More than half of M1, the narrowest definition of the money supply, consists of currency in circulation—those bills and coins held by the public. It’s obvious where currency comes from: it’s printed or minted by the U.S. Treasury. But the rest of M1 consists of bank deposits, and deposits account for the great bulk of M2, the broader definition of the money supply. By either measure, then, bank deposits are a major component of the money supply. And this fact brings us to our next topic: the monetary role of banks.

A bank is a financial intermediary that uses bank deposits, which you will recall are liquid assets, to finance borrowers’ investments in illiquid assets such as businesses and homes. Banks can lend depositors’ money to investors and thereby create liquidity because it isn’t necessary for a bank to keep all of its deposits on hand. Except in the case of a bank run—which we’ll discuss shortly—all of a bank’s depositors won’t want to withdraw their funds at the same time.

However, banks can’t lend out all the funds placed in their hands by depositors because they have to satisfy any depositor who wants to withdraw his or her funds. In order to meet these demands, a bank must keep substantial quantities of liquid assets on hand. In the modern U.S. banking system, these assets take the form of either currency in the bank’s vault or deposits held in the bank’s own account at the Federal Reserve. As we’ll see shortly, the latter can be converted into currency more or less instantly. Currency in bank vaults and bank deposits held at the Federal Reserve are called bank reserves. Because bank reserves are in bank vaults and at the Federal Reserve, not held by the public, they are not part of currency in circulation.

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To understand the role of banks in determining the money supply, we start by introducing a simple tool for analyzing a bank’s financial position: a T-account. A business’s T-account summarizes its financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right. Figure 25.1 shows the T-account for a hypothetical business that isn’t a bank—Samantha’s Smoothies. According to Figure 25.1, Samantha’s Smoothies owns a building worth $30,000 and has $15,000 worth of smoothie-making equipment. These are assets, so they’re on the left side of the table. To finance its opening, the business borrowed $20,000 from a local bank. That’s a liability, so the loan is on the right side of the table. By looking at the T-account, you can immediately see what Samantha’s Smoothies owns and what it owes. This type of table is called a T-account because the lines in the table make a T-shape.

Samantha’s Smoothies is an ordinary, nonbank business. Now let’s look at the T-account for a hypothetical bank, First Street Bank, which is the repository of $1 million in bank deposits.

Figure 25.2 shows First Street’s financial position. The loans First Street has made are on the left side because they’re assets: they represent funds that those who have borrowed from the bank are expected to repay. The bank’s only other assets, in this simplified example, are its reserves, which, as we’ve learned, can take the form of either cash in the bank’s vault or deposits at the Federal Reserve. On the right side we show the bank’s liabilities, which in this example consist entirely of deposits made by customers at First Street. These are liabilities because they represent funds that must ultimately be repaid to depositors. Notice, by the way, that in this example First Street’s assets are larger than its liabilities. That’s the way it’s supposed to be! In fact, as we’ll see shortly, banks are required by law to maintain assets larger than their liabilities by a specific percentage.

In this example, First Street Bank holds reserves equal to 10% of its customers’ bank deposits. The fraction of bank deposits that a bank holds as reserves is its reserve ratio.

In the modern American system, the Federal Reserve—which, among other things, regulates banks operating in the United States—sets a required reserve ratio, which is the smallest fraction of bank deposits that a bank must hold. To understand why banks are regulated, let’s consider a problem banks can face: bank runs.

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A bank can lend out most of the funds deposited in its care because in normal times only a small fraction of its depositors want to withdraw their funds on any given day. But what would happen if, for some reason, all or at least a large fraction of its depositors did try to withdraw their funds during a short period of time, such as a couple of days?

The answer is that the bank wouldn’t be able to raise enough cash to meet those demands. The reason is that banks convert most of their depositors’ funds into loans made to borrowers; that’s how banks earn revenue—by charging interest on loans. Bank loans, however, are illiquid: they can’t easily be converted into cash on short notice. To see why, imagine that First Street Bank has lent $100,000 to Drive-a-Peach Used Cars, a local dealership. To raise cash to meet demands for withdrawals, First Street can sell its loan to Drive-a-Peach to someone else—another bank or an individual investor. But if First Street tries to sell the loan quickly, potential buyers will be wary: they will suspect that First Street wants to sell the loan because there is something wrong and the loan might not be repaid. As a result, First Street Bank can sell the loan quickly only by offering it for sale at a deep discount—say, a discount of 50%, or $50,000.

The upshot is that, if a significant number of First Street’s depositors suddenly decided to withdraw their funds, the bank’s efforts to raise the necessary cash quickly would force it to sell off its assets very cheaply. Inevitably, this would lead to a bank failure: the bank would be unable to pay off its depositors in full.

What might start this whole process? That is, what might lead First Street’s depositors to rush to pull their money out? A plausible answer is a spreading rumor that the bank is in financial trouble. Even if depositors aren’t sure the rumor is true, they are likely to play it safe and get their money out while they still can. And it gets worse: a depositor who simply thinks that other depositors are going to panic and try to get their money out will realize that this could “break the bank.” So he or she joins the rush. In other words, fear about a bank’s financial condition can be a self-fulfilling prophecy: depositors who believe that other depositors will rush to the exit will rush to the exit themselves.

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A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. Moreover, bank runs aren’t bad only for the bank in question and its depositors. Historically, they have often proved contagious, with a run on one bank leading to a loss of faith in other banks, causing additional bank runs. The FYI “It’s a Wonderful Banking System” describes an actual case of just such a contagion, the wave of bank runs that swept across the United States in the early 1930s. In response to that experience and similar experiences in other countries, the United States and most other modern governments have established a system of bank regulations that protects depositors and prevents most bank runs.

Should you worry about losing money in the United States due to a bank run? No. After the banking crises of the 1930s, the United States and most other countries put into place a system designed to protect depositors and the economy as a whole against bank runs. This system has three main features: deposit insurance, capital requirements, and reserve requirements. In addition, banks have access to the discount window, a source of loans from the Federal Reserve when they’re needed.

Deposit Insurance Almost all banks in the United States advertise themselves as a “member of the FDIC”—the Federal Deposit Insurance Corporation. The FDIC provides deposit insurance, a guarantee that depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. As this book was going to press, the FDIC guaranteed the first $250,000 of each account.

It’s important to realize that deposit insurance doesn’t just protect depositors if a bank actually fails. The insurance also eliminates the main reason for bank runs: since depositors know their funds are safe even if a bank fails, they have no incentive to rush to pull them out because of a rumor that the bank is in trouble.

Capital Requirements Deposit insurance, although it protects the banking system against bank runs, creates a well-known incentive problem. Because depositors are protected from loss, they have no incentive to monitor their bank’s financial health, allowing risky behavior by the bank to go undetected. At the same time, the owners of banks have an incentive to engage in overly risky investment behavior, such as making questionable loans at high interest rates. That’s because if all goes well, the owners profit; and if things go badly, the government covers the losses through federal deposit insurance.

To reduce the incentive for excessive risk-taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits. That way, the bank will have assets larger than its deposits even if some of its loans go bad, and losses will accrue against the bank owners’ assets, rather than against the government. The excess of a bank’s assets over its bank deposits and other liabilities is called the bank’s capital. For example, First Street Bank has capital of $100,000, equal to 9% of the total value of its assets. In practice, banks’ capital is required to equal at least 7% of the value of their assets.

Reserve Requirements Another regulation used to reduce the risk of bank runs is reserve requirements, rules set by the Federal Reserve that establish the required reserve ratio for banks. For example, in the United States, the required reserve ratio for checkable bank deposits is currently between zero and 10%, depending on the amount deposited at the bank.

The Discount Window One final protection against bank runs is the fact that the Federal Reserve stands ready to lend money to banks through a channel known as the discount window. The ability to borrow money means a bank can avoid being forced to sell its assets at fire-sale prices in order to satisfy the demands of a sudden rush of depositors demanding cash. Instead, it can turn to the Federal Reserve and borrow the funds it needs to pay off depositors.

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