9.2 Money Created By Banks

Banks create money when they increase their deposit liabilities to pay for the loans they make to customers, or for the financial securities they buy. The public uses the deposit liabilities of the banks as money to make payments or to hold as a store of wealth. There are four key conditions that give banks the ability to create money:

  1. The non-bank public has confidence in banks and is willing to hold and use bank deposits as money.
  2. The non-bank public is willing to borrow from the banks to finance expenditure or asset purchases.
  3. The banks are willing to operate with cash reserves equal to some small fraction of their deposit liabilities.
  4. The banks are willing to accept the risks involved in lending to the non-bank public.

If any of these is absent, the banks cannot create money, although they may provide safekeeping services.

The first two conditions underlie the demand for banking services. Banks acquire cash by providing customers deposit services and bank customers use bank loans as a source for funds to pay for purchases of goods, services and financial assets like equities and bonds. If the non-bank public is unwilling to use bank services there is no banking industry.

The third condition required for the banks to create money is a bank reserve ratio that is less than one. The reserve ratio (rr) is the ratio of cash on hand to deposit liabilities that banks choose to hold.

rr=reserve assetsdeposit liabilities
(8.1)

Reserve ratio (rr): the ratio of cash reserves to deposit liabilities held by banks.

Cash holdings are reserve assets. If banks choose to hold reserves equal to their deposit liabilities, rr=1 and the banks cannot create deposits. They are simple safety deposit boxes.

A simplified case shows how banks can and do create deposits. Assume banks use a reserve ratio of 10 percent (rr=0.10). Suppose initially the non-bank public has wealth of $1,000 held in cash, before they decide to switch to bank deposit money. This cash is a private sector asset. It is a liability of the central bank or government, which issued it, but not a liability of the private banks. The ‘Initial position’ in Table 8.4 uses a simple balance sheet to show this cash as an asset of the non-bank private sector.

Table 8.4 How the banking system creates money
Banks Non-bank public
Assets Liabilities Assets Liabilities
Cash 0 Deposits 0 Cash 1,000 Bank loans 0
Cash 1,000 Deposits 1,000 Cash 0 Bank loans 0
Deposits 1,000
Cash 1,000 Deposits 10,000 Cash 0 Bank loans 9,000
Loans 9,000 Deposits 10,000

Then in the second part of the table people deposit this $1,000 of cash into the banks by opening bank accounts. Banks get assets of $1,000 in cash, distributed among individual banks by their customers and issue total deposit liabilities of $1,000. These deposits are money the banks owe to their depositors. If banks were simply safety deposit boxes or storerooms, they would hold cash assets equal to their deposit liabilities. Their reserve ratio would be 100 percent of deposits, making rr=1.0. Table 8.4 would end with part 2.

However, if the public uses bank deposits as money, the banks don’t need all deposits to be fully covered by cash reserves. It is unlikely that all depositors will show up at the same time and demand cash for their deposits. Recognizing this, the banks decide that reserves equal to 10 percent (rr=0.10) of deposits will cover all net customer demands for cash. In this case, the banks have excess reserves which in total equal 90 percent of their deposit liabilities or, initially, $900.

The banks use their excess reserves to expand their lending. Each bank makes new loans equal to its excess reserves. It pays for those loans by creating an equal amount of deposits. If you were to borrow from bank your personal deposit would be increased by the amount of the loan. The same thing happens to other people who borrow from their banks.

In our example, all banks combined can create $9,000 of loans based on $1,000 in new cash reserves. In part 3 of Table 8.4, we see loans of $9,000, as assets on the banks’ balance sheets, and $9,000 of new deposits to customers, against which they can write cheques or make payments online or by transfers. The newly created deposits of $9,000 are a part of the $10,000 liability on the banks’ balance sheets. The public now has bank deposit assets of $10,000 and liabilities, loans owed to the banks, of $9,000. Non-bank public net worth, assets minus liabilities is $1,000, the cash they originally deposited in the banks. Because the public uses bank deposits as money, the banks can buy new loans by creating new deposits.

The reserve ratio is 10 percent in part 3 of Table 8.4 (rr=$1,000 cash/$10,000 deposits =0.10 or 10%). It does not even matter whether the 10 percent reserve ratio is imposed by law or is merely smart profit-maximizing behaviour by the banks that balances risk and reward. The risk is the possibility of being caught short of cash; the reward is the net interest income earned.

Why were the banks able to create money? Originally, there was $1,000 of cash in circulation. That was the money supply. When paid into bank vaults, it went out of circulation as a medium of exchange. But the public got $1,000 of bank deposits against which cheques could be written. The money supply, cash in circulation plus bank deposits, was still $1,000. Then the banks created deposits not fully backed by cash reserves. Now the public had $10,000 of deposits against which to write cheques. The money supply rose from $1,000 to $10,000. The public was willing to use bank deposits as money, willing to borrow from the banks and the banks were willing to lend. This allowed the banks to create money by making loans based on their fractional reserve ratio.

Alternatively, suppose the public loses confidence in banks and withdraws and holds more currency. The banks are still able to create deposits but the extent of the deposit creation is limited by the public’s withdrawal of currency. Bank reserves are reduced. A fall in public confidence in the banks in times of financial problems and bank failures like those in that arose in the autumn of 2008 and even today in some European countries would result in a rise in the currency holdings outside banks. Bank deposits and lending capacity would be reduced as a result, and in extreme cases bank solvency might be at risk without central bank support.

Financial panics

Most people know that banks operate with fractional reserve ratios and are not concerned. But if people begin to suspect that a bank has lent too much, made high risk loans or faces problems in raising funds which would make it difficult to meet depositors’ claims for cash, there would be a run on the bank and a financial panic. Recognizing the bank cannot repay all depositors immediately, you try to get your money out first while the bank can still pay. Since everyone does the same thing, they ensure that the bank is unable to pay. It holds cash equal to a small percentage of its deposit liabilities and will be unable to liquidate its loans in time to meet the demands for cash.

Financial panic: a loss of confidence in banks and rush to withdraw cash.

Banking problems in Greece in the spring and early summer of 2015 provide an example. Concerns that the Greek government might default on loan payment agreements with IMF and European Union raised the possibility that Greece might leave the euro and return to its earlier national currency: the drachma. Should that happen, all euro deposits in Greek banks would convert to drachmas at an exchange rate that would reduce their real value substantially. Fearing this possibility, depositors in Greek banks tried to withdraw their balances in cash while they were still convertible into euros.

Greek banks, like other banks, operate on a fractional reserve basis. They could not meet this ‘run on the bank’ without outside support and assistance. The European Central Bank provided emergency cash to the banks but the run continued. In response, limits were placed on the amount of cash a depositor could withdraw at any one time. These measures sustained the banks until a solution to Greek debt crisis was negotiated and immediate concerns about Greek membership in the euro and the value of Greek bank deposits subsided.

However, earlier experience shows how financial crises can arise in other ways. In 2008-2009 the crisis originating in the US mortgage market and real estate sector caused wide spread problems for banks. Many banks had become reliant on large denomination, short-term deposits as sources of funds to support their mortgage lending. Other non-bank financial institutions like insurance companies and pension funds, as well as a relatively small number of individual customers bought these deposits. As the recession and falling property values emerged, the financial community began to worry that home-owners would not be able to pay back their mortgages.

If that happened banks would not be able to pay back depositors money, especially the large denomination short-term deposits. Once non-bank portfolio managers realized that it was difficult if not impossible to evaluate the risks of large denomination deposits, financial institutions that relied on renewing and issuing new deposits to raise funds were in difficulties. The supply of funds to replace expiring deposits dried up and banks could not repay depositors. Several large financial institutions in the United States and in other countries required government rescues or failed. The plight of famous names like Bear SternsCountrywide FinancialFannie May, and Freddie Mac became headline news.

Banks in Canada were not immune to the financial difficulties created by the collapse of the large denomination deposit markets. All the major chartered banks were holding some. They were forced to accept that without a market these deposits would no longer be a source of funds. Fortunately, Canadian banks relied more heavily on strong smaller retail depositor bases as sources of funds. The banks remained financially strong and public confidence in the banks did not collapse. No Canadian bank failed or required a government bailout.

Fortunately, financial panics involving depositor runs on the bank are rare, particularly in Canada. A key reason for this, which we discuss in the next chapter, is that the central bank, the Bank of Canada, and other national central banks, will lend cash to banks in temporary difficulties. Furthermore, deposit insurance plans like the Canadian Deposit Insurance Corporation, CDIC, cover individual bank deposits up to $100,000 against default. Knowledge of these institutional arrangements helps prevent a self-fulfilling stampede to withdraw deposits before the bank runs out of cash.

By contrast, the financial crisis and the extended real estate and credit collapse in 2008 created large problems for US banks. Loan and financial asset defaults destroyed bank assets and bank liquidity. Even in the absence of panics and bank runs, many banks became insolvent without sufficient liquid assets to cover their liabilities. Failed bank data illustrates the scale of the problem. The US Federal Deposit Insurance Corporation lists 457 US bank failures over the period January 2008 to September 2012. In the four preceding years, January 2004 to December 2007 there were just 7 US bank failures.

(http://www.fdic.gov/bank/individual/failed/banklist.html)

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