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{{short description|System of banking}} | |||
{{Banking}} | |||
{{Use dmy dates|date=August 2022}} | |||
{{Finance sidebar}} | |||
{{Banking |image=Saenredam - Het oude stadhuis te Amsterdam.jpeg|caption= The old town hall where the ] (a ]) operated|terms}} | |||
{{Finance sidebar |banking}} | |||
'''Fractional-reserve banking''' is the system of ]ing in all countries worldwide, under which banks that take ] from the public keep only part of their ] in liquid assets as a reserve, typically lending the remainder to borrowers. ] are held as ] in the bank or as balances in the bank's account at the ]. Fractional-reserve banking differs from the hypothetical alternative model, ], in which banks would keep all depositor funds on hand as reserves. | |||
'''Fractional-reserve banking''' is the practice whereby a ] retains only a portion of its customers' ] as readily available ] from which to satisfy demands for withdrawals. Reserves are held at the bank as currency or held as deposits in the bank's accounts at the ]. The remainder of customer-deposited funds is used to fund investments or loans that the bank makes to other customers. {{Citation needed|date=September 2013}} Most of these loaned funds are later redeposited into other banks, allowing further lending. Because ]s are usually considered money in their own right, fractional-reserve banking permits the ] to grow to a multiple (called the ]) of the underlying reserves of ] originally created by the central bank.<ref name="AbelAndrew">{{Cite book |last=Abel |first=Andrew |last2=Bernanke |first2=Ben |authorlink2=Ben Bernanke |title=Macroeconomics |publisher=Pearson |year=2005 |edition=5th|pages=522–532 |chapter=14.1 |postscript=<!-- Bot inserted parameter. Either remove it; or change its value to "." for the cite to end in a ".", as necessary. -->{{inconsistent citations}}}}</ref><ref name="Mankiw">{{Cite book |last=Mankiw |first=N. Gregory |title=Macroeconomics |publisher=Worth |year=2002 |edition=5th |pages=482–489 |chapter=Chapter 18: Money Supply and Money Demand |postscript=<!-- Bot inserted parameter. Either remove it; or change its value to "." for the cite to end in a ".", as necessary. -->{{inconsistent citations}} }}</ref> | |||
The country's central bank may determine a minimum amount that banks must hold in reserves, called the "]" or "reserve ratio". Most commercial banks hold more than this minimum amount as ]. Some countries, e.g. the core ] countries of the United States, the United Kingdom, Canada, Australia, and New Zealand, and the three Scandinavian countries, do not impose reserve requirements at all. | |||
To mitigate the risks of ]s (when a large proportion of depositors seek withdrawal of their demand deposits at the same time) or, when problems are extreme and widespread, ], the governments of most countries ] commercial banks, provide ] and act as ] to commercial banks.<ref name="AbelAndrew" /><ref name="Mankiw"/> In most countries, the central bank (or other monetary authority) regulates bank credit creation, imposing ] and other ] ratios. This limits the amount of ] that occurs in the commercial banking system, and helps ensure that banks have enough funds to meet the demand for withdrawals.<ref name="Mankiw"/> | |||
Bank deposits are usually of a relatively short-term duration, and may be "at call", while loans made by banks tend to be longer-term, resulting in a risk that customers may at any time collectively wish to withdraw cash out of their accounts in excess of the bank reserves. The reserves only provide ] to cover withdrawals within the normal pattern. Banks and the central bank expect that in normal circumstances only a proportion of deposits will be withdrawn at the same time, and that reserves will be sufficient to meet the demand for cash. However, banks may find themselves in a shortfall situation when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may borrow short-term funds in the ] from banks with a surplus. In exceptional situations, such as during an unexpected ], the central bank may provide funds to cover the short-term shortfall as ]. | |||
Fractional-reserve banking is the current form of banking in all countries worldwide.<ref>Frederic S. Mishkin, Economics of Money, Banking and Financial Markets, 10th Edition. Prentice Hall 2012</ref> | |||
As banks hold in reserve less than the amount of their deposit liabilities, and because the deposit liabilities are considered money in their own right (see ]), fractional-reserve banking permits the ] to grow beyond the amount of the underlying ] originally created by the central bank. In most countries, the ] (or other ] authority) regulates bank-credit creation, imposing ] and ] ratios. This helps ensure that banks remain solvent and have enough funds to meet demand for withdrawals, and can be used to influence the process of ] in the banking system. However, rather than directly controlling the money supply, contemporary central banks usually pursue an ] to control bank issuance of credit and the rate of ]. | |||
==History== | ==History== | ||
{{Main|History of banking}} | |||
Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers' realization that generally not all depositors demand payment at the same time.<ref></ref> | |||
{{See also|Banknote}} | |||
Fractional-reserve banking predates the existence of governmental monetary authorities and originated with bankers' realization that generally not all depositors demand payment at the same time. In the past, savers looking to keep their coins and valuables in safekeeping depositories deposited ] and ] at ]s, receiving in exchange a ] for their ] (''see ]''). These notes gained acceptance as a ] for commercial transactions and thus became an early form of circulating ].<ref name="moneyfacts">{{cite book |last=United States. Congress. House. Banking and Currency Committee. |title=Money facts; 169 questions and answers on money – a supplement to A Primer on Money, with index, Subcommittee on Domestic Finance ... 1964. |location=Washington D.C. |year=1964 |url=http://www.baldwinlivingtrust.com/pdfs/AllAboutMoney.pdf}}</ref> As the notes were used directly in ], the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated ] for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of ], charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.<ref name="Joseph Story 1832, p. 66">Thus by the 19th century we find "n ordinary cases of deposits of money with banking corporations, or bankers, the transaction amounts to a mere loan or mutuum, and the bank is to restore, not the same money, but an equivalent sum, whenever it is demanded." Joseph Story, Commentaries on the Law of Bailments (1832, p. 66) and "Money, when paid into a bank, ceases altogether to be the money of the principal (see Parker v. Marchant, 1 Phillips 360); it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it." Lord Chancellor Cottenham, Foley v Hill (1848) 2 HLC 28.</ref> | |||
If ]s (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, however, many would try to redeem their notes at the same time. If, in response, a bank could not raise enough funds by calling in loans or selling bills, the bank would either go into ] or default on its notes. Such a situation is called a ] and caused the demise of many early banks.<ref name="moneyfacts"/> | |||
Savers looking to keep their valuables in safekeeping depositories deposited ] and ] at ]s, receiving in exchange a ] for their ] (''see ]''). These notes gained acceptance as a ] for commercial transactions and thus became as an early form of circulating ].<ref name="moneyfacts">{{cite book |last=United States. Congress. House. Banking and Currency Committee. |title=Money facts; 169 questions and answers on money – a supplement to A Primer on Money, with index, Subcommittee on Domestic Finance ... 1964. |location=Washington D.C. |year=1964 |url=http://www.baldwinlivingtrust.com/pdfs/AllAboutMoney.pdf}}</ref> | |||
These early financial crises led to the creation of ]. The Swedish ] was the world's first central bank, created in 1668. Many nations followed suit in the late 1600s to establish ]s which were given the legal power to set a ], and to specify the form in which such assets (called the ]) were required to be held.<ref>Charles P. Kindleberger, A Financial History of Western Europe. Routledge 2007</ref> In order to mitigate the impact of bank failures and financial crises, central banks were also granted the authority to centralize banks' storage of precious metal reserves, thereby facilitating transfer of gold in the event of bank runs, to regulate commercial banks, and to act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today.<ref name="Mankiw">{{Cite book |last= Mankiw |first= N. Gregory |title= Macroeconomics |publisher= Worth |year= 2002 |edition= 5th |pages= 482–489 |chapter= 18}}</ref> where it is the system of banking prevailing in almost all countries worldwide.<ref>Frederic S. Mishkin, Economics of Money, Banking and Financial Markets, 10th Edition. Prentice Hall 2012</ref><ref>{{Cite book|last= Christophers|first= Brett|title= Banking Across Boundaries: Placing Finance in Capitalism|publisher= John Wiley and Sons|year= 2013|isbn= 978-1-4443-3829-4|location= New York}}</ref> | |||
As the notes were used directly in ], the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated ] for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of ], charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born. | |||
During the twentieth century, the role of the central bank grew to include influencing or managing various macroeconomic policy variables, including measures of inflation, unemployment, and the international ]. In the course of enacting such policy, central banks have from time to time attempted to manage interest rates, reserve requirements, and various measures of the money supply and ].<ref name="paf"> {{Webarchive|url=https://web.archive.org/web/20090326001945/http://www.stls.frb.org/publications/pleng/PDF/PlainEnglish.pdf |date=26 March 2009 }} – An easy-to-read guide to the structure and functions of the Federal Reserve System (See page 5 of the document for the purposes and functions)</ref> | |||
However, if ]s (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into ] or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.<ref name="moneyfacts"/> | |||
== Regulatory framework== | |||
Starting in the late 1600s nations began to establish central banks which were given the legal power to set ]s and to issue the reserve assets, or ], in which form such reserves are required to be held.<ref>Charles P. Kindleberger, A Financial History of Western Europe. Routledge 2007</ref> The reciprocal of the reserve requirement, called the ], limits the size to which the transactions in money supply may grow for a given level of reserves in the banking system. In order to mitigate the impact of bank failures and financial crises, governments created central banks – public (or semi-public) institutions that have the authority to centralize the storage of precious metal bullion amongst private banks to allow transfer of gold in case of bank runs, regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs inherent in fractional-reserve banking and allowed the practice to continue as it does today.<ref name="Mankiw">{{Cite book |last=Mankiw |first=N. Gregory |title=Macroeconomics |publisher=Worth |year=2002 |edition=5th |pages=482–489 |chapter=Chapter 18: Money Supply and Money Demand}}</ref><ref name="paf">The Federal Reserve in Plain English – An easy-to-read guide to the structure and functions of the Federal Reserve System. See page 5 of the document for the purposes and functions: http://www.frbsf.org/publications/education/plainenglish/index.html</ref> | |||
In most legal systems, a bank deposit is not a ]. In other words, the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a ] (a ] or ]). That deposit account is a ''liability'' on the ] of the bank.<ref name="Joseph Story 1832, p. 66"/> | |||
Each bank is legally authorized to issue credit up to a specified multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits. Largely, fractional-reserve banking functions smoothly, as relatively few depositors demand payment at any given time, and banks maintain enough of a buffer of reserves to cover depositors' cash withdrawals and other demands for funds. However, during a bank run or a generalized ], demands for withdrawal can exceed the bank's funding buffer, and the bank will be forced to raise additional reserves to avoid defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing in the ] or from the central bank), by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis.<ref group="note">For an example, see ]</ref> | |||
Over time, economists, central banks, and governments have changed their views as to the policy variables which should be targeted by monetary authorities. These have included interest rates, reserve requirements, and various measures of the money supply and ]. | |||
Many of the practices of contemporary bank regulation and ]—including centralized ] of payments, central bank lending to member banks, regulatory auditing, and government-administered ]—are designed to prevent the occurrence of such bank runs. | |||
==How it works== | |||
In most legal systems, a bank deposit is not a ]. In other words, the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a ] (a ] or ]). That deposit account is a ''liability'' of the bank on the bank's books and on its ]. Because the bank is authorized by law to create credit up to an amount equal to a multiple of the amount of its reserves, the bank's reserves on hand to satisfy payment of deposit liabilities amounts to only a fraction of the total amount which the bank is obligated to pay in satisfaction of its demand deposits. | |||
Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors' cash withdrawals and other demands for funds. However, during a bank run or a generalized ], demands for withdrawal can exceed the bank's funding buffer, and the bank will be forced to raise additional reserves to avoid defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing in the ] or from the central bank), by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis. | |||
Many of the practices of contemporary bank regulation and ], including centralized ] of payments, central bank lending to member banks, regulatory auditing, and government-administered ], are designed to prevent the occurrence of such bank runs. | |||
==Economic function== | ==Economic function== | ||
Fractional-reserve banking allows banks to |
Fractional-reserve banking allows banks to provide credit, which represent immediate liquidity to borrowers. The banks also provide longer-term loans, and act as ] for those funds.<ref name="Mankiw"/><ref name="Abel_Bernanke">{{Cite book |last1=Abel |first1=Andrew |last2=Bernanke |first2=Ben |author-link2=Ben Bernanke |title=Macroeconomics |publisher=Pearson |year=2005 |edition=5th|pages=266–269 |chapter=7}}</ref> Less liquid forms of deposit (such as ]) or riskier classes of financial assets (such as equities or long-term bonds) may lock up a depositor's wealth for a period of time, making it unavailable for use on demand. This "borrowing short, lending long" or ] function of fractional-reserve banking is a role that, according to many economists, can be considered to be an important function of the commercial banking system.<ref> Brad DeLong</ref> | ||
The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy.<ref name="purpose">Page 57 of 'The FED today', a publication on an educational site affiliated with the Federal Reserve Bank of Kansas City, designed to educate people on the history and purpose of the United States Federal Reserve system. {{Webarchive|url=https://web.archive.org/web/20110313201251/http://www.philadelphiafed.org/publications/economic-education/fed-today/fed-today_lesson-6.pdf |date=13 March 2011 }}</ref><ref>{{cite web |url=http://www.bankofengland.co.uk/publications/speeches/2009/speech381.pdf | |||
Additionally, according to ] theory, a well-regulated fractional-reserve bank system also benefits the economy by providing regulators with powerful tools for influencing the ] and interest rates. Many economists believe that these should be adjusted by the government to promote ].<ref name="Mankiw_Ch9">{{Cite book |last=Mankiw |first=N. Gregory |title=Macroeconomics |publisher=Worth |year=2002 |edition=5th |pages=238–255 |chapter=9}}</ref> | |||
Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy. The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals.<ref name="purpose">Page 57 of 'The FED today', a publication on an educational site affiliated with the Federal Reserve Bank of Kansas City, designed to educate people on the history and purpose of the United States Federal Reserve system. </ref><ref>{{cite web |url=http://www.bankofengland.co.uk/publications/speeches/2009/speech381.pdf | |||
|title=Mervyn King, Finance: A Return from Risk | |title=Mervyn King, Finance: A Return from Risk | ||
|publisher=Bank of England|quote= |
|publisher=Bank of England|quote=Banks are dangerous institutions. They borrow short and lend long. They create liabilities which promise to be liquid and hold few liquid assets themselves. That though is hugely valuable for the rest of the economy. Household savings can be channelled to finance illiquid investment projects while providing access to liquidity for those savers who may need it.... If a large number of depositors want liquidity at the same time, banks are forced into early liquidation of assets – lowering their value ...'}}</ref> | ||
Additionally, according to ] theory, a well-regulated fractional-reserve bank system could be used by the central bank to influence the ] and interest rates. Influencing interest rates are an important part of monetary policy used by central banks to promote ].<ref>{{cite book |last1=Mankiw |first1=Nicholas Gregory |title=Macroeconomics |date=2022 |publisher=Worth Publishers, Macmillan Learning |location=New York, NY |isbn=978-1-319-26390-4 |edition=Eleventh, international |pages=403–406}}</ref> Historically, central banks have occasionally changed reserve requirements discretionarily in order to influence the money supply directly and via that mechanism the interest rate level. Today, however, this implementation policy is rarely used. In the US, the Federal Reserve eliminated reserve requirements entirely in 2020, instead preferring to use changes in the interest rate paid on reserves held by commercial banks as its most important monetary policy instrument to directly influence the broader interest rate level in the economy.<ref>{{cite book |last1=Mankiw |first1=Nicholas Gregory |title=Macroeconomics |date=2022 |publisher=Worth Publishers, Macmillan Learning |location=New York, NY |isbn=978-1-319-26390-4 |edition=Eleventh, international |page=88}}</ref> | |||
==Money creation process== | ==Money creation process== | ||
{{ |
{{Main|Money creation}} | ||
When a loan is made by the commercial bank, the bank creates new demand deposits and the money supply expands by the size of the loan.<ref name="Mankiw"/> | |||
The proceeds of most bank loans are not in the form of currency. Banks typically make loans by accepting ]s in exchange for credits they make to the borrowers' deposit accounts.<ref>Eric N. Compton, ''Principles of Banking'', p. 150, American Bankers Ass'n (1979).</ref> Deposits created in this way are sometimes called derivative deposits and are part of the process of creation of money by commercial banks.<ref>Paul M. Horvitz, ''Monetary Policy and the Financial System'', pp. 56–57, Prentice-Hall, 3rd ed. (1974).</ref> Issuing loan proceeds in the form of paper currency and current coins is considered to be a weakness in internal control.<ref>See, generally, ''Industry Audit Guide: Audits of Banks'', p. 56, Banking Committee, American Institute of Certified Public Accountants (1983).</ref> | |||
There are two types of money in a fractional-reserve banking system operating with a central bank:<ref name="bis">Bank for International Settlements – The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf | |||
A quick quotation in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document: | |||
:"Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."</ref><ref name="ecb">European Central Bank – Domestic payments in Euroland: commercial and central bank money: | |||
http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quotation from the article referencing the two types of money: | |||
:"At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via cheques and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"</ref><ref>Macmillan report 1931 account of how fractional banking works http://books.google.ca/books?hl=en&id=EkUTaZofJYEC&dq=British+Parliamentary+reports+on+international+finance&printsec=frontcover&source=web&ots=kHxssmPNow&sig=UyopnsiJSHwk152davCIyQAMVdw&sa=X&oi=book_result&resnum=1&ct=result#PPA34,M1</ref> | |||
# '''Central bank money:''' money created or adopted by the central bank regardless of its form – precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money | |||
# '''Commercial bank money:''' demand deposits in the commercial banking system; sometimes referred to as "chequebook money" | |||
When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks' reserves (it is no longer counted as part of ]). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. When a loan is made by the commercial bank (which keeps only a fraction of the central bank money as reserves), using the central bank money from the commercial bank's reserves, the m1 money supply expands by the size of the loan.<ref name="Mankiw"/> This process is called "deposit multiplication". | |||
The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (] beyond the legal requirement that commercial banks voluntarily hold). Data for reserves and vault cash are published regularly by the ].<ref> (Updated weekly).</ref> The Federal Reserve does not impose a reserve requirement, but pays interest on reserve balances, influencing the general interest rate level in the economy in that way.<ref>{{cite web |title=Interest on Reserve Balances |url=https://www.federalreserve.gov/monetarypolicy/reserve-balances.htm |website=Board of Governors of the Federal Reserve System |access-date=4 November 2023 |language=en}}</ref> | |||
===Example of deposit multiplication=== | |||
The table below displays the relending model of how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is lent out 10 times with a fractional-reserve rate of 20% to ultimately create $500 of commercial bank money (it is important to note that the 20% reserve rate used here is for ease of illustration, actual ]s are usually a lot ''lower'', for example around 3% in the USA and UK). Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands. | |||
Just as taking out a new loan expands the money supply, the repayment of bank loans reduces the money supply.<ref>{{cite web |last1=McLeay |title=Money Creation in the Modern Economy |url=https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf |publisher=Bank of England}}</ref> | |||
The relending model begins when an initial $100 deposit of central bank money is made into Bank A. Bank A takes 20 percent of it, or $20, and sets it aside as reserves, and then loans out the remaining 80 percent, or $80. At this point, the money supply actually totals $180, not $100, because the bank has loaned out $80 of the central bank money, kept $20 of central bank money in reserve (not part of the money supply), and substituted a newly created $100 IOU claim for the depositor that ''acts equivalently to and can be implicitly redeemed for'' central bank money (the depositor can transfer it to another account, write a check on it, demand his cash back, etc.). These claims by depositors on banks are termed ''demand deposits'' or ''commercial bank money'' and are simply recorded in a bank's accounts as a liability (specifically, an IOU to the depositor). From a depositor's perspective, commercial bank money is equivalent to central bank money – it is impossible to tell the two forms of money apart unless a bank run occurs.<ref name="Mankiw"/> | |||
===Types of money=== | |||
At this point in the relending model, Bank A now only has $20 of central bank money on its books. The loan recipient is holding $80 in central bank money, but he soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, increasing money supply by $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out. | |||
There are two types of money created in a fractional-reserve banking system operating with a central bank:<ref name="bis">Bank for International Settlements – The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": | |||
{| class="wikitable" | |||
A quick quotation in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document: | |||
|+ Table Sources: | |||
! Individual Bank | |||
! Amount Deposited | |||
! Lent Out | |||
! Reserves | |||
|- | |||
| height="16" align="CENTER" | A | |||
| bgcolor="#00AA00" align="CENTER" | 100 | |||
| align="CENTER" | 80 | |||
| bgcolor="#FF0000" align="CENTER" | 20 | |||
|- | |||
| height="16" align="CENTER" | B | |||
| align="CENTER" | 80 | |||
| align="CENTER" | 64 | |||
| bgcolor="#FF0000" align="CENTER" | 16 | |||
|- | |||
| height="16" align="CENTER" | C | |||
| align="CENTER" | 64 | |||
| align="CENTER" | 51.20 | |||
| bgcolor="#FF0000" align="CENTER" | 12.80 | |||
|- | |||
| height="16" align="CENTER" | D | |||
| align="CENTER" | 51.20 | |||
| align="CENTER" | 40.96 | |||
| bgcolor="#FF0000" align="CENTER" | 10.24 | |||
|- | |||
| height="16" align="CENTER" | E | |||
| align="CENTER" | 40.96 | |||
| align="CENTER" | 32.77 | |||
| bgcolor="#FF0000" align="CENTER" | 8.19 | |||
|- | |||
| height="16" align="CENTER" | F | |||
| align="CENTER" | 32.77 | |||
| align="CENTER" | 26.21 | |||
| bgcolor="#FF0000" align="CENTER" | 6.55 | |||
|- | |||
| height="16" align="CENTER" | G | |||
| align="CENTER" | 26.21 | |||
| align="CENTER" | 20.97 | |||
| bgcolor="#FF0000" align="CENTER" | 5.24 | |||
|- | |||
| height="16" align="CENTER" | H | |||
| align="CENTER" | 20.97 | |||
| align="CENTER" | 16.78 | |||
| bgcolor="#FF0000" align="CENTER" | 4.19 | |||
|- | |||
| height="16" align="CENTER" | I | |||
| align="CENTER" | 16.78 | |||
| align="CENTER" | 13.42 | |||
| bgcolor="#FF0000" align="CENTER" | 3.36 | |||
|- | |||
| height="16" align="CENTER" | J | |||
| align="CENTER" | 13.42 | |||
| align="CENTER" | 10.74 | |||
| bgcolor="#FF0000" align="CENTER" | 2.68 | |||
|- | |||
| height="16" align="CENTER" | K | |||
| align="CENTER" | 10.74 | |||
| align="CENTER" | 0.0 | |||
| bgcolor="#FF0000" align="CENTER" | 10.74 | |||
|- | |||
| height="16" align="CENTER" | | |||
| align="CENTER" | | |||
| align="CENTER" | | |||
| align="CENTER" | | |||
|- | |||
| | |||
| align="CENTER" | '''Total Amount of Deposits:''' | |||
| align="CENTER" | '''Total Amount Lent Out:''' | |||
| align="CENTER" | '''Total Reserves:''' | |||
|- | |||
| height="16" align="CENTER" | | |||
| bgcolor="#99CCFF" align="CENTER" | 457.05 | |||
| bgcolor="#99CCFF" align="CENTER" | 357.05 | |||
| bgcolor="#00AA00" align="CENTER" | 100 | |||
|- | |||
|} | |||
] | |||
Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum increase in the money supply is $400. | |||
: "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."</ref><ref name="ecb">: commercial and central bank money: | |||
For an individual bank, the deposit is considered a '']'' whereas the loan it gives out and the reserves are considered '']''. Deposits will always be equal to loans plus a bank's reserves, since loans and reserves are created from deposits. This is the basis for a bank's '']''. Fractional-reserve banking allows the money supply to expand or contract. Generally the expansion or contraction of the money supply is dictated by the balance between the rate of new loans being created and the rate of existing loans being repaid or defaulted on. The balance between these two rates can be influenced to ''some degree'' by actions of the central bank. However, the central bank has no direct control over the amount of money created by commercial (or high street) banks. | |||
One quotation from the article referencing the two types of money: | |||
: "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via cheques and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"</ref><ref> account of how fractional banking works</ref> | |||
# '''Central bank money:''' money created or adopted by the central bank regardless of its form – precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money. | |||
===Money multiplier=== | |||
# '''Commercial bank money:''' demand deposits in the commercial banking system; also referred to as "chequebook money", "sight deposits" or simply "credit". | |||
{{main|Money multiplier}} | |||
] | |||
The most common mechanism used to measure this increase in the money supply is typically called the "money multiplier". It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio. | |||
==Money multiplier== | |||
====Formula==== | |||
{{Main|Money multiplier}} | |||
The money multiplier, ''m'', is the inverse of the reserve requirement, ''R'':<ref>http://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html</ref> | |||
The money multiplier is a ] traditionally used to demonstrate the maximum amount of ] that could be created by commercial banks for a given fixed amount of base money and reserve ratio. This theoretical maximum is never reached, because some eligible reserves are held as cash outside of banks.<ref>{{cite web|title=Managing the central bank's balance sheet: where monetary policy meets financial stability|url=http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb040306.pdf|publisher=Bank of England}}</ref> Rather than holding the quantity of base money fixed, contemporary central banks typically focus on setting and maintaining target interest rates in order to satisfy their ] goals,<ref>{{cite book |last1=Blanchard |first1=Olivier |title=Macroeconomics |date=2021 |publisher=Pearson |location=Harlow, England |isbn=978-0-134-89789-9 |pages=505–509 |edition=Eighth, global}}</ref> implying that the theoretical ceiling imposed by the money multiplier does not impose a limit on money creation in practice.<ref name="hando">{{cite book|last= Hubbard and O'Brien|title= Economics|chapter= Chapter 25: Monetary Policy, p. 943}}</ref> | |||
:<math>m=\frac1R</math> | |||
===Formula=== | |||
;Example | |||
The money multiplier, ''m'', is the inverse of the reserve requirement, ''R'':<ref> {{webarchive |url=https://web.archive.org/web/20071205005513/http://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html |date=5 December 2007 }}</ref> | |||
:<math>m=\frac1R.</math> | |||
In countries where the central bank does not impose a reserve requirement, such as the United States, Canada and the United Kingdom, the theoretical money multiplier is undefined, having a denominator of zero.<ref name=Ihrig>{{cite journal |last1=Ihrig |first1=Jane |last2=Weinbach |first2=Gretchen |last3=Wolla |first3=Scott |title=How are Banks and the Fed Linked? Teaching Key Concepts Today |journal=Review of Political Economy |date=3 April 2023 |volume=35 |issue=2 |pages=555–571 |doi=10.1080/09538259.2022.2040906 |url=https://www.tandfonline.com/doi/full/10.1080/09538259.2022.2040906 |access-date=4 November 2023 |language=en |issn=0953-8259}}</ref> | |||
For example, with the reserve ratio of 20 percent, this reserve ratio, ''R'', can also be expressed as a fraction: | |||
:<math>R=\tfrac15</math> | |||
So then the money multiplier, ''m'', will be calculated as: | |||
:<math>m=\frac{1}{1/5}=5</math> | |||
This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to. | |||
==Money supply== | |||
The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (] beyond the legal requirement that commercial banks voluntarily hold – usually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.<ref>http://www.federalreserve.gov/releases/h3/Current/ Federal Reserve Board, "AGGREGATE RESERVES OF DEPOSITORY INSTITUTIONS AND THE MONETARY BASE" (Updated weekly).</ref> In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.<ref>http://books.google.com/books?id=FdrbugYfKNwC&pg=PA169&lpg=PA169&dq=united+states+money+multiplier&source=web&ots=C_Hw1u82xe&sig=m7g0bMz167DijFsOCbn5f4aWAOU#PPA170,M1 Bruce Champ & Scott Freeman, Modeling Monetary Economies, p. 170 (Figure 9.1).</ref> | |||
]) since 1959. In January 2007, the amount of "central bank money" was $750.5 billion while the amount of "commercial bank money" (in the M2 supply) was $6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is M2 plus large time deposits and other forms of money. | |||
The M3 data ends in 2006 because the federal reserve ceased reporting it.<!-- this, and ], still needs improving: what is large and what is not, and what is "other larger liquid assets". -->]] | |||
==Money supplies around the world== | |||
]) since 1959. In January 2007, the amount of "central bank money" was $750.5 billion while the amount of "commercial bank money" (in the M2 supply) was $6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is M2 plus large time deposits and other forms of money. | |||
The M3 data ends in 2006 because .<!-- this, and ], still needs improving: what is large and what is not, and what is "other larger liquid assets." -->]] | |||
] | ] | ||
{{ |
{{See also|Money supply}} | ||
Fractional-reserve banking determines the relationship between the amount of "central bank money" in the official money supply statistics and the total money supply. Most of the money in these systems is "commercial bank money". Fractional-reserve banking allows the creation of commercial bank money, which increases the money supply through the ]. The issue of money through the banking system is a mechanism of monetary transmission, which a ] can influence only indirectly by raising or lowering ]s (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances). | |||
In countries with fractional-reserve banking, ] usually forms the majority of the money supply.<ref name="bis"/> The acceptance and value of commercial bank money is based on the fact that it can be exchanged freely at a commercial bank for central bank money.<ref name="bis"/><ref name="ecb"/> | |||
The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold ] of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process.<ref> |
The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold ] of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process.<ref>, p. 295, University of Connecticut, {{ISBN|978-1-13318-923-7}}</ref> Government regulations may also limit the money creation process by preventing banks from giving out loans even when the reserve requirements have been fulfilled.<ref>{{Dead link|date=December 2019 |bot=InternetArchiveBot |fix-attempted=yes }} | ||
(See pages 13 and 14 of the pdf version for information on government regulations and supervision over banks)</ref> | |||
==Regulation== | ==Regulation== | ||
Because the nature of fractional-reserve banking involves the possibility of ]s, central banks have been created throughout the world to address these problems.<ref name="paf"/><ref name="rbievolution">Reserve Bank of India – Report on Currency and Finance 2004–05 (See page 71 of the full report or just download the section ''Functional Evolution of Central Banking''): |
Because the nature of fractional-reserve banking involves the possibility of ]s, central banks have been created throughout the world to address these problems.<ref name="paf"/><ref name="rbievolution"> (See page 71 of the full report or just download the section ''Functional Evolution of Central Banking''): The monopoly power to issue currency is delegated to a central bank in full or sometimes in part. The practice regarding the currency issue is governed more by convention than by any particular theory. It is well known that the basic concept of currency evolved in order to facilitate exchange. The primitive currency note was in reality a promissory note to pay back to its bearer the original precious metals. With greater acceptability of these promissory notes, these began to move across the country and the banks that issued the promissory notes soon learnt that they could issue more receipts than the gold reserves held by them. This led to the evolution of the fractional reserve system. It also led to repeated bank failures and brought forth the need to have an independent authority to act as lender-of-the-last-resort. Even after the emergence of central banks, the concerned governments continued to decide on asset backing for the issue of coins and notes. The asset backing took various forms including gold coins, bullion, foreign exchange reserves and foreign securities. With the emergence of a fractional reserve system, this reserve backing (gold, currency assets, etc.) came down to a fraction of the total currency put in circulation.</ref> | ||
===Central banks=== | ===Central banks=== | ||
{{ |
{{Main|Central bank}} | ||
Government controls and ]s related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit |
Government controls and ]s related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit-taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included: | ||
# Minimum ] (RRRs) | # Minimum ] (RRRs) | ||
# Minimum ]s | # Minimum ]s | ||
Line 185: | Line 97: | ||
===Reserve requirements=== | ===Reserve requirements=== | ||
The currently prevailing view of ]s is that they are intended to prevent banks from: | The currently prevailing view of ]s is that they are intended to prevent banks from: | ||
# |
# Generating too much money by making too many loans against a narrow money deposit base; | ||
# |
# Having a shortage of cash when large deposits are withdrawn (although a legal minimum reserve amount is often established as a regulatory requirement, reserves may be made available on a temporary basis in the event of a crisis or ]). | ||
In some jurisdictions (such as the European Union), the central bank does not require reserves to be held during the day.{{citation needed|date=October 2021}}{{clarification needed|reason=Why is the phrase 'during the day' here? What does it mean?|date=October 2021}} Reserve requirements are intended to ensure that the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence. | |||
In practice, some central banks do not require reserves to be held, and in some countries that do, such as the USA and the EU they are not required to be held during the day when the banks are lending, and banks can borrow from other banks at near the central bank policy rate to ensure they have the necessary amount of required reserves by the close of business. ''Required'' reserves are therefore considered by some central bankers, monetary economists and textbooks to only play a very small role in limiting money creation in these countries. Most commentators agree however, that they help the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence. The UK for example, which does not have required reserves, does have requirements that the banks keep a certain amount of cash, and in Australia while there are no reserve requirements, there ''are'' a variety of requirements to ensure the banks have a stabilising ratio of liquid assets, such as deposits held with local banks. Individual countries adhere to varying ] which have changed over time. | |||
In other jurisdictions (such as the United States,<ref>{{cite web | url=https://www.federalreserve.gov/monetarypolicy/reservereq.htm | title=Federal Reserve Board - Reserve Requirements }}</ref> Canada,<ref name='monetary-economics'>{{cite book|title=Monetary Economics|edition=2nd|author=Jagdish Handa|publisher=Routledge|year=2008}}</ref>{{Rp|347}}<ref>{{cite web |last1=Carter |first1=Thomas J. |last2=Mendes |first2=Rhys R. |last3=Schembri |first3=Lawrence |title=Credibility, Flexibility and Renewal: The Evolution of Inflation Targeting in Canada |url=https://www.bankofcanada.ca/2018/12/staff-discussion-paper-2018-18/ |website=www.bankofcanada.ca |access-date=8 November 2023 |date=18 December 2018}}</ref>{{Rp|5}} the United Kingdom,<ref name='monetary-economics'/> Australia,<ref name=AuSRD>"</ref> New Zealand,<ref>{{cite magazine|url=http://www.rbnz.govt.nz/research-and-publications/reserve-bank-bulletin/1985/rbb1985-48-04-02|volume=48|number=4|date=April 1985|publisher=]|title=Abolition of compulsory ratio requirements|magazine=Reserve Bank Bulletin}}</ref> and the Scandinavian countries<ref name=pengepolitik>{{cite book |title=Pengepolitik i Danmark |date=2009 |publisher=Danmarks Nationalbank |isbn=978-87-87251-70-9 |pages=43 |url=https://www.nationalbanken.dk/media/oq4ew4rp/pengepol-3udg-dk-web.pdf}}</ref>), the central bank does not require reserves to be held at any time – that is, it does not impose reserve requirements. | |||
In addition to reserve requirements, there are other required ]s that affect the amount of loans that a bank can fund. The ] is perhaps the most important of these other required ratios. When there are ], which are considered by some economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending. | |||
In addition to reserve requirements, there are other required ]s that affect the amount of loans that a bank can fund. The ] is perhaps the most important of these other required ratios. When there are ], which are considered by some economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending.{{citation needed|date=April 2014}} | |||
===Liquidity and capital management for a bank=== | ===Liquidity and capital management for a bank=== | ||
{{ |
{{Main|Capital requirement|Market liquidity}} | ||
To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with |
To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance: | ||
# Selling or redeeming other assets, or ] of illiquid assets, | # Selling or redeeming other assets, or ] of illiquid assets, | ||
# Restricting investment in new loans, | # Restricting investment in new loans, | ||
# Borrowing funds (whether repayable on demand or at a fixed maturity), | # Borrowing funds (whether repayable on demand or at a fixed maturity), | ||
# Issuing additional ], or | # Issuing additional ], or | ||
# Reducing ]s.<ref>{{Cite web |title=What macroprudential policies are countries using to help their economies through the Covid-19 crisis? {{!}} Yale School of Management |url=https://som.yale.edu/blog/what-macroprudential-policies-are-countries-using-to-help-their-economies-through-the-covid-19-crisis |access-date=2024-12-22 |website=som.yale.edu |language=en}}</ref> | |||
# Reducing ].{{Citation needed|date=February 2011}} | |||
Because different funding options have different costs |
Because different funding options have different costs and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as: | ||
# Demand deposits with other banks | # Demand deposits with other banks | ||
# High quality marketable debt securities | # High quality marketable debt securities | ||
# Committed lines of credit with other banks<ref>{{Cite web |last=Global |first=K. E. D. |title=S.Korea’s IBK, Japan’s Mizuho Bank agree on $218-million committed line |url=https://www.kedglobal.com/banking-finance/newsView/ked202404230014 |access-date=2024-12-22 |website=KED Global |language=en}}</ref> | |||
# Committed lines of credit with other banks{{Citation needed|date=February 2011}} | |||
As with reserves, other sources of liquidity are managed with targets. | As with reserves, other sources of liquidity are managed with targets. | ||
The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, |
The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, demand creditors have an incentive to demand payment immediately, causing a bank run to occur.<ref>{{Cite web |date=2023-03-11 |title=Is the Collapse of SVB the Start of a Banking Panic? {{!}} Yale Insights |url=https://insights.som.yale.edu/insights/is-the-collapse-of-svb-the-start-of-banking-panic |access-date=2024-12-22 |website=insights.som.yale.edu |language=en}}</ref> | ||
Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected |
Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected counterparty behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.<ref>{{Cite news |last=Schroeder |first=Pete |last2=Price |first2=Michelle |title=Explainer: What are the Fed's bank 'stress tests' and what's new this year? |url=https://www.reuters.com/business/finance/what-are-feds-bank-stress-tests-whats-new-this-year-2024-06-24/ |work=Reuters |publication-date=June 24, 2024}}</ref> | ||
==Hypothetical example of a bank balance sheet and financial ratios== | ==Hypothetical example of a bank balance sheet and financial ratios== | ||
Line 216: | Line 130: | ||
{|class="wikitable" | {|class="wikitable" | ||
|- | |- | ||
! colspan=4 | Example 2: ANZ National Bank Limited Balance Sheet as |
! colspan=4 | Example 2: ANZ National Bank Limited Balance Sheet as of 30 September 2017 | ||
|- | |- | ||
|'''Assets''' | |'''Assets''' | ||
Line 265: | Line 179: | ||
|Shares in controlled entities | |Shares in controlled entities | ||
| align = "right" | 206 | | align = "right" | 206 | ||
| Loan capital | | Loan capital | ||
| align = "right" | 2,062 | | align = "right" | 2,062 | ||
|- | |- | ||
Line 280: | Line 194: | ||
|Deferred tax assets | |Deferred tax assets | ||
| align = "right" | 11 | | align = "right" | 11 | ||
| Reserves | | Reserves | ||
| align = "right" | 83 | | align = "right" | 83 | ||
|- | |- | ||
Line 299: | Line 213: | ||
|} | |} | ||
In this example the cash reserves held by the bank is NZ$3,010m (NZ$201m |
In this example the cash reserves held by the bank is NZ$3,010m (NZ$201m cash + NZ$2,809m balance at Central Bank) and the demand deposits (liabilities) of the bank are NZ$25,482m, for a cash reserve ratio of 11.81%. | ||
=== Other financial ratios === | === Other financial ratios === | ||
The key ] used to analyze fractional-reserve banks is the ], which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc. | The key ] used to analyze fractional-reserve banks is the ], which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc. | ||
For example the ANZ National Bank Limited balance sheet above gives the following financial ratios: | For example, the ANZ National Bank Limited balance sheet above gives the following financial ratios: | ||
# |
# Cash reserve ratio is $3,010m/$25,482m, i.e., 11.81%. | ||
# |
# Liquid assets reserve ratio is ($201m + $2,809m + $1,797m)/$25,482m, i.e., 18.86%. | ||
# |
# Equity capital ratio is $8,703m/107,787m, i.e., 8.07%. | ||
# |
# Tangible equity ratio is ($8,703m − $3,297m)/107,787m, i.e., 5.02% | ||
# |
# Total capital ratio is ($8,703m + $2,062m)/$107,787m, i.e., 9.99%. | ||
It is |
It is important how the term "reserves" is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for ], disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity. | ||
== Commentary == | |||
=== How the example bank manages its liquidity === | |||
{{ |
{{Main|Monetary reform}} | ||
{{see also|Full-reserve banking}} | |||
The ANZ National Bank Limited explains its methods as:{{Citation needed|date=January 2008}} | |||
{{quote|Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements.}} | |||
=== Instability === | |||
{{quote|The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour.}} | |||
In 1935, economist ] proposed a system of ], where banks would not lend on ]s but would only lend from ]s.<ref> Jeremy Warner, UK Telegraph</ref><ref>{{Cite web|last=Weisenthal|first=Joe|title=Ban All the Banks: Here's The Wild Idea That People Are Starting To Take Seriously|url=https://www.businessinsider.com/banning-banks-2014-4|access-date=30 November 2020|website=Business Insider}}</ref> It was proposed as a method of reversing the deflation of the ], as it would give the central bank (the ] in the US) more direct control of the money supply.<ref>{{Cite book | title = 100% Money | publisher = Pickering & Chatto Ltd | first = Irving | last = Fisher|author-link= Irving Fisher | isbn = 978-1-85196-236-5 | year = 1997}}</ref>{{page needed|date=October 2013}} | |||
=== Austrian School criticism === | |||
{|class="wikitable" | |||
] economists such as ] and ] have strongly criticized fractional-reserve banking, calling for it to be outlawed and criminalized. According to them, not only does money creation cause macroeconomic instability (based on the ]), but it is a form of ] or financial ], legalized only due to the influence of powerful rich bankers on corrupt governments around the world.<ref name=rothbard>{{cite book|last1=Rothbard|first1=Murray|title=The Mystery of Banking|date=1983|publisher=Richardson & Snyder |isbn=9780943940045}}</ref><ref>{{cite book |author=Jesús Huerta de Soto |title=Money, Bank Credit, and Economic Cycles |url=https://www.mises.org/store/Money-Bank-Credit-and-Economic-Cycles-P290C0.aspx |year=2012 |publisher=Ludwig von Mises Institute |location=Auburn, AL |pages=881 |edition=3d |isbn=9781610161893 |oclc=807678778 }} (with Melinda A. Stroup, translator) Also available as a {{Webarchive|url=https://web.archive.org/web/20141216200530/http://library.freecapitalists.org//books/Jesus%20Huerta%20de%20Soto/Money,%20Bank%20Credit,%20and%20Economic%20Cycles_Vol_4.pdf |date=16 December 2014 }}</ref> US politician ] has also criticized fractional-reserve banking based on Austrian School arguments.<ref>{{cite book |last=Paul |first=Ron |title=End the Fed |year=2009 |publisher=] |location=New York |isbn=978-0-446-54919-6 |chapter-url=https://mises.org/daily/3687 |author-link=Ron Paul |chapter=2 The Origin and Nature of the Fed|title-link=End the Fed }}</ref> | |||
|- | |||
! colspan=7 | Example 2: ANZ National Bank Limited Maturity Analysis of Assets and Liabilities as at 30 September 2007{{Citation needed|date=January 2008}} | |||
|- | |||
| | |||
| align = "center" | '''Total <br>Carrying <br>Value''' | |||
| align = "center" | '''< 3 <br>Months''' | |||
| align = "center" | '''3–12 <br>Months''' | |||
| align = "center" | '''1–5 <br>Years''' | |||
| align = "center" | '''5+<br> Years''' | |||
| align = "center" | '''No <br>Specified <br>Maturity''' | |||
|- | |||
|'''Assets''' | |||
| | |||
| | |||
| | |||
| | |||
| | |||
| | |||
|- | |||
|Liquid assets | |||
| align = "right" | 4,807 | |||
| align = "right" | 4,807 | |||
| | |||
| | |||
| | |||
| | |||
|- | |||
|Due from other financial institutions | |||
| align = "right" | 3,563 | |||
| align = "right" | 2,650 | |||
| align = "right" | 440 | |||
| align = "right" | 187 | |||
| align = "right" | 286 | |||
| | |||
|- | |||
|Derivative financial instruments | |||
| align = "right" | 4,711 | |||
| | |||
| | |||
| | |||
| | |||
| align = "right" | 4,711 | |||
|- | |||
|Assets available for sale | |||
| align = "right" | 48 | |||
| align = "right" | 33 | |||
| align = "right" | 1 | |||
| align = "right" | 13 | |||
| | |||
| align = "right" | 1 | |||
|- | |||
|Net loans and advances | |||
| align = "right" | 87,878 | |||
| align = "right" | 9,276 | |||
| align = "right" | 9,906 | |||
| align = "right" | 24,142 | |||
| align = "right" | 44,905 | |||
| | |||
|- | |||
|Other assets | |||
| align = "right" | 4,903 | |||
| align = "right" | 970 | |||
| align = "right" | 179 | |||
| | |||
| | |||
| align = "right" | 3,754 | |||
|- | |||
|'''Total Assets''' | |||
| align = "right" | '''107,787''' | |||
| align = "right" | '''18,394''' | |||
| align = "right" | '''10,922''' | |||
| align = "right" | '''25,013''' | |||
| align = "right" | '''45,343''' | |||
| align = "right" | '''8,115''' | |||
|- | |||
|'''Liabilities''' | |||
| | |||
| | |||
| | |||
| | |||
| | |||
| | |||
|- | |||
|Due to other financial institutions | |||
| align = "right" | 3,170 | |||
| align = "right" | 2,356 | |||
| align = "right" | 405 | |||
| align = "right" | 32 | |||
| align = "right" | 377 | |||
| | |||
|- | |||
|Deposits and other borrowings | |||
| align = "right" | 70,030 | |||
| align = "right" | 53,059 | |||
| align = "right" | 14,726 | |||
| align = "right" | 2,245 | |||
| | |||
| | |||
|- | |||
|Derivative financial instruments | |||
| align = "right" | 4,932 | |||
| | |||
| | |||
| | |||
| | |||
| align = "right" | 4,932 | |||
|- | |||
|Other liabilities | |||
| align = "right" | 1,516 | |||
| align = "right" | 1,315 | |||
| align = "right" | 96 | |||
| align = "right" | 32 | |||
| align = "right" | 60 | |||
| align = "right" | 13 | |||
|- | |||
|Bonds and notes | |||
| align = "right" | 14,607 | |||
| align = "right" | 672 | |||
| align = "right" | 4,341 | |||
| align = "right" | 9,594 | |||
| | |||
| | |||
|- | |||
|Related party funding | |||
| align = "right" | 2,275 | |||
| align = "right" | 2,275 | |||
| | |||
| | |||
| | |||
| | |||
|- | |||
|Loan capital | |||
| align = "right" | 2,062 | |||
| | |||
| align = "right" | 100 | |||
| align = "right" | 1,653 | |||
| align = "right" | 309 | |||
| | |||
|- | |||
|'''Total Liabilities''' | |||
| align = "right" | '''99,084''' | |||
| align = "right" | '''60,177''' | |||
| align = "right" | '''19,668''' | |||
| align = "right" | '''13,556''' | |||
| align = "right" | '''746''' | |||
| align = "right" | '''4,937''' | |||
|- | |||
|Net liquidity gap (Total Assets less Total Liabilities) | |||
| align = "right" | 8,703 | |||
| align = "right" | (41,783) | |||
| align = "right" | (8,746) | |||
| align = "right" | 11,457 | |||
| align = "right" | 44,597 | |||
| align = "right" | 3,178 | |||
|- | |||
|'''Net Liquidity Gap – Cumulative''' | |||
| align = "right" | '''8,703''' | |||
| align = "right" | '''(41,783)''' | |||
| align = "right" | '''(50,529)''' | |||
| align = "right" | '''(39,072)''' | |||
| align = "right" | '''5,525''' | |||
| align = "right" | '''8,703''' | |||
|} | |||
== |
===Descriptions=== | ||
{{NPOV|date=September 2013}} | |||
Some economists dispute the standard textbook description of fractional-reserve banking.<ref>{{cite web|last=Goodhart|first=Charles|title=Money, credit and bank behaviour: need for a new approach|url=http://www.thefreelibrary.com/Money,+credit+and+bank+behaviour%3A+need+for+a+new+approach.-a0250677146}}</ref><ref>{{cite web|last=Carpenter|first=Seth|title=Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?|url=http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf}}</ref><ref>{{cite web|last=Tobin|first=James|title=Commercial Banks as Creators of "Money"|url=http://cowles.econ.yale.edu/P/cm/m21/m21-01.pdf}}</ref><ref>{{cite web|last=Turner|first=Adair|title=Credit Money and Leverage, what Wicksell, Hayek and Fisher knew and modern macroeconomics forgot|url=http://ineteconomics.org/sites/inet.civicactions.net/files/Adair%20Turner%20Stockholm%20School%20of%20Economics%20September%2012.pdf}}</ref> | |||
], former chief financial regulator of the United Kingdom, stated that banks "create credit and money '']''{{snd}} extending a loan to the borrower and simultaneously crediting the borrower's money account".<ref>{{cite web|last=Turner|first=Adair|title=Credit Money and Leverage, what Wicksell, Hayek and Fisher knew and modern macroeconomics forgot|url=https://cdn.evbuc.com/eventlogos/67785745/turner.pdf |work=Proceedings of Towards a Sustainable Financial System |publisher=Stockholm School of Economics}}</ref> | |||
Critics of fractional-reserve banking have included economist ]<ref>{{Cite book | |||
| title = 100% Money | |||
| publisher = Pickering & Chatto Ltd; | |||
| first = Irving | |||
| last = Fisher | |||
| isbn = 978-1-85196-236-5 | |||
| year = 1997 | |||
| postscript = <!-- Bot inserted parameter. Either remove it; or change its value to "." for the cite to end in a ".", as necessary. -->{{inconsistent citations}} }}</ref> former U.S. Congressman ] and ] ].<ref name="Paul_End">Ron Paul. , ''Mises Institute'', September 03, 2009. Chapter 2 of the book ''End the Fed''. Referenced 2011-03-16.</ref> | |||
In Rothbard's analysis, the practice of fractional-reserve banking amounts to a form of fraud, embezzlement or legalized counterfeiting.<ref>^ Rothbard, Murray. The Mystery of Banking, pp. 259-268</ref> | |||
==See also== | ==See also== | ||
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==Notes== | |||
{{Reflist|group=note}} | |||
==References== | ==References== | ||
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{{Reflist|30em}} | ||
==Further reading== | ==Further reading== | ||
* Crick, W.F. (1927), The genesis of bank deposits, ''Economica'', vol 7, 1927, pp 191–202. | * Crick, W.F. (1927), The genesis of bank deposits, ''Economica'', vol 7, 1927, pp 191–202. | ||
* ] (1960), ''A Program for Monetary Stability'', New York, ]. | * ] (1960), ''A Program for Monetary Stability'', New York, ]. | ||
* ], "The Invention of Money: How the heresies of two bankers became the basis of our modern economy", '']'', 5 & 12 August 2019, pp. 28–31. | |||
* Meigs, A.J. (1962), ''Free reserves and the money supply'', Chicago, University of Chicago, 1962. | * Meigs, A.J. (1962), ''Free reserves and the money supply'', Chicago, University of Chicago, 1962. | ||
* Philips, C.A. (1921), ''Bank Credit'', New York, Macmillan, chapters 1–4, 1921, | * Philips, C.A. (1921), ''Bank Credit'', New York, Macmillan, chapters 1–4, 1921, | ||
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==External links== | ==External links== | ||
* {{Webarchive|url=https://web.archive.org/web/20181225154823/https://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf |date=25 December 2018 }} Bank of England | |||
* | * | ||
* Calculator that details deposit multiplication for any reserve requirement. | |||
* {{broken citation|date=January 2013}} | |||
* {{broken citation|date=January 2013}} | |||
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Latest revision as of 17:09, 22 December 2024
System of banking
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Fractional-reserve banking is the system of banking in all countries worldwide, under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve, typically lending the remainder to borrowers. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. Fractional-reserve banking differs from the hypothetical alternative model, full-reserve banking, in which banks would keep all depositor funds on hand as reserves.
The country's central bank may determine a minimum amount that banks must hold in reserves, called the "reserve requirement" or "reserve ratio". Most commercial banks hold more than this minimum amount as excess reserves. Some countries, e.g. the core Anglosphere countries of the United States, the United Kingdom, Canada, Australia, and New Zealand, and the three Scandinavian countries, do not impose reserve requirements at all.
Bank deposits are usually of a relatively short-term duration, and may be "at call", while loans made by banks tend to be longer-term, resulting in a risk that customers may at any time collectively wish to withdraw cash out of their accounts in excess of the bank reserves. The reserves only provide liquidity to cover withdrawals within the normal pattern. Banks and the central bank expect that in normal circumstances only a proportion of deposits will be withdrawn at the same time, and that reserves will be sufficient to meet the demand for cash. However, banks may find themselves in a shortfall situation when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may borrow short-term funds in the interbank lending market from banks with a surplus. In exceptional situations, such as during an unexpected bank run, the central bank may provide funds to cover the short-term shortfall as lender of last resort.
As banks hold in reserve less than the amount of their deposit liabilities, and because the deposit liabilities are considered money in their own right (see commercial bank money), fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank. In most countries, the central bank (or other monetary policy authority) regulates bank-credit creation, imposing reserve requirements and capital adequacy ratios. This helps ensure that banks remain solvent and have enough funds to meet demand for withdrawals, and can be used to influence the process of money creation in the banking system. However, rather than directly controlling the money supply, contemporary central banks usually pursue an interest-rate target to control bank issuance of credit and the rate of inflation.
History
Main article: History of banking See also: BanknoteFractional-reserve banking predates the existence of governmental monetary authorities and originated with bankers' realization that generally not all depositors demand payment at the same time. In the past, savers looking to keep their coins and valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit (see Bank of Amsterdam). These notes gained acceptance as a medium of exchange for commercial transactions and thus became an early form of circulating paper money. As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.
If creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, however, many would try to redeem their notes at the same time. If, in response, a bank could not raise enough funds by calling in loans or selling bills, the bank would either go into insolvency or default on its notes. Such a situation is called a bank run and caused the demise of many early banks.
These early financial crises led to the creation of central banks. The Swedish Riksbank was the world's first central bank, created in 1668. Many nations followed suit in the late 1600s to establish central banks which were given the legal power to set a reserve requirement, and to specify the form in which such assets (called the monetary base) were required to be held. In order to mitigate the impact of bank failures and financial crises, central banks were also granted the authority to centralize banks' storage of precious metal reserves, thereby facilitating transfer of gold in the event of bank runs, to regulate commercial banks, and to act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today. where it is the system of banking prevailing in almost all countries worldwide.
During the twentieth century, the role of the central bank grew to include influencing or managing various macroeconomic policy variables, including measures of inflation, unemployment, and the international balance of payments. In the course of enacting such policy, central banks have from time to time attempted to manage interest rates, reserve requirements, and various measures of the money supply and monetary base.
Regulatory framework
In most legal systems, a bank deposit is not a bailment. In other words, the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a deposit account (a checking or savings account). That deposit account is a liability on the balance sheet of the bank.
Each bank is legally authorized to issue credit up to a specified multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits. Largely, fractional-reserve banking functions smoothly, as relatively few depositors demand payment at any given time, and banks maintain enough of a buffer of reserves to cover depositors' cash withdrawals and other demands for funds. However, during a bank run or a generalized financial crisis, demands for withdrawal can exceed the bank's funding buffer, and the bank will be forced to raise additional reserves to avoid defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing in the interbank lending market or from the central bank), by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis.
Many of the practices of contemporary bank regulation and central banking—including centralized clearing of payments, central bank lending to member banks, regulatory auditing, and government-administered deposit insurance—are designed to prevent the occurrence of such bank runs.
Economic function
Fractional-reserve banking allows banks to provide credit, which represent immediate liquidity to borrowers. The banks also provide longer-term loans, and act as financial intermediaries for those funds. Less liquid forms of deposit (such as time deposits) or riskier classes of financial assets (such as equities or long-term bonds) may lock up a depositor's wealth for a period of time, making it unavailable for use on demand. This "borrowing short, lending long" or maturity transformation function of fractional-reserve banking is a role that, according to many economists, can be considered to be an important function of the commercial banking system.
The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy.
Additionally, according to macroeconomic theory, a well-regulated fractional-reserve bank system could be used by the central bank to influence the money supply and interest rates. Influencing interest rates are an important part of monetary policy used by central banks to promote macroeconomic stability. Historically, central banks have occasionally changed reserve requirements discretionarily in order to influence the money supply directly and via that mechanism the interest rate level. Today, however, this implementation policy is rarely used. In the US, the Federal Reserve eliminated reserve requirements entirely in 2020, instead preferring to use changes in the interest rate paid on reserves held by commercial banks as its most important monetary policy instrument to directly influence the broader interest rate level in the economy.
Money creation process
Main article: Money creationWhen a loan is made by the commercial bank, the bank creates new demand deposits and the money supply expands by the size of the loan.
The proceeds of most bank loans are not in the form of currency. Banks typically make loans by accepting promissory notes in exchange for credits they make to the borrowers' deposit accounts. Deposits created in this way are sometimes called derivative deposits and are part of the process of creation of money by commercial banks. Issuing loan proceeds in the form of paper currency and current coins is considered to be a weakness in internal control.
The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold). Data for reserves and vault cash are published regularly by the Federal Reserve in the United States. The Federal Reserve does not impose a reserve requirement, but pays interest on reserve balances, influencing the general interest rate level in the economy in that way.
Just as taking out a new loan expands the money supply, the repayment of bank loans reduces the money supply.
Types of money
There are two types of money created in a fractional-reserve banking system operating with a central bank:
- Central bank money: money created or adopted by the central bank regardless of its form – precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money.
- Commercial bank money: demand deposits in the commercial banking system; also referred to as "chequebook money", "sight deposits" or simply "credit".
Money multiplier
Main article: Money multiplierThe money multiplier is a heuristic traditionally used to demonstrate the maximum amount of broad money that could be created by commercial banks for a given fixed amount of base money and reserve ratio. This theoretical maximum is never reached, because some eligible reserves are held as cash outside of banks. Rather than holding the quantity of base money fixed, contemporary central banks typically focus on setting and maintaining target interest rates in order to satisfy their monetary policy goals, implying that the theoretical ceiling imposed by the money multiplier does not impose a limit on money creation in practice.
Formula
The money multiplier, m, is the inverse of the reserve requirement, R:
In countries where the central bank does not impose a reserve requirement, such as the United States, Canada and the United Kingdom, the theoretical money multiplier is undefined, having a denominator of zero.
Money supply
See also: Money supplyIn countries with fractional-reserve banking, commercial bank money usually forms the majority of the money supply. The acceptance and value of commercial bank money is based on the fact that it can be exchanged freely at a commercial bank for central bank money.
The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process. Government regulations may also limit the money creation process by preventing banks from giving out loans even when the reserve requirements have been fulfilled.
Regulation
Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.
Central banks
Main article: Central bankGovernment controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit-taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:
- Minimum required reserve ratios (RRRs)
- Minimum capital ratios
- Government bond deposit requirements for note issue
- 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844 (UK)
- Sanction on bank defaults and protection from creditors for many months or even years, and
- Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors.
Reserve requirements
The currently prevailing view of reserve requirements is that they are intended to prevent banks from:
- Generating too much money by making too many loans against a narrow money deposit base;
- Having a shortage of cash when large deposits are withdrawn (although a legal minimum reserve amount is often established as a regulatory requirement, reserves may be made available on a temporary basis in the event of a crisis or bank run).
In some jurisdictions (such as the European Union), the central bank does not require reserves to be held during the day. Reserve requirements are intended to ensure that the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence.
In other jurisdictions (such as the United States, Canada, the United Kingdom, Australia, New Zealand, and the Scandinavian countries), the central bank does not require reserves to be held at any time – that is, it does not impose reserve requirements.
In addition to reserve requirements, there are other required financial ratios that affect the amount of loans that a bank can fund. The capital requirement ratio is perhaps the most important of these other required ratios. When there are no mandatory reserve requirements, which are considered by some economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending.
Liquidity and capital management for a bank
Main articles: Capital requirement and Market liquidityTo avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:
- Selling or redeeming other assets, or securitization of illiquid assets,
- Restricting investment in new loans,
- Borrowing funds (whether repayable on demand or at a fixed maturity),
- Issuing additional capital instruments, or
- Reducing dividends.
Because different funding options have different costs and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:
- Demand deposits with other banks
- High quality marketable debt securities
- Committed lines of credit with other banks
As with reserves, other sources of liquidity are managed with targets.
The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, demand creditors have an incentive to demand payment immediately, causing a bank run to occur.
Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected counterparty behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.
Hypothetical example of a bank balance sheet and financial ratios
An example of fractional-reserve banking, and the calculation of the "reserve ratio" is shown in the balance sheet below:
Example 2: ANZ National Bank Limited Balance Sheet as of 30 September 2017 | |||
---|---|---|---|
Assets | NZ$m | Liabilities | NZ$m |
Cash | 201 | Demand deposits | 25,482 |
Balance with Central Bank | 2,809 | Term deposits and other borrowings | 35,231 |
Other liquid assets | 1,797 | Due to other financial institutions | 3,170 |
Due from other financial institutions | 3,563 | Derivative financial instruments | 4,924 |
Trading securities | 1,887 | Payables and other liabilities | 1,351 |
Derivative financial instruments | 4,771 | Provisions | 165 |
Available for sale assets | 48 | Bonds and notes | 14,607 |
Net loans and advances | 87,878 | Related party funding | 2,775 |
Shares in controlled entities | 206 | Loan capital | 2,062 |
Current tax assets | 112 | Total Liabilities | 99,084 |
Other assets | 1,045 | Share capital | 5,943 |
Deferred tax assets | 11 | Reserves | 83 |
Premises and equipment | 232 | Retained profits | 2,667 |
Goodwill and other intangibles | 3,297 | Total Equity | 8,703 |
Total Assets | 107,787 | Total Liabilities plus Net Worth | 107,787 |
In this example the cash reserves held by the bank is NZ$3,010m (NZ$201m cash + NZ$2,809m balance at Central Bank) and the demand deposits (liabilities) of the bank are NZ$25,482m, for a cash reserve ratio of 11.81%.
Other financial ratios
The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc.
For example, the ANZ National Bank Limited balance sheet above gives the following financial ratios:
- Cash reserve ratio is $3,010m/$25,482m, i.e., 11.81%.
- Liquid assets reserve ratio is ($201m + $2,809m + $1,797m)/$25,482m, i.e., 18.86%.
- Equity capital ratio is $8,703m/107,787m, i.e., 8.07%.
- Tangible equity ratio is ($8,703m − $3,297m)/107,787m, i.e., 5.02%
- Total capital ratio is ($8,703m + $2,062m)/$107,787m, i.e., 9.99%.
It is important how the term "reserves" is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.
Commentary
Main article: Monetary reform See also: Full-reserve bankingInstability
In 1935, economist Irving Fisher proposed a system of full-reserve banking, where banks would not lend on demand deposits but would only lend from time deposits. It was proposed as a method of reversing the deflation of the Great Depression, as it would give the central bank (the Federal Reserve in the US) more direct control of the money supply.
Austrian School criticism
Austrian School economists such as Jesús Huerta de Soto and Murray Rothbard have strongly criticized fractional-reserve banking, calling for it to be outlawed and criminalized. According to them, not only does money creation cause macroeconomic instability (based on the Austrian Business Cycle Theory), but it is a form of embezzlement or financial fraud, legalized only due to the influence of powerful rich bankers on corrupt governments around the world. US politician Ron Paul has also criticized fractional-reserve banking based on Austrian School arguments.
Descriptions
Adair Turner, former chief financial regulator of the United Kingdom, stated that banks "create credit and money ex nihilo – extending a loan to the borrower and simultaneously crediting the borrower's money account".
See also
- Asset liability management
- Basel II
- Basel III
- Chicago plan
- Credit theory of money
- Endogenous money
- Monetary reform
- Positive Money
Notes
- For an example, see Nationalisation of Northern Rock#Run on the bank
References
- ^ United States. Congress. House. Banking and Currency Committee. (1964). Money facts; 169 questions and answers on money – a supplement to A Primer on Money, with index, Subcommittee on Domestic Finance ... 1964 (PDF). Washington D.C.
{{cite book}}
: CS1 maint: location missing publisher (link) - ^ Thus by the 19th century we find "n ordinary cases of deposits of money with banking corporations, or bankers, the transaction amounts to a mere loan or mutuum, and the bank is to restore, not the same money, but an equivalent sum, whenever it is demanded." Joseph Story, Commentaries on the Law of Bailments (1832, p. 66) and "Money, when paid into a bank, ceases altogether to be the money of the principal (see Parker v. Marchant, 1 Phillips 360); it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it." Lord Chancellor Cottenham, Foley v Hill (1848) 2 HLC 28.
- Charles P. Kindleberger, A Financial History of Western Europe. Routledge 2007
- ^ Mankiw, N. Gregory (2002). "18". Macroeconomics (5th ed.). Worth. pp. 482–489.
- Frederic S. Mishkin, Economics of Money, Banking and Financial Markets, 10th Edition. Prentice Hall 2012
- Christophers, Brett (2013). Banking Across Boundaries: Placing Finance in Capitalism. New York: John Wiley and Sons. ISBN 978-1-4443-3829-4.
- ^ The Federal Reserve in Plain English Archived 26 March 2009 at the Wayback Machine – An easy-to-read guide to the structure and functions of the Federal Reserve System (See page 5 of the document for the purposes and functions)
- Abel, Andrew; Bernanke, Ben (2005). "7". Macroeconomics (5th ed.). Pearson. pp. 266–269.
- Maturity Transformation Brad DeLong
- Page 57 of 'The FED today', a publication on an educational site affiliated with the Federal Reserve Bank of Kansas City, designed to educate people on the history and purpose of the United States Federal Reserve system. The FED today Lesson 6 Archived 13 March 2011 at the Wayback Machine
- "Mervyn King, Finance: A Return from Risk" (PDF). Bank of England.
Banks are dangerous institutions. They borrow short and lend long. They create liabilities which promise to be liquid and hold few liquid assets themselves. That though is hugely valuable for the rest of the economy. Household savings can be channelled to finance illiquid investment projects while providing access to liquidity for those savers who may need it.... If a large number of depositors want liquidity at the same time, banks are forced into early liquidation of assets – lowering their value ...'
- Mankiw, Nicholas Gregory (2022). Macroeconomics (Eleventh, international ed.). New York, NY: Worth Publishers, Macmillan Learning. pp. 403–406. ISBN 978-1-319-26390-4.
- Mankiw, Nicholas Gregory (2022). Macroeconomics (Eleventh, international ed.). New York, NY: Worth Publishers, Macmillan Learning. p. 88. ISBN 978-1-319-26390-4.
- Eric N. Compton, Principles of Banking, p. 150, American Bankers Ass'n (1979).
- Paul M. Horvitz, Monetary Policy and the Financial System, pp. 56–57, Prentice-Hall, 3rd ed. (1974).
- See, generally, Industry Audit Guide: Audits of Banks, p. 56, Banking Committee, American Institute of Certified Public Accountants (1983).
- Federal Reserve Board, "Aggregate Reserves of Depository Institutions and the Monetary Base" (Updated weekly).
- "Interest on Reserve Balances". Board of Governors of the Federal Reserve System. Retrieved 4 November 2023.
- McLeay. "Money Creation in the Modern Economy" (PDF). Bank of England.
- ^ Bank for International Settlements – The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency":
A quick quotation in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:
- "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."
- ^ European Central Bank – Domestic payments in Euroland: commercial and central bank money:
One quotation from the article referencing the two types of money:
- "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via cheques and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"
- Macmillan report 1931 account of how fractional banking works
- "Managing the central bank's balance sheet: where monetary policy meets financial stability" (PDF). Bank of England.
- Blanchard, Olivier (2021). Macroeconomics (Eighth, global ed.). Harlow, England: Pearson. pp. 505–509. ISBN 978-0-134-89789-9.
- Hubbard and O'Brien. "Chapter 25: Monetary Policy, p. 943". Economics.
- McGraw Hill Higher Education Archived 5 December 2007 at the Wayback Machine
- Ihrig, Jane; Weinbach, Gretchen; Wolla, Scott (3 April 2023). "How are Banks and the Fed Linked? Teaching Key Concepts Today". Review of Political Economy. 35 (2): 555–571. doi:10.1080/09538259.2022.2040906. ISSN 0953-8259. Retrieved 4 November 2023.
- William MacEachern (2014) Macroeconomics: A Contemporary Introduction, p. 295, University of Connecticut, ISBN 978-1-13318-923-7
- The Federal Reserve – Purposes and Functions (See pages 13 and 14 of the pdf version for information on government regulations and supervision over banks)
- Reserve Bank of India – Report on Currency and Finance 2004–05 (See page 71 of the full report or just download the section Functional Evolution of Central Banking): The monopoly power to issue currency is delegated to a central bank in full or sometimes in part. The practice regarding the currency issue is governed more by convention than by any particular theory. It is well known that the basic concept of currency evolved in order to facilitate exchange. The primitive currency note was in reality a promissory note to pay back to its bearer the original precious metals. With greater acceptability of these promissory notes, these began to move across the country and the banks that issued the promissory notes soon learnt that they could issue more receipts than the gold reserves held by them. This led to the evolution of the fractional reserve system. It also led to repeated bank failures and brought forth the need to have an independent authority to act as lender-of-the-last-resort. Even after the emergence of central banks, the concerned governments continued to decide on asset backing for the issue of coins and notes. The asset backing took various forms including gold coins, bullion, foreign exchange reserves and foreign securities. With the emergence of a fractional reserve system, this reserve backing (gold, currency assets, etc.) came down to a fraction of the total currency put in circulation.
- "Federal Reserve Board - Reserve Requirements".
- ^ Jagdish Handa (2008). Monetary Economics (2nd ed.). Routledge.
- Carter, Thomas J.; Mendes, Rhys R.; Schembri, Lawrence (18 December 2018). "Credibility, Flexibility and Renewal: The Evolution of Inflation Targeting in Canada". www.bankofcanada.ca. Retrieved 8 November 2023.
- "Submission to Inquiry into the Australian Banking Industry", Reserve Bank of Australia, January 1991
- "Abolition of compulsory ratio requirements". Reserve Bank Bulletin. Vol. 48, no. 4. Reserve Bank of New Zealand. April 1985.
- Pengepolitik i Danmark (PDF). Danmarks Nationalbank. 2009. p. 43. ISBN 978-87-87251-70-9.
- "What macroprudential policies are countries using to help their economies through the Covid-19 crisis? | Yale School of Management". som.yale.edu. Retrieved 22 December 2024.
- Global, K. E. D. "S.Korea's IBK, Japan's Mizuho Bank agree on $218-million committed line". KED Global. Retrieved 22 December 2024.
- "Is the Collapse of SVB the Start of a Banking Panic? | Yale Insights". insights.som.yale.edu. 11 March 2023. Retrieved 22 December 2024.
- Schroeder, Pete; Price, Michelle (24 June 2024). "Explainer: What are the Fed's bank 'stress tests' and what's new this year?". Reuters.
- A banking revolution Jeremy Warner, UK Telegraph
- Weisenthal, Joe. "Ban All the Banks: Here's The Wild Idea That People Are Starting To Take Seriously". Business Insider. Retrieved 30 November 2020.
- Fisher, Irving (1997). 100% Money. Pickering & Chatto Ltd. ISBN 978-1-85196-236-5.
- Rothbard, Murray (1983). The Mystery of Banking. Richardson & Snyder. ISBN 9780943940045.
- Jesús Huerta de Soto (2012). Money, Bank Credit, and Economic Cycles (3d ed.). Auburn, AL: Ludwig von Mises Institute. p. 881. ISBN 9781610161893. OCLC 807678778. (with Melinda A. Stroup, translator) Also available as a PDF here Archived 16 December 2014 at the Wayback Machine
- Paul, Ron (2009). "2 The Origin and Nature of the Fed". End the Fed. New York: Grand Central Pub. ISBN 978-0-446-54919-6.
- Turner, Adair. "Credit Money and Leverage, what Wicksell, Hayek and Fisher knew and modern macroeconomics forgot" (PDF). Proceedings of Towards a Sustainable Financial System. Stockholm School of Economics.
Further reading
- Crick, W.F. (1927), The genesis of bank deposits, Economica, vol 7, 1927, pp 191–202.
- Friedman, Milton (1960), A Program for Monetary Stability, New York, Fordham University Press.
- Lanchester, John, "The Invention of Money: How the heresies of two bankers became the basis of our modern economy", The New Yorker, 5 & 12 August 2019, pp. 28–31.
- Meigs, A.J. (1962), Free reserves and the money supply, Chicago, University of Chicago, 1962.
- Philips, C.A. (1921), Bank Credit, New York, Macmillan, chapters 1–4, 1921,
- Thomson, P. (1956), Variations on a theme by Philips, American Economic Review vol 46, December 1956, pp. 965–970.
External links
- Money creation in the modern economy Archived 25 December 2018 at the Wayback Machine Bank of England
- Regulation D of the Federal Reserve Board of the U.S.
- Bank for International Settlements – The Role of Central Bank Money in Payment Systems