Where
does money come from? How is its quantity increased or decreased? The
answer to these questions suggests that money has an almost magical
quality: money is created by banks when they issue loans. In effect, money is created by the stroke of a pen or the click of a computer key.
We will
begin by examining the operation of banks and the banking system. We
will find that, like money itself, the nature of banking is experiencing
rapid change.
Banks and Other Financial Intermediaries
An institution that amasses funds from one group and makes them available to another is called a
financial intermediary.
A pension fund is an example of a financial intermediary. Workers and
firms place earnings in the fund for their retirement; the fund earns
income by lending money to firms or by purchasing their stock. The fund
thus makes retirement saving available for other spending. Insurance
companies are also financial intermediaries, because they lend some of
the premiums paid by their customers to firms for investment. Mutual
funds make money available to firms and other institutions by purchasing
their initial offerings of stocks or bonds.
Banks
play a particularly important role as financial intermediaries. Banks
accept depositors’ money and lend it to borrowers. With the interest
they earn on their loans, banks are able to pay interest to their
depositors, cover their own operating costs, and earn a profit, all the
while maintaining the ability of the original depositors to spend the
funds when they desire to do so. One key characteristic of banks is that
they offer their customers the opportunity to open checking accounts,
thus creating checkable deposits. These functions define a
bank, which is a financial intermediary that accepts deposits, makes loans, and offers checking accounts.
Over
time, some nonbank financial intermediaries have become more and more
like banks. For example, brokerage firms usually offer customers
interest-earning accounts and make loans. They now allow their customers
to write checks on their accounts.
The
fact that banks account for a declining share of U.S. financial assets
alarms some observers. We will see that banks are more tightly regulated
than are other financial institutions; one reason for that regulation
is to maintain control over the money supply. Other financial
intermediaries do not face the same regulatory restrictions as banks.
Indeed, their relative freedom from regulation is one reason they have
grown so rapidly. As other financial intermediaries become more
important, central authorities begin to lose control over the money
supply.
The
declining share of financial assets controlled by “banks” began to
change in 2008. Many of the nation’s largest investment banks—financial
institutions that provided services to firms but were not regulated as
commercial banks—began having serious financial difficulties as a result
of their investments tied to home mortgage loans. As home prices in the
United States began falling, many of those mortgage loans went into
default. Investment banks that had made substantial purchases of
securities whose value was ultimately based on those mortgage loans
themselves began failing. Bear Stearns, one of the largest investment
banks in the United States, required federal funds to remain solvent.
Another large investment bank, Lehman Brothers, failed. In an effort to
avoid a similar fate, several other investment banks applied for status
as ordinary commercial banks subject to the stringent regulation those
institutions face. One result of the terrible financial crisis that
crippled the U.S. and other economies in 2008 may be greater control of
the money supply by the Fed.
Bank Finance and a Fractional Reserve System
Bank
finance lies at the heart of the process through which money is created.
To understand money creation, we need to understand some of the basics
of bank finance.
Banks
accept deposits and issue checks to the owners of those deposits. Banks
use the money collected from depositors to make loans. The bank’s
financial picture at a given time can be depicted using a simplified
balance sheet, which is a financial statement showing assets, liabilities, and net worth.
Assets are anything of value.
Liabilities are obligations to other parties.
Net worth
equals assets less liabilities. All these are given dollar values in a
firm’s balance sheet. The sum of liabilities plus net worth therefore
must equal the sum of all assets. On a balance sheet, assets are listed
on the left, liabilities and net worth on the right.
The
main way that banks earn profits is through issuing loans. Because their
depositors do not typically all ask for the entire amount of their
deposits back at the same time, banks lend out most of the deposits they
have collected—to companies seeking to expand their operations, to
people buying cars or homes, and so on. Banks keep only a fraction of
their deposits as cash in their vaults and in deposits with the Fed.
These assets are called
reserves.
Banks lend out the rest of their deposits. A system in which banks hold
reserves whose value is less than the sum of claims outstanding on
those reserves is called a
fractional reserve banking system.
Table 9.1 “The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012”
shows a consolidated balance sheet for commercial banks in the United
States for January 2012. Banks hold reserves against the liabilities
represented by their checkable deposits. Notice that these reserves were
a small fraction of total deposit liabilities of that month. Most bank
assets are in the form of loans.
Table 9.1 The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012
| Assets |
Liabilities and Net Worth |
| Reserves |
$1,592.9 |
Checkable deposits |
$8,517.9 |
| Other assets |
$1,316.2 |
Borrowings |
1,588.1 |
| Loans |
$7,042.0 |
Other liabilities |
1,049.4 |
| Securities |
$2,546.1 |
|
|
| Total assets |
$12,497.2 |
Total liabilities |
$11,155.4 |
|
Net worth |
$1,341.8 |
This balance sheet for all commercial banks in the
United States shows their financial situation in billions of dollars,
seasonally adjusted, in January 2012.
Source: Federal Reserve Statistical Release H.8 (February 17, 2012).
In the next section, we will learn that money is created when banks issue loans.
Money Creation
To
understand the process of money creation today, let us create a
hypothetical system of banks. We will focus on three banks in this
system: Acme Bank, Bellville Bank, and Clarkston Bank. Assume that all
banks are required to hold reserves equal to 10% of their checkable
deposits. The quantity of reserves banks are required to hold is called
required reserves. The reserve requirement is expressed as a
required reserve ratio;
it specifies the ratio of reserves to checkable deposits a bank must
maintain. Banks may hold reserves in excess of the required level; such
reserves are called
excess reserves. Excess reserves plus required reserves equal total reserves.
Because
banks earn relatively little interest on their reserves held on deposit
with the Federal Reserve, we shall assume that they seek to hold no
excess reserves. When a bank’s excess reserves equal zero, it is
loaned up.
Finally, we shall ignore assets other than reserves and loans and
deposits other than checkable deposits. To simplify the analysis
further, we shall suppose that banks have no net worth; their assets are
equal to their liabilities.
Let us
suppose that every bank in our imaginary system begins with $1,000 in
reserves, $9,000 in loans outstanding, and $10,000 in checkable deposit
balances held by customers. The balance sheet for one of these banks,
Acme Bank, is shown in Table 9.2 “A Balance Sheet for Acme Bank”.
The required reserve ratio is 0.1: Each bank must have reserves equal
to 10% of its checkable deposits. Because reserves equal required
reserves, excess reserves equal zero. Each bank is loaned up.
Table 9.2 A Balance Sheet for Acme Bank
| Acme Bank |
| Assets |
Liabilities |
| Reserves |
$1,000 |
Deposits |
$10,000 |
| Loans |
$9,000 |
|
We assume that all banks in a hypothetical system of
banks have $1,000 in reserves, $10,000 in checkable deposits, and $9,000
in loans. With a 10% reserve requirement, each bank is loaned up; it
has zero excess reserves.
Acme
Bank, like every other bank in our hypothetical system, initially holds
reserves equal to the level of required reserves. Now suppose one of
Acme Bank’s customers deposits $1,000 in cash in a checking account. The
money goes into the bank’s vault and thus adds to reserves. The
customer now has an additional $1,000 in his or her account. Two
versions of Acme’s balance sheet are given here. The first shows the
changes brought by the customer’s deposit: reserves and checkable
deposits rise by $1,000. The second shows how these changes affect
Acme’s balances. Reserves now equal $2,000 and checkable deposits equal
$11,000. With checkable deposits of $11,000 and a 10% reserve
requirement, Acme is required to hold reserves of $1,100. With reserves
equaling $2,000, Acme has $900 in excess reserves.
At this
stage, there has been no change in the money supply. When the customer
brought in the $1,000 and Acme put the money in the vault, currency in
circulation fell by $1,000. At the same time, the $1,000 was added to
the customer’s checking account balance, so the money supply did not
change.
Figure 9.2
Because
Acme earns only a low interest rate on its excess reserves, we assume
it will try to loan them out. Suppose Acme lends the $900 to one of its
customers. It will make the loan by crediting the customer’s checking
account with $900. Acme’s outstanding loans and checkable deposits rise
by $900. The $900 in checkable deposits is new money; Acme created it
when it issued the $900 loan. Now you know where money comes from—it is
created when a bank issues a loan.
Figure 9.3
Presumably,
the customer who borrowed the $900 did so in order to spend it. That
customer will write a check to someone else, who is likely to bank at
some other bank. Suppose that Acme’s borrower writes a check to a firm
with an account at Bellville Bank. In this set of transactions, Acme’s
checkable deposits fall by $900. The firm that receives the check
deposits it in its account at Bellville Bank, increasing that bank’s
checkable deposits by $900. Bellville Bank now has a check written on an
Acme account. Bellville will submit the check to the Fed, which will
reduce Acme’s deposits with the Fed—its reserves—by $900 and increase
Bellville’s reserves by $900.
Figure 9.4
Notice
that Acme Bank emerges from this round of transactions with $11,000 in
checkable deposits and $1,100 in reserves. It has eliminated its excess
reserves by issuing the loan for $900; Acme is now loaned up. Notice
also that from Acme’s point of view, it has not created any money! It
merely took in a $1,000 deposit and emerged from the process with $1,000
in additional checkable deposits.
The
$900 in new money Acme created when it issued a loan has not vanished—it
is now in an account in Bellville Bank. Like the magician who shows the
audience that the hat from which the rabbit appeared was empty, Acme
can report that it has not created any money. There is a wonderful irony
in the magic of money creation: banks create money when they issue
loans, but no one bank ever seems to keep the money it creates. That is
because money is created within the banking system, not by a single
bank.
The
process of money creation will not end there. Let us go back to
Bellville Bank. Its deposits and reserves rose by $900 when the Acme
check was deposited in a Bellville account. The $900 deposit required an
increase in required reserves of $90. Because Bellville’s reserves rose
by $900, it now has $810 in excess reserves. Just as Acme lent the
amount of its excess reserves, we can expect Bellville to lend this
$810. The next set of balance sheets shows this transaction. Bellville’s
loans and checkable deposits rise by $810.
Figure 9.5
The
$810 that Bellville lent will be spent. Let us suppose it ends up with a
customer who banks at Clarkston Bank. Bellville’s checkable deposits
fall by $810; Clarkston’s rise by the same amount. Clarkston submits the
check to the Fed, which transfers the money from Bellville’s reserve
account to Clarkston’s. Notice that Clarkston’s deposits rise by $810;
Clarkston must increase its reserves by $81. But its reserves have risen
by $810, so it has excess reserves of $729.
Figure 9.6
Notice
that Bellville is now loaned up. And notice that it can report that it
has not created any money either! It took in a $900 deposit, and its
checkable deposits have risen by that same $900. The $810 it created
when it issued a loan is now at Clarkston Bank.
The
process will not end there. Clarkston will lend the $729 it now has in
excess reserves, and the money that has been created will end up at some
other bank, which will then have excess reserves—and create still more
money. And that process will just keep going as long as there are excess
reserves to pass through the banking system in the form of loans. How
much will ultimately be created by the system as a whole? With a 10%
reserve requirement, each dollar in reserves backs up $10 in checkable
deposits. The $1,000 in cash that Acme’s customer brought in adds $1,000
in reserves to the banking system. It can therefore back up an
additional $10,000! In just the three banks we have shown, checkable
deposits have risen by $2,710 ($1,000 at Acme, $900 at Bellville, and
$810 at Clarkston). Additional banks in the system will continue to
create money, up to a maximum of $7,290 among them. Subtracting the
original $1,000 that had been a part of currency in circulation, we see
that the money supply could rise by as much as $9,000.
Heads Up!
Notice that when the
banks received new deposits, they could make new loans only up to the
amount of their excess reserves, not up to the amount of their deposits
and total reserve increases. For example, with the new deposit of
$1,000, Acme Bank was able to make additional loans of $900. If instead
it made new loans equal to its increase in total reserves, then after
the customers who received new loans wrote checks to others, its
reserves would be less than the required amount. In the case of Acme,
had it lent out an additional $1,000, after checks were written against
the new loans, it would have been left with only $1,000 in reserves
against $11,000 in deposits, for a reserve ratio of only 0.09, which is
less than the required reserve ratio of 0.1 in the example.
The Deposit Multiplier
We can relate the potential increase in the money supply to the change in reserves that created it using the
deposit multiplier (
md), which equals the ratio of the maximum possible change in checkable deposits (∆
D) to the change in reserves (∆
R). In our example, the deposit multiplier was 10:
Equation 9.1
To see how the deposit multiplier md is related to the required reserve ratio, we use the fact that if banks in the economy are loaned up, then reserves, R, equal the required reserve ratio (rrr) times checkable deposits, D:
Equation 9.2
A
change in reserves produces a change in loans and a change in checkable
deposits. Once banks are fully loaned up, the change in reserves, ∆R, will equal the required reserve ratio times the change in deposits, ∆D:
Equation 9.3
Solving for ∆D, we have
Equation 9.4
Dividing both sides by ∆R, we see that the deposit multiplier, md, is 1/rrr:
Equation 9.5
The deposit multiplier is thus given by the reciprocal of the required reserve ratio.
With a required reserve ratio of 0.1, the deposit multiplier is 10. A
required reserve ratio of 0.2 would produce a deposit multiplier of 5.
The higher the required reserve ratio, the lower the deposit multiplier.
Actual
increases in checkable deposits will not be nearly as great as suggested
by the deposit multiplier. That is because the artificial conditions of
our example are not met in the real world. Some banks hold excess
reserves, customers withdraw cash, and some loan proceeds are not spent.
Each of these factors reduces the degree to which checkable deposits
are affected by an increase in reserves. The basic mechanism, however,
is the one described in our example, and it remains the case that
checkable deposits increase by a multiple of an increase in reserves.
The
entire process of money creation can work in reverse. When you withdraw
cash from your bank, you reduce the bank’s reserves. Just as a deposit
at Acme Bank increases the money supply by a multiple of the original
deposit, your withdrawal reduces the money supply by a multiple of the
amount you withdraw. And just as money is created when banks issue
loans, it is destroyed as the loans are repaid. A loan payment reduces
checkable deposits; it thus reduces the money supply.
Suppose,
for example, that the Acme Bank customer who borrowed the $900 makes a
$100 payment on the loan. Only part of the payment will reduce the loan
balance; part will be interest. Suppose $30 of the payment is for
interest, while the remaining $70 reduces the loan balance. The effect
of the payment on Acme’s balance sheet is shown below. Checkable
deposits fall by $100, loans fall by $70, and net worth rises by the
amount of the interest payment, $30.
Similar
to the process of money creation, the money reduction process decreases
checkable deposits by, at most, the amount of the reduction in deposits
times the deposit multiplier.
Figure 9.7
The Regulation of Banks
Banks
are among the most heavily regulated of financial institutions. They are
regulated in part to protect individual depositors against corrupt
business practices. Banks are also susceptible to crises of confidence.
Because their reserves equal only a fraction of their deposit
liabilities, an effort by customers to get all their cash out of a bank
could force it to fail. A few poorly managed banks could create such a
crisis, leading people to try to withdraw their funds from well-managed
banks. Another reason for the high degree of regulation is that
variations in the quantity of money have important effects on the
economy as a whole, and banks are the institutions through which money
is created.
Deposit Insurance
From
a customer’s point of view, the most important form of regulation comes
in the form of deposit insurance. For commercial banks, this insurance
is provided by the Federal Deposit Insurance Corporation (FDIC).
Insurance funds are maintained through a premium assessed on banks for
every $100 of bank deposits.
If a
commercial bank fails, the FDIC guarantees to reimburse depositors up
to $250,000 (raised from $100,000 during the financial crisis of 2008)
per insured bank, for each account ownership category. From a
depositor’s point of view, therefore, it is not necessary to worry about
a bank’s safety.
One
difficulty this insurance creates, however, is that it may induce the
officers of a bank to take more risks. With a federal agency on hand to
bail them out if they fail, the costs of failure are reduced. Bank
officers can thus be expected to take more risks than they would
otherwise, which, in turn, makes failure more likely. In addition,
depositors, knowing that their deposits are insured, may not scrutinize
the banks’ lending activities as carefully as they would if they felt
that unwise loans could result in the loss of their deposits.
Thus,
banks present us with a fundamental dilemma. A fractional reserve
system means that banks can operate only if their customers maintain
their confidence in them. If bank customers lose confidence, they are
likely to try to withdraw their funds. But with a fractional reserve
system, a bank actually holds funds in reserve equal to only a small
fraction of its deposit liabilities. If its customers think a bank will
fail and try to withdraw their cash, the bank is likely to fail. Bank
panics, in which frightened customers rush to withdraw their deposits,
contributed to the failure of one-third of the nation’s banks between
1929 and 1933. Deposit insurance was introduced in large part to give
people confidence in their banks and to prevent failure. But the deposit
insurance that seeks to prevent bank failures may lead to less careful
management—and thus encourage bank failure.
Regulation to Prevent Bank Failure
To
reduce the number of bank failures, banks are limited in what they can
do. Banks are required to maintain a minimum level of net worth as a
fraction of total assets. Regulators from the FDIC regularly perform
audits and other checks of individual banks to ensure they are operating
safely.
The
FDIC has the power to close a bank whose net worth has fallen below the
required level. In practice, it typically acts to close a bank when it
becomes insolvent, that is, when its net worth becomes negative.
Negative net worth implies that the bank’s liabilities exceed its
assets.
When
the FDIC closes a bank, it arranges for depositors to receive their
funds. When the bank’s funds are insufficient to return customers’
deposits, the FDIC uses money from the insurance fund for this purpose.
Alternatively, the FDIC may arrange for another bank to purchase the
failed bank. The FDIC, however, continues to guarantee that depositors
will not lose any money.
Regulation in Response to Financial Crises
In
the aftermath of the Great Depression and the banking crisis that
accompanied it, laws were passed to try to make the banking system
safer. The Glass-Steagall Act of that period created the FDIC and the
separation between commercial banks and investment banks. Over time, the
financial system in the United States and in other countries began to
change, and in 1999, a law was passed in the United States that
essentially repealed the part of the Glass-Steagall Act that had created
the separation between commercial and investment banking. Proponents of
eliminating the separation between the two types of banks argued that
banks could better diversify their portfolios if allowed to participate
in other parts of the financial markets and that banks in other
countries operated without such a separation.
Similar
to the reaction to the banking crisis of the 1930s, the financial
crisis of 2008 and the Great Recession led to calls for financial market
reform. The result was the Dodd-Frank Wall Street Reform and Consumer
Protection Act, usually referred to as the Dodd-Frank Act, which was
passed in July 2010. More than 2,000 pages in length, the regulations to
implement most provisions of this act were set to take place over a
nearly two-year period, with some provisions expected to take even
longer to implement. This act created the Consumer Financial Protection
Agency to oversee and regulate various aspects of consumer credit
markets, such as credit card and bank fees and mortgage contracts. It
also created the Financial Stability Oversight Council (FSOC) to assess
risks for the entire financial industry. The FSOC can recommend that a
nonbank financial firm, such as a hedge fund that is perhaps threatening
the stability of the financial system (i.e., getting “too big to
fail”), become regulated by the Federal Reserve. If such firms do become
insolvent, a process of liquidation similar to what occurs when the
FDIC takes over a bank can be applied. The Dodd-Frank Act also calls for
implementation of the Volcker rule, which was named after the former
chair of the Fed who argued the case. The Volcker rule is meant to ban
banks from using depositors’ funds to engage in certain types of
speculative investments to try to enhance the profits of the bank, at
least partly reinstating the separation between commercial and
investment banking that the Glass-Steagall Act had created. There are
many other provisions in this wide-sweeping legislation that are
designed to improve oversight of nonbank financial institutions,
increase transparency in the operation of various forms of financial
instruments, regulate credit rating agencies such as Moody’s and
Standard & Poor’s, and so on. Given the lag time associated with
fully implementing the legislation, it will probably be many years
before its impact can be fully assessed.
