The Banking System: Banks Make Loans and Create Checkable Deposits

Banks Make Loans and Create Checkable Deposits The term bank is generally used to refer to commercial banks and thrift institutions that offer checkable deposits. In fact, the banking industry in the United States consists of about 12,000 commercial banks, 3,000 savings and loan associations (some of which are now simply called savings banks), 400 mutual savings banks, and 20,000 small credit unions. Each of these institutions offers checkable deposits, time deposits, and makes loans to businesses and households, extends credit to governments, and provides other financial services. How a Bank Accepts Deposits and Makes Loans To understand how the banking system of a modern nation operates, it's useful to begin by analyzing the operations of a single bank in a fractional reserve banking system. By examining the way a single bank accepts deposits and makes loans, you'll begin to understand how a modern banking system can actually create money in the same way the ancient goldsmiths created receipts. The reserves of a modern bank in the United States consist of balances kept on deposit with the Federal Reserve bank in its district or as currency in its vault. The 12 regional Federal Reserve banks serve the function of "banker's bank" in which banks have accounts just as you have accounts at your bank. The Federal Reserve System seeks to control the money stock and, as you'll see shortly, requires banks to maintain a certain minimum fractional reserve ratio. A bank's operations can be greatly clarified by examining its balance sheet, a statement of its assets and the claims against those assets. A balance sheet summarizes the financial position by showing the relationship between a bank's loans, property, reserves, and the claims that can be made on the bank by its creditors and owners. A bank's most important creditors are its depositors, who place their funds in the bank for safekeeping and who have the right to withdraw those funds. The deposits that customers place in the bank are part of the bank's liabilities; they are debts of the bank to the depositors. The bank's assets are property, cash, and debts owed to the bank, which include loans and any marketable securities the bank holds, such as Treasury bills and other notes of indebtedness. The net worth of the bank is the difference between its assets and liabilities. Liabilities and net worth are two types of claims made against a bank's assets. The liabilities of the bank are the claims of its depositors and other creditors who are not owners of the bank. The net worth of the bank is the claim the bank's owners have to its assets after the claims of its creditors have been met. To understand how a bank can create money, we need to examine the relationship between its assets, liabilities, and net worth. The function of a balance sheet is to divide the claims against assets into two mutually exclusive categories-liabilities and net worth. In other words, the bottom line of a balance sheet always shows that: Assets = Liabilities + Net worth The balance sheet equation is actually an identity because it must always hold by definition. Box 1 shows the balance sheet of a bank that has just opened for business. After one week, the bank has attracted $10 million in deposits. Assume these are all deposits of currency. The deposits don't actually increase the money stock. They simply convert currency to checkable deposits, which are the bank's liabilities. The bank has yet to extend any loans. The $10 million in currency that the bank accepts is deposited as reserves in the bank's own account at its district Federal Reserve bank. These reserves constitute part of the bank's assets because they are a sum of money owed to the bank. When the bank needs currency to meet the demands of its depositors, it can draw on its account at the Federal Reserve bank and request a delivery of currency. (Remember that currency is issued by the Federal Reserve banks.) The bank also has other assets in the form of structures and equipment that constitute its physical plant. Assume the value of the bank's property is $500,000. As shown in Box 1, the bank's assets consist of $10 million of reserves and $500,000 of property. Its liabilities are $10 million of checkable deposits. Its net worth, which is the portion of its assets not owed to creditors or other nonowners, is $500,000. The total assets of $10.5 million exactly equal the sum of liabilities and net worth of $10.5 million. With reserves equal to its deposits, the bank is like the goldsmith who doesn't issue any more receipts than the gold on deposit. The bank cannot make any loans as long as it keeps reserves equal to 100 percent of its deposits. Its only source of income will be the fees it charges its depositors for the services it provides.