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Content Objective:
Explain the purpose and functions of money in the banking system.
Language Objectives:
- Understand, learn, and use new vocabulary that is introduced and taught directly through informational text and direct instruction.
- Identify and/or summarize main ideas, facts, supporting details, and opinions in an informational and/or practical selection.
- Read and synthesize information found in various parts of charts, tables, or diagrams to reach supported conclusions.
Learning Target:
Students will explain and analyze a balance sheets as a visual record of the fractional reserve banking within a bank.
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Bank balance sheets report the assets, liabilities, and bank capital for an individual bank. The assets are items that the bank owns. This includes loans, securities, and reserves. Liabilities are items that the bank owes to someone else, including deposits and bank borrowing from other institutions. Capital is sometimes referred to as “net worth,” “equity capital,” or “bank equity.” Bank capital are funds that are raised by either selling new equity in the bank, or that come from retained earnings (profits) the bank earns from its assets net of liabilities.
All commercial banks and thrift institutions that provide checkable deposits must by law keep required reserves. Required reserves are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities. A bank must keep these reserves on deposit with the Federal Reserve Bank in its district or as cash in the bank’s vault. This specified percentage of checkable deposit liabilities that a commercial bank must keep as reserves is known as the reserve ratio.
Reserve ratio = bank reserves / total checkable deposit liabilities.
The Federal Reserve has the authority to establish and vary the reserve ratio within limits legislated by Congress.
The bank receives $100,000 cash deposit from customers and businesses, which is an asset to the bank. This money is deposited in the bank as checkable deposits or checking account entries, rather than as savings accounts or time deposits. these newly created checkable deposits constitute claims that the depositors have against the assets of the bank and therefore are a new liability account.
The reserve ratio for checkable deposits is 20 percent. By depositing $20,000 in the Federal Reserve, the bank will be meeting the required 20 percent ratio between its reserves and its own deposit liabilities. We use “reserves” to mean the funds commercial banks deposit in the Federal Reserve Banks, to distinguish those funds from the public’s deposits in commercial banks.
Suppose, instead of sending the minimum amount of $20,000, the bank sends an extra $90,000 for a total of $110,000. A bank would not deposit all its cash in the Federal Reserve Bank. We’re doing it to simplify the problem, so we don’t need to bother adding two assets, “cash” and “deposits in the Federal Reserve Bank” to determine “reserves.”
A bank’s excess reserves are found by subtracting its required reserves from its actual reserves.
Excessive reserves = actual reserves – required reserves
To compute the excess reserves, multiply the bank’s checkable deposit liabilities by the reserve ratio to obtain the required reserves ($100,000 x 20 % = 20,000). Subtract the required reserves from the actual reserves listed on the asset side of the bank balance sheet. In this case excess reserves = $110,000 – $20,000 = $90,000.
Assume that farmer Harvey deposited a substantial portion of the $100,000 the bank received in transaction 3. Suppose farmer Harvey buys $50,000 of farm machinery from Snarf Farming Equipment. Farmer Harvey pays for this machinery by writing a $50,000 check against his deposit in the bank. Harvey gives the check to Snarf. Snarf deposits the check into their bank. Whenever a check is drawn against one bank and deposited in another bank, collection of that check will reduce both the reserves and the checkable deposits of the bank on which the check is drawn. Conversely, if a bank receives a check drawn on another bank, the bank receiving the check will in the process of collecting it, have its reserves and checkable deposits increased by the amount of the check.
Harvey’s bank discovers that one of its depositors has drawn a check for $50,000 against his checkable deposit. The bank reduces checkable deposits by $50,000 and notes that the collection of this check caused a $50,000 decline in its reserves at the Federal Reserve Bank.
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A single bank in a banking system can lend one dollar for each dollar of its excess reserves. The commercial banking system can lend, that is, can create money, by a multiple of its excess reserves.
Suppose a person finds a $100 and deposits the $100 in bank A, which adds the $100 to its reserves. Of the newly acquired $100 in currency, 20 percent, or $20 must be earmarked for required reserves on the new $100 checkable deposit, and the remaining $80 goes to excess reserves. A single bank can lend only an amount equal to its excess reserves, therefore bank A can lend a maximum of $80.
When a loan for this amount is made, bank A’s loans increase by $80 and the borrower gets an $80 checkable deposit.
We add these figures to bank A’s balance sheet.
The borrower draws a check for the entire amount of the loan ($80) and gives it to someone who deposits it in bank B, a different bank. Bank A loses both reserves and deposits equal to the amount of the loan. The net results of these transactions is that bank A’s reserves now stand at ($100 – $80 = )$20, loans at $80, and checkable deposits at ($180 – $80 =) $100. Bank A is just meeting the 20 percent reserve ratio.
Bank B acquires the reserves and the deposits that bank A has lost. When the borrower’s check is drawn and cleared, bank A loses $80 in reserves and deposits and bank B gains $80 in reserves and deposits.
But 20 percent or $16 of bank B’s new reserves must be kept as required reserves against the new $80 in checkable deposits. This means that bank B has ($80 – $16 =)$64 in excess reserves. It can therefore lend $64 to a new borrower.
We add these figures to bank B’s balance sheet.
The new borrower draws a check for the entire amount of the loan and deposits it in bank C. The reserves and deposits of bank B fall by $64. As a result of these transactions bank B’s reserves now stand at ($80 – $64 =)$16, loans at $64, and checkable deposits at ($144 – $64 =)$80. After all this, bank B is just meeting the 20 percent reserve requirement.
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The Fed’s balance sheet helps us understand how the Fed conducts monetary policy. The Fed’s assets and liabilities differ from those found on the balance sheet of a commercial bank. The two main assets of the Federal Reserve Banks are securities and loans to commercial banks. On the liabilities side of the Fed’s balance sheet, we find three items: reserves, Treasury deposits, and Federal Reserve Notes. With this look at the Fed’s balance sheet, we can explore how the Fed can influence the money creating abilities of the commercial banking system. The Fed has three tools of monetary control it can use to alter the reserves of commercial banks: open market operations, the discount rate, and the reserve ratio.
When the Fed buys government bonds, the bank give up part of their holdings of securities (a) to the Fed. The Fed, in paying for these securities, place newly created reserves in the accounts of the bank at the Fed. The reserves of the bank goes up by the amount of the purchase of the securities (b). The upward arrow shows that securities have moved from the bank to the Fed. So we enter minus “Securities” in the asset column of the balance sheet of the bank. We enter plus “Securities” in the asset column of the Fed balance sheet. The downward arrow indicates that the Fed provided reserves to the bank. So we enter plus “Reserves” in the asset column of the bank balance sheet. In the liabilities column of the Fed balance sheet, the plus “Reserves” indicates that although bank reserves have increased, they are a liability to the Fed because the reserves are owned by the bank. What is important about this transaction is that when the Fed purchase securities from banks, they increase the reserves in the banking system, which then increases the lending ability of the commercial banks.
When the Fed sells government bonds, the Fed gives up securities (a) that banks acquire. The bank pay for securities by drawing checks against their deposits, that is, their reserves (b). The Fed collects those checks by reducing the bank’s reserves accordingly. The balance sheet changes, identified by (a) and (b), appear as shown above. The reduction in bank reserves is indicated by the minus sign before the appropriate entries.
One of the functions of the central bank is to be a lender of last resort. Occasionally, banks have unexpected and immediate needs for additional funds. In such cases, the Fed will make short-term loans to banks in its district. When a bank borrows, it gives the Fed a promissory note drawn against itself and secured by acceptable collateral, usually U.S. government securities. Just as banks charge interest on their loans, so too the Fed charge interest on loans they grant to banks. The interest rate the Fed charges is called the discount rate.
The borrowing bank’s loan is an asset to the Fed and appears on its balance sheet as “Loans to Bank” (a). To the bank, the loan is a liability appearing as “Loans from Fed” (a) on the bank’s balance sheet. In providing the loan, the Fed increases the reserves of the borrowing bank. No required reserves need to be kept against the loans from the Fed. All new reserves acquired by borrowing from the Fed are excess reserves (b). In short, borrowing from the Fed by banks increases the reserves of the banks and enhances their ability to extend credit.
The Fed has the power to set the discount rate at which banks borrow from the Fed. From the bank’s point of view, the discount rate is a cost of acquiring reserves. A lowering of the discount rate encourages banks to obtain additional reserves by borrowing from the Fed. When banks lend new reserves, the money supply increases. An increase in the discount rate discourages banks from obtaining additional reserves through borrowing from the Fed. So the Fed may raise the discount rate when it wants to restrict the money supply.
The Fed can also manipulate the reserve ratio in order to influence the ability of the banks to lend. Suppose a bank’s balance sheet shows that reserves are $5,000 and checkable deposits are $20,000.
If the reserve ratio is 20 percent, the bank’s required reserves are $4,000. Since actual reserves are $5,000, the excess reserves of this bank is $1,000. On the basis of $1,000 of excess reserves, this one bank can lend $1,000. However, the banking system asa whole can create a maximum of $5,000 of new checkable deposit money by lending.
If the Fed raised the reserve ratio from 20 to 25 percent, the required reserves would jump from $4,000 to $5,000. This shrinks the excess reserves from $1,000 to zero. Raising the reserve ratio increases the amount of required reserves banks must keep. As a consequence, either banks lose excess reserves, diminishing their ability to create money by lending, or the find their reserves deficient and are forced to contract checkable deposits and therefore the money supply.
If the Fed lowered the reserve ratio from the original 20 percent to 10 percent, the required reserve would decline from $4,000 to $2,000. The excess reserves would jump from $1,000 to $3,000. The ban’s lending ability would increase from $1,000 to $3,000 and the banking system’s money creating potential would expand from $5,000 to $30,000. Lowering the reserve ratio transforms required reserves into excess reserves and enhances the ability of banks to create new money by lending.
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Filed under: bank balance sheet, Econ, macroeconomics unit, monetary policy | Comments Off on Econ: Bank Balance Sheets
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