in place of gold for convenience. • Goldsmiths realized they could “loan” gold by issuing receipts to borrowers

Goldsmiths • The 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: • Banks can create money by lending more than the original reserves on hand • Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds • Federal Deposit Insurance Corporation (FDIC) was created to prevent panics

Money Creation by a Single Bank in Banking System • Bank is formed (example - with $250,000 worth of owners’ capital stock)‏ • Bank obtains property and equipment with some of the capital funds • Bank begins operations by accepting deposits • Banks keep reserve deposits in its district Federal Reserve Bank • Ex. pg. 254

Required Reserves Required reserves are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities. • Banks keep a significant portion of their own reserves in their vaults

Reserve Ratio • The “specified percentage” of checkable-deposit liabilities that a commercial bank must keep as reserves. • The Fed has the authority to establish and vary the reserve ration within limits legislated by Congress (between 8% and 14%)‏ • First 6 million of checkable deposits held by bank exempt from reserve requirements

Reserves • Three percent reserve required on checkable deposits between $6 million and $42.1million • No reserves are required against non-checkable non-personal (business) savings CDs. (up to 9% can be required)‏

Control: • Required reserves do not exist to protect against “runs” because banks must keep their required reserves. • Required reserves exists to give the Federal Reserve control over the amount of lending or deposits that banks can create • Required reserves help the Fed control credit and money creation. • Banks cannot loan beyond their fraction required reserves.

Asset and Liability • Reserves are an asset to banks • Reserves are a Liability to the Fed

Profits, Liquidity, and the Federal Funds Market • Profits: Banks are in business to make a profit • They earn profits primarily from interest on loans and securities they hold • Liquidity: Banks must seek safety by having liquidity to meet cash needs of depositors and meet check-clearing transactions

Profits, Liquidity, and the Federal Funds Market • Federal funds rate: Banks can borrow from one another to meet cash needs in the federal funds market, where banks borrow from each other’s available reserves on overnight basis • The interest rate paid is called the Federal Funds Rate

Need for Monetary Control • During prosperity, banks will lend as much as possible and reserve requirements provide a limit to the expansion of loans • During recession, banks may cut lending, which can worsen recession. • Profit-seeking bankers will be motivated to expand or contract loans that could worsen the business cycle. • The Fed uses monetary policy to counteract such results in order to prevent worsening recessions or inflation. (Cpt. 15)‏

How Banks and Thrifts Create Money