Lesson 9-2 Money Creation by Banks

The Banking System and Money Creation Banks and Other Financial Intermediaries A financial intermediary is an institution that amasses funds from one group and makes them available to another. Pension funds, insurance companies, and mutual funds are all financial intermediaries. A bank is a financial intermediary that accepts deposits, makes loans, and offers checking accounts.

Non-bank financial intermediaries have become more and more like banks and have assumed a larger and larger share of the nation’s total financial assets. Banks are tightly regulated but non-bank financial intermediaries are less tightly regulated.

Bank Finance and a Fractional Reserve System A balance sheet is a financial statement showing assets, liabilities, and net worth. Assets are anything that is of value. Liabilities are obligations to other parties. Net worth equals assets less liabilities. Banks make profits by earning more interest on loans than they have to pay to pay depositors along with other costs.

Banks must hold some of depositors’ cash in reserves, but they may lend out the rest. A system in which banks hold reserves whose value is less than the sum of claims out-standing on those reserves is called a fractional reserve banking system.

Money Creation Required reserves plus excess reserves equal total reserves. Required reserves are the quantity of reserves banks are required to hold. Excess reserves are any reserves banks hold in excess of required reserves. The required reserve ratio is the ratio of reserves to checkable deposits banks are required to maintain. When a bank has no excess reserves, it is loaned up. Bank transactions can be presented on a bank statement.

When a depositor deposits cash into his checking account, the money supply does not change. There is less cash in circulation and more money in checkable accounts than before. Money deposited in banks is divided between required reserves and loans. New loans generate more cash in circulation or more checkable deposits. Part of the new money is returned to some bank somewhere as additional deposits that are divided between required reserves and loans and the process starts over again.

Eventually, all of the initial new deposit is used up in required reserves. The total amount of money in checkable accounts has expanded, thereby increasing the money supply. If the initial action had been to withdraw money from a checkable account, the process would have continued as above but in a negative direction.

The Deposit Multiplier The deposit multiplier (md ) equals the ratio of the maximum possible change in checkable deposits divided by the change in reserves that created it. R = rrD where R equals reserves, rr equals required reserve ratio, and D equals checkable deposits..R = rr.D. 1/rr =.D/.R = md.

The Regulation of Banks Banks are among the most heavily regulated of financial institutions. Regulations help protect depositors against corrupt business practices. Regulations help prevent crises of confidence. Regulations help control the quantity of money.

Deposit Insurance Deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC). Having insurance may make banks take greater risks than they would otherwise. Regulations to Prevent Bank Failure Banks are severely limited in what they can do. Regulators routinely perform audits. The FDIC has the power to close a bank whose net worth has fallen below the required level.