18.2 The Monetary Role of Banks

Roughly 40% of M1, the narrowest definition of the money supply, consists of currency in circulation—$1 bills, $5 bills, and so on. It’s obvious where currency comes from: it’s printed 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.

What Banks Do

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A bank 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.

Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve.

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 U.S. 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 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.

A T-account is a tool for analyzing a business’s financial position by showing, in a single table, the business’s assets (on the left) and liabilities (on the right).

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 18-2 shows the T-account for a hypothetical business that isn’t a bank—Samantha’s Smoothies. According to Figure 18-2, 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. 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.

Figure 18.2: FIGURE 18-2 A T-Account For Samantha’s Smoothies
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Figure 18.2: A T-account summarizes a business’s financial position. Its assets, in this case consisting of a building and some smoothie-making machinery, are on the left side. Its liabilities, consisting of the money it owes to a local bank, are on the right side.

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 18-3 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 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 Bank. These are liabilities because they represent funds that must ultimately be repaid to depositors.

Figure 18.3: FIGURE 18-3 Assets and Liabilities of First Street Bank
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Figure 18.3: First Street Bank’s assets consist of $1,200,000 in loans and $100,000 in reserves. Its liabilities consist of $1,000,000 in deposits—money owed to people who have placed funds in First Street’s hands.

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Notice that in this example First Street Bank’s assets are larger than its liabilities. That’s the way it’s supposed to be! Banks are required by law to maintain assets larger by a specific percentage than their liabilities.

The reserve ratio is the fraction of bank deposits that a bank holds as reserves.

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 minimum required reserve ratio that banks are required to maintain. To understand why banks are regulated, let’s consider a problem banks can face: bank runs.

The Problem of Bank Runs

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 demanded 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 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.

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.

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 upcoming Economics in Action 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 protect depositors and prevent most bank runs.

Bank Regulation

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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 four main features: deposit insurance, capital requirements, reserve requirements, and, in addition, banks have access to the discount window, a source of cash when it’s needed.

Deposit insurance guarantees that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account.

1. 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. The FDIC currently guarantees the first $250,000 per depositor, per insured bank.

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.

2. 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; 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 still have assets larger than its deposits even if some of its loans go bad, and losses will accrue against the bank owners’ assets, not 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 $300,000, equal to $300,000/($1,200,000 + $100,000) = 23% 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 are rules set by the Federal Reserve that determine the minimum reserve ratio for banks.

3. Reserve Requirements Another regulation used to reduce the risk of bank runs is reserve requirements, rules set by the Federal Reserve that specify the minimum reserve ratio for banks. For example, in the United States, the minimum reserve ratio for checkable bank deposits is 10%.

The discount window is an arrangement in which the Federal Reserve stands ready to lend money to banks in trouble.

4. The Discount Window One final protection against bank runs is the fact that the Federal Reserve, which we’ll discuss more thoroughly later in this chapter, stands ready to lend money to banks in trouble, an arrangement 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 Fed and borrow the funds it needs to pay off depositors.

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It’s a Wonderful Banking System

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Next Christmastime, it’s a sure thing that at least one TV channel will show the 1946 film It’s a Wonderful Life, featuring Jimmy Stewart as George Bailey, a small-town banker whose life is saved by an angel. The movie’s climactic scene is a run on Bailey’s bank, as fearful depositors rush to take their funds out.

When the movie was made, such scenes were still fresh in Americans’ memories. There was a wave of bank runs in late 1930, a second wave in the spring of 1931, and a third wave in early 1933. By the end, more than a third of the nation’s banks had failed. To bring the panic to an end, on March 6, 1933, the newly inaugurated president, Franklin Delano Roosevelt, declared a national “bank holiday,” closing all banks for a week to give bank regulators time to close unhealthy banks and certify healthy ones.

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In July 2008, panicky IndyMac depositors lined up to pull their money out of the troubled California bank.
Gabriel Bouys/AFP/Getty Images

Since then, regulation has protected the United States and other wealthy countries against most bank runs. In fact, the scene in It’s a Wonderful Life was already out of date when the movie was made. But recent decades have seen several waves of bank runs in developing countries. For example, bank runs played a role in an economic crisis that swept Southeast Asia in 1997–1998 and in the severe economic crisis in Argentina that began in late 2001. And a “panic” with strong resemblance to a wave of bank runs swept world financial markets in 2008 during the financial crisis.

Notice that we said most bank runs. There are some limits on deposit insurance; in particular, in the United States currently only the first $250,000 of an individual depositor’s funds in an insured bank is covered. As a result, there can still be a run on a bank perceived as troubled. In fact, that’s exactly what happened in July 2008 to IndyMac, a Pasadena-based lender that had made a large number of questionable home loans. As questions about IndyMac’s financial soundness were raised, depositors began pulling out funds, forcing federal regulators to step in and close the bank. In Britain the limits on deposit insurance are much lower, which exposed the bank Northern Rock to a classic bank run that same year. Unlike in the bank runs of the 1930s, however, most depositors at both IndyMac and Northern Rock got all their funds back—and the panics at these banks didn’t spread to other institutions.

Quick Review

  • A T-account is used to analyze a bank’s financial position. A bank holds bank reserves—currency in its vaults plus deposits held in its account at the Federal Reserve. The reserve ratio is the ratio of bank reserves to customers’ bank deposits.

  • Because bank loans are illiquid, but a bank is obligated to return depositors’ funds on demand, bank runs are a potential problem. Although they took place on a massive scale during the 1930s, they have been largely eliminated in the United States through bank regulation in the form of deposit insurance, capital requirements, and reserve requirements, as well as through the availability of the discount window.

Check Your Understanding 18-2

Question 18.4

1. Suppose you are a depositor at First Street Bank. You hear a rumor that the bank has suffered serious losses on its loans. Every depositor knows that the rumor isn’t true, but each thinks that most other depositors believe the rumor. Why, in the absence of deposit insurance, could this lead to a bank run? How does deposit insurance change the situation?

Even though you know that the rumor about the bank is not true, you are concerned about other depositors pulling their money out of the bank. And you know that if enough other depositors pull their money out, the bank will fail. In that case, it is rational for you to pull your money out before the bank fails. All depositors will think like this, so even if they all know that the rumor is false, they may still rationally pull their money out, leading to a bank run. Deposit insurance leads depositors to worry less about the possibility of a bank run. Even if a bank fails, the FDIC will currently pay each depositor up to $250,000 per account. This will make you much less likely to pull your money out in response to a rumor. Since other depositors will think the same, there will be no bank run.

Question 18.5

2. A con artist has a great idea: he’ll open a bank without investing any capital and lend all the deposits at high interest rates to real estate developers. If the real estate market booms, the loans will be repaid and he’ll make high profits. If the real estate market goes bust, the loans won’t be repaid and the bank will fail—but he will not lose any of his own wealth. How would modern bank regulation frustrate his scheme?

The aspects of modern bank regulation that would frustrate this scheme are capital requirements and reserve requirements. Capital requirements mean that a bank has to have a certain amount of capital—the difference between its assets (loans plus reserves) and its liabilities (deposits). So the con artist could not open a bank without putting any of his own wealth in because the bank needs a certain amount of capital—that is, it needs to hold more assets (loans plus reserves) than deposits. So the con artist would be at risk of losing his own wealth if his loans turn out badly.

Solutions appear at back of book.