Money and Banking II

Transcription

1 Money and Banking II

2 Four different topics 1. What services do banks provide? 2. How do banks create money? 3. How do banks keep track of their funds? 4. How have acts of Congress changed the banking industry over the last 100 years?

3 Banks offer a range of services 1. Banks cash checks, issue credit cards, change foreign currency into dollars and vice versa, and provide safe-deposit boxes for storing valuables. 2. Banks also offer the convenience of electronic banking through ATMs, debit cards, direct deposit of paychecks, and automatic paying of bills. 3. Banks also serve as financial intermediaries bringing together buyers and sellers, borrowers and savers in financial markets. They receive deposits from savers and make loans to borrowers.

4 How do banks create money? Banks don t create money like the U.S. Treasury does when it prints dollar bills and distributes them through the regional Federal Reserve banks. Nor do banks today create money like they did before the Civil War, by issuing certificates that could be redeemed for silver or some other precious metal. Banks create money in a different way. They create money (i.e., expand the money supply) through lending. It is through loans, which change the amount of checkable deposits, that banks create money. Key insight: Because we have a fractional reserve banking system, banks are only required to keep a fraction of their deposits in their vaults or on deposit with the Federal Reserve. The remaining deposits can be loaned out.

5 We can see how this works in the following example

6 How long will this process continue? Much depends on the money multiplier, which is an attempt to measure the rate of growth in the money supply through lending. As shown on the example, the total increase in checkable bank deposits is equal to a sum (essentially the sum of a geometric sequence) that looks like: $1,000 + $900 + $810 + $729 + A converging series of this form can be simplified to: Increase in checkable bank deposits from x in excess reserves = x/rr, where x represents a specific dollar amount (e.g., $1,000) and rr represents the reserve ratio (e.g., 10%). Thus, $1,000/0.1 = $10,000. A $1,000 deposit can lead to an expansion of $10,000 in the money supply. The money multiplier in this example is 10.

7 The total amount of money created in this manner may be less than is possible, though. Bear in mind that some of these loaned funds may be held by borrowers in their wallets and not deposited in a bank, which means that some of the loaned funds would leak out of the banking system. Therefore not so much money would be created as our model would suggest. The money multiplier hardly works automatically, it is not fixed, and it is subject to other limitations as well.

8 How do banks keep track of their assets and liabilities? For an overview, one can use a model like the following. For most commercial banks, their primary assets are loans. Part of their assets will include reserves, however, since they are not allowed to loan out all their money; they have to keep at a minimum a certain percentage of their deposits as reserves. The Federal Reserve determines this percentage (which can change over time). Since loans and reserves are assets, they are listed as debits in T-accounts. Other debits may include investments, property, and equipment. Liabilities, on the other hand, comprise checkable deposits and other items. Capital or Equity or Stock (not shown here) is usually included as a credit and counted after liabilities. Assets must equal Liabilities + Equity. The next slide provides a sample T-account.

9 A T-account is a simple tool for analyzing a bank s financial position. Two questions: In this example, what is the reserve ratio for this bank? Yes, 10% is the reserve ratio for this bank (190/1,900 =.10). At present the bank has $900 listed as loans on its balance sheet. How much can the bank still loan out if it wants? Yes, it can loan out an additional $810.

10 Bank financial statements are a little different than the financial statements of other businesses. For one thing, loans are assets for banks whereas for most other businesses, loans are liabilities.

11 Final comments on the money multiplier The money multiplier is the reciprocal of the required reserve ratio; it is the multiple by which a bank or banks can expand the money supply for each dollar of excess reserves. The money multiplier works in both directions; it applies to money destruction from the repayment of loans as well as the creation of money from banks making loans. Paying back loans thus contracts the money supply. Not everyone accepts the idea that banks create money by the process described above. There is indeed something fanciful about the notion that banks can somehow set into effect a chain of events by which a $1000 deposit could lead to an increase in the money supply of $10,000!

12 Congress has changed the banking industry greatly over the past 100 years In 1913 Congress passes the Federal Reserve Act, which creates the Federal Reserve System. The Federal Reserve acts as a kind of central bank.

13 In 1933, because of the Great Depression, Congress passes the Banking Act of 1933, aka known as the Glass-Steagall Act This act forbids banks from engaging in both commercial banking and investment banking. By keeping these activities separate, the bill s sponsors believed they could restore an element of stability and security to the banking system.

14 That Banking Act also created the Federal Deposit Insurance Corporation. Its goal was to restore confidence and stability in the banking system. It attempted to protect consumers deposits in banks and avoid bank runs through deposit insurance. As a result of this act and several modifications over time, depositor s accounts are insured up to $250, 000 per institution.

15 This act and prudent management of the financial sector enabled the banking industry to rebound and become profitable by the 1950s and 1960s

16 By the 1970s, however, banks are under financial pressure from other industries, such as the mutual fund industry. As a consequence, their leaders successfully lobby Congress for a greater deregulation of their business. Commercial banks and savings and loans (or S & Ls) are increasingly allowed to compete with other financial intermediaries for customers business. Commercial banks and S & Ls are now allowed to buy junk bonds and invest in shopping malls and other speculative ventures. By the late 1980s and early 1990s, the Savings and Loan Crisis is in full bloom. Congress creates several agencies, such as the Resolution Trust Corporation (RTC), to clean up the mess. The eventual bailout ends up costing taxpayers billions!

17 In 1999, Congress passed the Gramm-Leach-Bliley Act. This bill was passed during the dot.com boom. This act effectively repeals the Glass- Steagall Act of It gave banks the right to combine commercial and investment banking activities.

18 In 2010, after the financial crisis of 2007, Congress passed the Dodd-Frank Act This act called for greater oversight of the financial services industry. It tried to place risky financial instruments (such as derivatives) under greater supervision. It also sought to end the practice of providing bailouts for large financial firms that engaged in risky activities. Lastly, it called for the establishment of a Consumer Protection Bureau and other bodies to protect consumers and investors.