Roughly 10% of M1, the narrowest definition of the money supply, consists of currency in circulation—$5 bills, $10 bills, and so on. It’s obvious where this currency comes from: it’s printed by the Bank of Canada. But the rest of M1 consists of demand deposits. Likewise, bank deposits also account for the bulk of M1+, M2, M2+, and M3, the broader definitions of the money supply. Thus, by any measure, bank deposits are the major component of the money supply.

As we learned in Chapter 10, a bank is a financial intermediary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers. Banks can create liquidity because it isn’t necessary for a bank to keep all of the funds deposited with it in the form of highly liquid assets. Except in the case of a bank run—which we’ll get to shortly—all of a bank’s depositors won’t want to withdraw their funds at the same time. So a bank can provide its depositors with liquid assets yet still invest much of the depositors’ funds in illiquid assets, such as mortgages and business loans.

Banks can’t, however, 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 Canadian banking system, these assets take the form either of currency in the bank’s vault or deposits held in the bank’s own account at the Bank of Canada. 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 Bank of Canada are called bank reserves. Because bank reserves are in bank vaults and at the Bank of Canada and not held by the public, they are not part of currency in circulation.

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 and equity on the right.

Figure 14-2 shows the T-account for a hypothetical business that isn’t a bank—Samantha’s Smoothies. According to Figure 14-2, 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. The total assets of Samantha’s Smoothies, valued at $45 000, exceed its total liabilities, valued at $20 000, and so Samantha’s Smoothies has an equity that is worth $25 000. Equity is the difference between total assets and total liabilities. By looking at the T-account, you can immediately see what Samantha’s Smoothies owns and what it owes. Oh, and it’s called a T-account because the lines in the table make a T-shape.

Samantha’s Smoothies is an ordinary, non-bank 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 14-3 shows First Street Bank’s financial position. The loans First Street Bank 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 either of cash in the bank’s vault or deposits at the Bank of Canada. On the right side we show the bank’s liabilities and equity, which in this example consist entirely of deposits made by customers at First Street Bank. These are liabilities because they represent funds that must ultimately be repaid to depositors. First Street Bank’s assets are larger than its liabilities and the difference is shown as an equity of $300 000. That’s the way it’s supposed to be! In fact, we’ll see shortly, if the bank’s equity is low or turns negative, the bank will suffer a bank run.

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. At one time, the Bank of Canada required banks to maintain a certain minimum reserve ratio, but this requirement was phased out between 1992 and 1994. In our current system, banks maintain whatever reserve ratio they think is appropriate to avoid running out of cash. Running out of cash could have serious consequences, such as a banking panic or a bank run.

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?

If a significant share of its depositors demand their money back at the same time, 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 Bank can sell its loan to Drive-A-Peach to someone else—another bank or an individual investor. But if First Street Bank tries to sell the loan quickly, potential buyers will be wary: they will suspect that First Street Bank 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 40%, for a sale price of $60 000.

The upshot is that if a significant number of First Street Bank’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 leads 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 Bank’s depositors to rush to pull their money out? A plausible answer is a spreading rumour that the bank is in financial trouble. Even if depositors aren’t sure the rumour 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.

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. Canada has not had a major bank run in over a century, not even during the Great Depression. (Two small Western banks did collapse in the 1980s, but these failures had little effect on our banking system.) So we will look at the American experience instead. The upcoming Economics in Action describes a 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, Canada and most other modern governments have established a system of bank regulations that protect depositors and reduce the likelihood of bank runs. We’ll encounter bank runs again in Chapter 17, which contains an in-depth analysis of financial crises and their aftermath.

Should you worry about losing money in Canada due to a bank run? No. Not only have banking crises been relatively rare in Canadian history and bank runs practically unheard of, but it looks as though that will continue to be the case. The World Economic Forum ranked our banking system as the safest in the world in recent years as our banks remain financially sound and stable in the wake of the Great Recession of 2008.

The financial viability of the Canadian banking system is maintained, in part, through the Bank of Canada’s willingness to loan money to banks that are fundamentally sound but temporarily lack cash. The federal agency principally responsible for supervising all financial institutions (not just banks) is the Office of the Superintendent of Financial Institutions (OSFI). The OSFI’s role is to administer the regulatory framework—in particular, banks’ capital requirements. In Canada, the stability of our financial systems hinges on three main tools at OFSI’s disposal: deposit insurance, capital requirements, and reserve requirements.

1. Deposit Insurance Almost every bank in Canada advertises itself as a “member of the CDIC”—the Canadian Deposit Insurance Corporation. The CDIC is a federal crown corporation created in 1967 to contribute to the stability of Canada’s financial system. As we saw in Chapter 10, the CDIC provides deposit insurance, a guarantee by the federal government that depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. As of 2006 the CDIC guarantees the first $100 000 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 rumour that the bank is in trouble. Since the provision of deposit insurance greatly diminishes the possibility of bank runs, this also allows banks to keep their (voluntary) reserve ratio at low levels.

2. Capital Requirements Deposit insurance does protect us against bank runs, but it also creates a big problem. Since depositors are protected from loss, they have no incentive to monitor their bank’s financial health. And, bank owners have an incentive to engage in overly risky investments, such as making speculative loans at high interest. If all goes well, the bank owners make large profits; if things go badly, the federal deposit insurance covers the losses. To reduce the incentive for taking excessive risk, there are capital requirements. Regulators require that bank owners hold substantially more assets than the value of their banks’ deposits. That way, a bank will still have assets greater than its deposits even if some of its loans go bad, and losses will be paid by the bank owners’ assets instead of by the government. The excess of a bank’s assets over its bank deposits and other liabilities is called the bank’s capital (or equity of the bank). In Canada, the OSFI requires that a bank’s capital is at least a minimum percentage of its assets. Figure 14-3 showed that First Street Bank has an equity of $300 000, or about 23% of its assets. In practice, a bank’s capital would be a smaller percent. The OSFI also recognizes that some capital is riskier than others, so it divides the banks’ capital into two categories: Tier 1 and Tier 2, with Tier 1 being the safer of the two. As of January 1, 2013, the minimum Tier 1 capital ratio was 4.5% and at least 3.5% of the Tier 1 capital ratio had to be in the form of common equity Tier 1 (CET1) capital. It is planned that by 2015, the percentage of capital requirements in the form of Tier 1 capital and CET1 capital will gradually increase to 6% and 4.5%, respectively. By increasing the Tier 1 capital ratio, the OSFI is increasing the financial strength of our banks. Assets that can be used to satisfy the capital requirements include common shareholders’ equity and non-cumulative, perpetual preferred shares. In general, banks hold a significant portion of their assets in the form of loans, mostly residential mortgage loans, but also loans to consumers and businesses, as well as government treasury bills and bonds.

3. Reserve Ratios At one time, the federal government required Canada’s chartered banks to hold a minimum part of their assets as non-interest-bearing reserves (placed on deposit at the Bank of Canada) as another safeguard against bank runs. This set of rules, known as reserve requirements, meant that banks had to maintain a higher reserve ratio than they might have held otherwise. However, the banks argued that reserve requirements put them at an unfair disadvantage because their competitors—foreign banks and Canadian non-bank financial institutions—were not subject to this law. The federal government agreed, and phased out reserve requirements by 1994.³

Although Canadian banks are no longer required to hold minimum reserves, they continue to do so voluntarily. In general, chartered banks maintain a relatively low desired (or voluntary) reserve ratio. Figure 14-4 shows Canada’s chartered banks’ desired reserves ratios from August 2003 to August 2012. Before 2008, the ratio was about 3.9%, but during the recession of 2008–2009 it rose to 4.9%. At this time, some of the largest financial institutions in the U.S. faced liquidity and solvency problems, so Canada’s chartered banks chose to hold more reserves to protect themselves against unexpected large withdrawals of deposits that might lead to a run. Once the recession was over, the reserve ratios fell back to pre-recession levels.