Banking

Originally, money existed in the form of coins made of precious metals. Banknotes represented a promise to provide precious metals on request. After a transaction involving banknotes, there would eventually be a reconciliation where precious metals changed hands. This is called ‘cloakroom banking.’ Over time, the banknotes themselves took on acceptability as a form of money in their own right. The recipient of a banknote would simply exchange it for other goods, never requiring conversion to the actual precious metals underlying its value. As a result, banks found they could issue banknotes in excess of their holdings of precious metals and still maintain convertibility. Thus, the banks became manufacturers of money, practicing ‘fractional-reserve banking.’

Any fractional reserve banking system depends on its ability to maintain confidence and convertibility. The power of banks to issue banknotes in excess of their deposits was sometimes abused, and when confidence weakened, this could result in an inability to maintain convertibility—and the collapse of the bank. To avoid this outcome, banks became regulated by the government. Eventually the right to create banknotes was vested in a state-controlled central bank, and the commercial banks turned to deposit banking. The commercial banks are still able to create money, not by issuing banknotes, but by creating deposit accounts in excess of their cash reserves. The banks have to be able to convert deposit accounts to cash on demand, but by long experience have found that if cash reserves meet or exceed some ratio of total deposits, this is sufficient to maintain convertibility under all normal situations. This is not a foolproof system; banks can still go broke. But since banks can create deposit balances larger than the cash balance they hold, they are still manufacturers of money.

Generally speaking, the greater the liquidity of an asset, the less profitable it is. Banks therefore do not want to keep their assets in liquid forms such as cash. However, in order to satisfy their customers’ demands for cash, at least some of the bank’s assets must be in cash or short-term liquid forms. The bank will have to choose a cash ratio that is believed to be sufficient to meet demands for cash, and act to maintain cash reserves at the level this ratio indicates.

As an example, consider a monopoly commercial bank, with a desired cash ratio of 10%. For simplicity, assume that members of the public wish to hold a constant amount of cash, and will immediately deposit all cash they receive above this amount; in other words, the public’s marginal propensity to hold cash is zero.

On the first day, the bank opens its doors and a member of the public deposits $100. The bank’s balance sheet will read:

Assets	Liabilities
Cash $100	Deposit $100

The bank’s cash ratio is now 100%, which is well above its desired ratio of 10%. The bank will therefore act to bring the cash ratio back to its desired level. In order to do so, it must create deposits actively. It can do this in two ways: Making loans to customers, and purchasing securities. When the bank makes a loan, it issues a check drawn on itself  (but no cash) in exchange for a promise to pay back the loan amount plus interest. Similarly, when the bank purchases securities it pays for them with a check drawn on itself and expects to receive dividends or coupon payments as a result. Because the bank is a monopoly and the public’s marginal propensity to hold cash is zero, the deposit creation process cannot reduce the bank’s cash reserves; there is no leakage of cash back to the public because any cash that gets out to the public is immediately returned to the bank. In addition, if the bank issues a check drawn on itself as payment for loans or securities, this check will immediately be returned to the bank to credit the account of the household or firm to whom the loan was made or from whom the securities were purchased. If we assume that on day two the bank returns to its desired cash ratio by purchasing $600 in bonds and issuing $300 in loans, the new balance sheet will be:

Assets	Liabilities
Cash $100	Deposit $1000
Bonds $600
Loans $300

This is an equilibrium position because the cash ratio is 10% as desired by the bank. The change in deposits required for any given change in cash holdings is given by: DD=dDC, where d is the credit multiplier, which is simply the reciprocal of the cash ratio. In this case, if the cash ratio is 10%, the credit multiplier is 10. Whatever change occurs to the bank’s cash holdings must be multiplied by 10 to determine the change that will occur in the bank’s total deposits.

The initial assumptions of a monopoly bank and zero cash leakage are somewhat unrealistic. The monopoly assumption is not really necessary: If many banks exist, the process of deposit creation becomes more complicated, but the result is the same. From the individual bank’s perspective, any deposit creation must reduce its cash reserves. When a bank issues loans and purchases securities through checks drawn on itself, some of these checks will be deposited at other banks. This will result in a cash drain to the bank creating the deposits. As cash reserves decrease and deposits increase, the bank will reach an equilibrium position where the cash ratio equals the desired value, but it will do so more quickly and with less total deposits on the books than the monopoly bank. However, even though there is a leakage of cash from the individual bank, the total amount of cash held by the banking system as a whole has not changed. Other banks’ cash reserves have increased by the same amount by which the first bank’s reserves have decreased. These other banks, if they were in equilibrium to begin with and if they desire the same cash ratio as the first bank, will now desire to issue loans and buy securities to restore their own cash ratios. For the banking system as a whole, the change in deposits will still equal the change in cash reserves times the credit multiplier.

Removing the assumption of zero marginal propensity to hold cash, however, does change the situation somewhat. If this is greater than zero, then any increase in deposits will result in some additional cash staying with the public, resulting in a ‘leakage’ from bank cash reserves. In this event, the banks will not be able to increase deposits by the full credit multiplier; the amount by which deposits will increase for any given increase in cash reserves will be d(1-MPHC). The ability of banks to create deposits is therefore limited by two factors: The public’s propensity to hold cash, and the banks’ propensity to keep cash for liquidity purposes as represented by the desired cash ratio.

All modern economies have a central bank, responsible for controlling the commercial banks in such a way as to support the monetary policy of the economy. The central bank conducts its business by acting as a banker’s bank, or lender of last resort, and also as the government’s bank and the manager of public debt. The central bank attempts to influence the level of economic activity through regulating the supply of money and the availability and cost of credit. In most countries, the central bank has many instruments of control, including a monopoly over the creation of bank notes, the ability to dictate the minimum cash ratio which must be observed by the commercial banks, regulatory authority over consumer credit, and ultimately the ability to issue direct instructions to the commercial banks and other financial institutions.

The most important instrument of control available to the central bank is the buying and selling of government bonds in the open market. If the central bank buys bonds, it pays for them with a check drawn on itself and payable to the seller, say a private citizen. The seller will then deposit the check with the commercial bank where they hold an account, which will then present the check for payment by the central bank. This payment will increase the cash reserves of the commercial bank, which will then increase its deposits by a credit multiplier factor to bring its cash ratio back to the desired level. On the other hand, if the central bank sells bonds, it expects payment in the form of a check drawn on a commercial bank. It will present this check for payment, resulting in a transfer from the commercial bank back to the central bank, reducing the cash reserves of the commercial bank and therefore requiring a multiplied reduction in deposits to restore liquidity.

These open market operations also affect the cost of borrowing. If the central bank acts to expand the money supply by buying bonds, commercial banks will desire to make more loans. Since the supply of loans is now greater, and assuming the demand curve has not changed, the ‘price’ of loans—the interest rate—will decrease. Conversely, if the central bank restricts the money supply by selling bonds, commercial banks will cut down on the number of loans they want to make, thus raising interest rates. Monetary policy can therefore affect aggregate demand and therefore the level of output, income and expenditure. When interest rates fall (rise), investment expenditure increases (decreases) and therefore aggregate demand increases (decreases) by some multiplier. The process is as follows:

1.       The government desires to conduct an expansionary (restrictive) monetary policy, so the central bank buys (sells) government bonds on the open market—or perhaps simply changes the cash ratio required of commercial banks.

2.       The increase (decrease) in cash reserves of the commercial banks will have a magnified effect on deposits, through the credit multiplier. Thus the money supply will increase (decrease) by a multiple of the change in cash reserves.

3.       The increase (decrease) in the money supply will reduce (raise) the cost of borrowing. Interest rates will fall (rise) as a result.

4.       The change in interest rates will cause a movement along firms’ marginal efficiency of investment schedules. This movement will lower (raise) the standard to which business investments are compared. Firms will therefore take on more (less) investments.

5.       Through the multiplier process, the increase (decrease) in investment expenditure will lead to a magnified increase (decrease) in national income, output and expenditure.