Chapter 26
Money Creation and the
Banking System
© 2002 South-Western
Economic Principles
• The Fractional Reserve System
• The Legal Reserve
Requirement
• A Bank’s Balance Sheet, Its
Assets and Liabilities
• Demand Deposits and Bank
Loans
2
Economic Principles
• The Potential Money Multiplier
• Bank Failure
• The Federal Deposit Insurance
Corporation (FDIC)
3
How Banks Create Money
Fractional reserve system
A banking system that provides
people immediate access to their
deposits but allows banks to hold
only a fraction of those deposits
in reserve.
4
How Banks Create Money
The fractional reserve system
serves as the basis of all modern
banking.
5
How Banks Create Money
If all depositors lost faith in the
banking system and demanded
their money back, banks would
be unable to meet their demands.
6
How Banks Create Money
Balance sheet
The bank’s statement of liabilities
(what it owes) and assets (what it
owns).
7
How Banks Create Money
Banks make a profit on the loans
they provide, not on their
deposits.
8
How Banks Create Money
Legal reserve requirement
The percentage of demand
deposits banks and other
financial intermediaries are
required to keep in cash reserves.
9
Virtual Banks Raise
Regulatory Challenges
What is a virtual bank?
• Virtual banks, or cyberbanks, only
exist on the Internet.
10
How Banks Create Money
1. Suppose that the banking system
initially has $100,000 in demand deposits,
and loans out $80,000. Those who borrow
this money in turn put it in their demand
deposit accounts. How much money is
now held in demand deposit accounts?
• $100,000 + $80,000 = $180,000.
11
How Banks Create Money
1. Suppose that the banking system
initially has $100,000 in demand deposits,
and loans out $80,000. Those who borrow
this money in turn put it in their demand
deposit accounts. How much money is
now held in demand deposit accounts?
• Thus fractional reserve banking creates
money through loans.
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How Banks Create Money
Financial intermediaries
Firms that accept deposits from
savers and use those deposits to
make loans to borrowers.
13
How Banks Create Money
2. What three factors are needed
for a banking system to create
money?
• A fractional reserve system operating
within financial intermediaries.
14
How Banks Create Money
2. What three factors are needed
for a banking system to create
money?
• A fractional reserve system operating
within financial intermediaries.
• People willing to make demand deposits.
15
How Banks Create Money
2. What three factors are needed
for a banking system to create
money?
• A fractional reserve system operating
within financial intermediaries.
• People willing to make demand deposits.
• Borrows prepared to take out loans.
16
How Banks Create Money
Potential money multiplier
The increase in the money supply
that is potentially generated by a
change in demand deposits.
17
How Banks Create Money
3. If the legal reserve requirement
is 10 percent, what is the
potential money multiplier?
• The potential money multiplier “m” =
1/(legal reserve requirement) = 1/0.1 = 10.
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How Banks Create Money
4. If the legal reserve requirement (LRR)
is 25 percent and the initial demand
deposit (ID) is $100,000, then what is the
maximum potential increase in the money
supply (M)?
• M = ID/LRR.
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How Banks Create Money
4. If the legal reserve requirement (LRR)
is 25 percent and the initial demand
deposit (ID) is $100,000, then what is the
maximum potential increase in the money
supply (M)?
• M = $100,000/.25 = $400,000.
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How Banks Create Money
5. Why might the actual increase in the
money supply be less than the maximum
potential increase in the money supply?
• Because there may not be a sufficient
number of borrowers to take advantage of
all the available loanable reserves in the
banking system.
21
How Banks Create Money
Excess reserves
The quantity of reserves held by
a bank in excess of the legally
required amount.
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How Banks Create Money
If there is not a sufficient number
of borrowers to take advantage of
all the available loanable reserves
in the banking system, then the
banking system will end up
holding excess reserves.
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How Banks Create Money
6. Suppose that a bank holds $100,000 in
demand deposits, has a legal reserve
requirement of 20 percent, and holds
$35,000 in reserves. How much of these
reserves are required, and how much are
excess?
• Required reserves are 0.2*($100,000) =
$20,000.
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How Banks Create Money
6. Suppose that a bank holds $100,000 in
demand deposits, has a legal reserve
requirement of 20 percent, and holds
$35,000 in reserves. How much of these
reserves are required, and how much are
excess?
• Excess reserves = (total reserves) –
(required reserves).
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How Banks Create Money
6. Suppose that a bank holds $100,000 in
demand deposits, has a legal reserve
requirement of 20 percent, and holds
$35,000 in reserves. How much of these
reserves are required, and how much are
excess?
• Excess reserves = $35,000 - $20,000 =
$15,000.
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How Banks Create Money
7. How are required reserves
recorded on a bank’s balance
sheet?
• Required reserves are an asset.
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How Banks Create Money
8. How are excess reserves
recorded on a bank’s balance
sheet?
• Excess reserves are an asset.
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How Banks Create Money
9. How are loans recorded on a
bank’s balance sheet?
• Loans are an asset.
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How Banks Create Money
10. How are demand deposits
recorded on a bank’s balance
sheet?
• Demand deposits are a liability.
30
How Banks Create Money
11. Suppose that a bank’s assets are made
up of required reserves of $10,000, excess
reserves of $5,000 and loans of $85,000. If
the legal reserve requirement is 10
percent, can we determine how much
money the bank holds in demand
deposits?
• Yes.
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How Banks Create Money
11. Suppose that a bank’s assets are made
up of required reserves of $10,000, excess
reserves of $5,000 and loans of $85,000. If
the legal reserve requirement is 10
percent, can we determine how much
money the bank holds in demand
deposits?
• With required reserves of $10,000 and a
legal reserve requirement is 10 percent,
then demand deposits equal $100,000.
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Reversing the Money
Creation Process
1. What will happen if the
Federal Reserve increased the
legal reserve requirement for
banks?
• Some excess reserves that may have
otherwise been loaned out will instead be
converted to required reserves.
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Reversing the Money
Creation Process
1. What will happen if the
Federal Reserve increased the
legal reserve requirement for
banks?
• Banks with no excess reserves will have to
borrow reserves until enough loans are
repaid or enough new deposits are made.
34
Reversing the Money
Creation Process
1. What will happen if the
Federal Reserve increased the
legal reserve requirement for
banks?
• Either way, increasing the legal reserve
requirement will reduce loanable reserves
in the banking system, and thus reduce the
money supply.
35
Reversing the Money
Creation Process
2. What will happen to a bank’s
assets if the Federal Reserve
increased the legal reserve
requirement?
• Required reserves will increase.
36
Reversing the Money
Creation Process
2. What will happen to a bank’s
assets if the Federal Reserve
increased the legal reserve
requirement?
• Excess reserves will decrease.
37
Reversing the Money
Creation Process
2. What will happen to a bank’s
assets if the Federal Reserve
increased the legal reserve
requirement?
• Loans will decrease.
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Why Banks Sometimes Fail
1. What will happen if too many
borrowers are unable to repay
their loans?
• A bank may fail.
39
Why Banks Sometimes Fail
2. If a bank fails, what will
happen to the depositors?
• If deposits are insured by the federal
government, then the government will step
in and pay depositors up to the maximum
insurable amount.
40
Why Banks Sometimes Fail
2. If a bank fails, what will
happen to the depositors?
• If deposits are not insured by the federal
government, then depositors may lose their
money.
41
Why Banks Sometimes Fail
3. If rumors spread that some
borrowers are defaulting on their
loans, how will some depositors
respond?
• Fearing that they may lose their money,
and having lost confidence in the banking
system, some depositors will demand their
money back from their deposits.
42
Why Banks Sometimes Fail
3. If rumors spread that some
borrowers are defaulting on their
loans, how will some depositors
respond?
• Too many depositors withdrawing their
money from their demand deposit accounts
will overwhelm the fractional reserve
43
system, and may cause it to fail.
Why Banks Sometimes Fail
3. If rumors spread that some
borrowers are defaulting on their
loans, how will some depositors
respond?
• Many people will lose their money,
loanable funds for investment will be
eliminated, and a recession may result.
44
Why Banks Sometimes Fail
3. If rumors spread that some
borrowers are defaulting on their
loans, how will some depositors
respond?
• Prior to modern banking regulation and
practices, many recessions were caused by
financial panics and banking system
failures.
45
Safeguarding The System
Federal Deposit Insurance
Corporation (FDIC)
A government insurance agency
that provides depositors in FDICparticipating banks 100 percent
coverage on their first $100,000 of
deposits.
46
Safeguarding The System
Banks participating in the FDIC
insurance program must pay
insurance premiums in return for
FDIC protection.
47
Safeguarding The System
The FDIC was created in 1933,
too late for the tens of thousands
of people who had been
financially wiped out by bank
failures in the Great Depression.
48
Federal Deposit Insurance
and Moral Hazard
Fully insuring deposits leads to a
costly side effect known as moral
hazard.
49
Federal Deposit Insurance
and Moral Hazard
Once a bank is insured, it has an
incentive to take on more risky
loans than it otherwise would if it
were not insured.
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Federal Deposit Insurance
and Moral Hazard
Proposed solutions for the moral hazard
problem with deposit insurance include:
• Privatize the deposit insurance system.
• Reduce the scope of deposit insurance.
Yet any change in the deposit insurance
system may itself destabilize the banking
system.
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Safeguarding The System
In addition to deposit insurance,
the FDIC also audits banks to
make sure that they use sound
banking practices.
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Safeguarding The System
Despite these safeguards,
approximately 10 banks fail each
year.
53
Safeguarding The System
During the 1970s, high farm
commodity prices inflated the
price of farmland, and high oil
prices inflated the value of
property in Texas and Oklahoma.
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Safeguarding The System
Banks made loans with inflated
property values as collateral.
55
Safeguarding The System
When farm commodity prices
and oil prices collapsed in the
recession of the early 1980s,
many farms and businesses
failed, and were unable to repay
their loans.
56
Safeguarding The System
Banks were left holding
collateral—land, buildings, and
other capital—that was worth
less than the amount of the loan.
57
Safeguarding The System
Consequently, many banks failed,
particularly in farm states and in
Texas and Oklahoma.
58
Safeguarding The System
Due to the moral hazard
problem, there were questions
regarding proper lending
practices at some of the failed
banks.
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EXHIBIT 1
BANK FAILURES: 1930–2000
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Exhibit 1: Bank Failures
Which of the two time periods
experienced the largest number
of bank failures:
a. The mid- to late-1930s.
b. The mid- to late-1980s.
61
Exhibit 1: Bank Failures
Which of the two time periods
experienced the largest number
of bank failures:
b. The mid- to late-1980s.
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EXHIBIT 2
BANK FAILURES, SELECTED STATES:
1987–89
Source: Federal Deposit Insurance Corporation, Annual Report, 1989 (Washington, D.C., 1989), p. 11.
63
Exhibit 2: Bank Failures,
Selected States: 1987-89
Which of the following states had
the largest number of bank
failures between 1987-89?
a. Alabama.
b. Texas.
c. California.
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Exhibit 2: Bank Failures,
Selected States: 1987-89
Which of the following states had
the largest number of bank
failures between 1987-89?
b. Texas.
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EXHIBIT 3
THRIFT FAILURES: 1980–91
66
Exhibit 3: Thrift Failures:
1980-91
In which of the following years
were there the most thrift
failures?
a. 1983.
b. 1987.
c. 1989.
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Exhibit 3: Thrift Failures:
1981-91
In which of the following years
were there the most thrift
failures?
c. 1989.
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Safeguarding The System
Many “thrifts” (savings and
loans) in the early 1980s were
locked in to long-term mortgage
loans that paid the thrifts less
than the interest they paid on
deposits, causing thrifts to lose
money.
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Safeguarding The System
This motivated some thrifts to
move in to new, more speculative
and risky loan markets. Another
factor contributing to the failure
of so many thrifts was fraudulent
lending practices.
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Safeguarding The System
The large number of thrift
failures in the 1980s put the
Federal Savings and Loan
Insurance Corporation (FSLIC)
in crisis.
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Safeguarding The System
Legislation was passed that
created the Resolution Trust
Corporation, which handled the
disposal of all failed thrifts. The
FDIC has assumed the insurance
function of the now-defunct
FSLIC.
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