determine the reserve requirements, the proportion of deposits a bank must keep as reserves in the vault of the bank. Keeping only a small fraction of the depositors' funds available for withdrawal is called fractional reserve banking. This system allows banks to create money.
Money creation is the process of generating additional money by repeatedly lending, through the fractional reserve banking system, an original deposit to a bank.
EXAMPLE
Suppose Bank A has collected deposits totaling USD 100 and retains 10 % of those deposits as reserves to meet withdrawals. Bank A uses the remaining 90 %, or USD 90, for lending purposes. Suppose the USD 90 is lent to one person, who then spends all the funds at one store. This USD 90 is effectively “new” money. The store then deposits the USD 90 in Bank B. At that point there are deposits in the two banks of USD 190 (the initial deposit of USD 100 plus the new deposit of USD 90). Bank B now sets aside 10 % of the USD 90, or USD 9, in reserves, and loans the remaining USD 81, which is then deposited by the borrower in Bank C. There is now USD 100 + USD 90 + USD 81, or USD 271 of deposits in the three banks. As this process continues, more deposits are loaned out and spent and more money is deposited; at each turn, more and more money is made available through the lending process.
Figure 1.3 below shows the amount of money that an initial USD 100 deposit generates, assuming a 10 % reserve requirement, transaction by transaction. (The dark shading is the reserve requirement held back from each loan (10 %), and the lighter gray shading is each successive loan amount). Over the course of 21 separate transactions, USD 801 of deposits is generated, from an initial deposit of only USD 100. Allowed to continue indefinitely, this process would generate a total of USD 1,000 in deposits – the original USD 100 deposit plus USD 900 created through subsequent loans.
Figure 1.3 Money Creation (USD 801 in New Lending from Initial USD 100 Deposit)
In the example, the cycle started with an initial deposit of USD 100; no additional money was put into the system. Portions of the original USD 100 repeatedly flowed through the system, increasing both bank deposits and bank loans. The amount of money created at each deposit is 90 % of the previous step (100 % less the 10 % held in reserve).
Reserve requirements limit how much money an initial deposit can create in the fractional reserve banking system. The money multiplier, the inverse of the reserve requirement, is a formula used to determine how much new money each unit of currency can create. As the following example shows, the higher the reserve requirement, the more the bank must keep as regulatory reserves in the vault of the bank and the less money the bank can create.
EXAMPLE
With a reserve requirement of 10 %, the money multiplier is 10 (1/10 % = 10). Thus, the amount of money that can be created on a USD 100 deposit is USD 1,000. Out of USD 1,000, USD 900 (or 90 %) is new money and USD 100 (or 10 %) is the original deposit.
With a reserve requirement of 20 %, the money multiplier falls to 5 (1/20 % = 5). Thus, the amount of money that can be created on a USD 100 deposit would be USD 500. Out of this USD 500, USD 400 (or 80 %) is new money and USD 100 (or 20 %) is the original deposit.
Globally, banks represent the largest source of financing for businesses and are therefore critical to economic development. Banks provide financing directly, by extending loans and buying bonds, and they also help companies secure financing by arranging for others to lend them money or invest in their bonds. Banks can also help companies secure financing by arranging share issues for them or even taking direct ownership stakes in them. Debt and equity are the two types of financing and two sources of capital.
Banks also provide financing for consumers, who use bank loans to purchase and finance assets they might not otherwise be able to afford, such as a car or a house. Credit cards, another type of bank loan, provide consumers with convenient access to credit that enables them to make purchases and can also stimulate economic growth. Chapter 4 will discuss in greater detail the various loan products and how they are used. Through their core functions – financial intermediation, asset transformation, and money creation – banks play a central role in advanced economies.
EXAMPLE
The global financial crisis of 2007-2009 vividly showed the interrelationship between bank functions and economic activity. Because banks were unable to collect on loans that were made to low credit quality borrowers called subprime borrowers, banks became unable to recirculate deposits and lend to other parties. This in turn meant there was less credit available for the use of companies and individuals who depend on bank loans to finance their purchases. Consequently, the companies and individuals made fewer deposits, creating less money. The effects were widely felt around the world and led to a substantial reduction in credit, which first led to a reduction in the demand for goods and services and further reduced the amount of money being deposited at banks. This caused an even further tightening of credit availability, which was one of a number of different causes and consequences related to the financial crisis.
1.1.4 Payment Services
Depositors can use their deposit accounts at banks to make and receive payments between depositors and between banks. Payments refer to the settlement of financial transactions between parties and usually involve the transfer of funds between the parties. There are various payment systems that facilitate transfer of funds for transactions, including checks, payment orders, bill payment, and electronic payments in the form of wire services and other electronic settlement systems. Payment systems can also help large corporations and government organizations handle their payments for goods and services.
Apart from settlement for payments, banks can also offer payment services by providing their customers with foreign currencies to make international payments. In arranging international payments, banks facilitate international transactions by, on one hand, offering facilities that enable the creation of payment documents that foreign banks accept and, on the other hand, by accepting payment documents that foreign banks have issued. By using international payment networks between banks, banks can also send payments according to their customers' requests.
1.1.5 Other Banking Services
Apart from its core services, a bank usually offers other financial services, sometimes in competition with nonbank financial service providers that typically include finance companies, brokerage firms, risk management consultants, and insurance companies. Banks and the companies offering these services typically receive fees, or “fee income,” for providing these services.
Fee income is the second main source of revenue to banks after the interest the bank receives from its borrowers. Other banking services may include:
• Cash management. As a part of their core deposit collection and arranging payments function, banks provide cash or treasury management services to large corporations. In general, this service means the bank agrees to handle cash collection and payments for a company and invest any temporary cash surplus.
• Investment- and securities-related activities. Many bank customers demand investment products – such as mutual funds, unit trusts, and annuities – that offer higher returns, with higher associated risks, than bank deposits. Historically, customers have turned to nonbanks for these investment products. Today, however, most banks offer them in an effort to maintain customer relationships.
Banks also offer other securities-related activities, including brokerage and investment banking services. Brokerage services involve the buying and selling of securities (e.g., stocks and bonds) on behalf of customers. Investment banking services include advising commercial customers on mergers and acquisitions, as well as offering a broad range of financing options, including direct investment in the companies themselves.
• Derivatives trading. Derivatives such as swaps, options, forwards, and futures are financial instruments whose value is “derived”