The Banking System: Deposit Creation by a Single Bank

Deposit Creation by a Single Bank During the second week of business, the executives of the newly organized bank in this example will advertise their services and drum up some loan business. But how much can they loan out? Suppose the bank's managers believe it's safe to keep 20 percent reserves against its deposits. Also assume that the regulatory authorities overseeing bank operations will not permit bank reserves to fall below 20 percent of deposits. The regulators set a required reserve ratio, which is the minimum percentage of deposits that the bank must hold in reserves. The bank can hold more than this minimum percentage of deposits in reserves if it wants, but it cannot hold less. The required reserve ratio is one of the tools the Federal Reserve System can use to control the amount of money in circulation.? Required reserves are the dollar value of currency and deposits in Federal Reserve banks that a bank must hold to meet current regulations. For our example the banks required reserves are $2 million, which equals 20 percent of current deposits. Excess reserves represent the difference between total reserves and required reserves held against deposits. Our bank currently holds $8 million in excess reserves. This is the excess of its $10 million total reserves over its $2 million required reserves. An individual bank can make loans in an amount up to the value of its excess reserves. This bank can therefore make up to $8 million in loans out of its initial deposits of $10 million when it operates under a 20-percent required reserve rule. Many local business firms that want funds to finance expansion, inventories, new equipment, and other investments come to the bank and fill out applications for credit. The bank managers carefully examine the applications and choose the most creditworthy businesses as their loan clients. Bank managers must be concerned about the risk of default, which is nonrepayment of the principal and interest, on each of its loans. The risk of default must be carefully balanced against the interest income the bank obtains from making any given loan. After the bank sorts through the applications and makes its decisions, it creates deposits for the clients to whom it makes loans. Usually a bank will require that its loan clients have an account at the bank. When the loan is approved, the bank simply adds the amount of the loan as a checkable deposit to the client's account. Assume this bank actually does lend out all its excess reserves by creating deposits for its clients on the first day of business of its second week of operation. The resulting balance sheet is shown in Box 2. The bank now has $18 million in deposits, of which $8 million represents the proceeds of the loans it has just made. Because the newly created deposits didn't result from inflows of currency or from an increase in deposits in the bank's Federal Reserve account, reserves do not increase. Total reserves remain $10 million on the day the loans are made. The bottom line of both sides of the bank's balance sheet increases by $8 million on the first day of business of week 2 as the bank acquires assets in the form of loans of $8 million balanced by $8 million of newly created liabilities in the form of deposits. By making loans in this way, the bank has created $8 million of checkable deposits. It therefore has created money equal to its initial amount of excess reserves. How Checks Drawn on Newly Created Deposits Affect an Individual Bank's Balance Sheet If the $8 million of newly created deposits were to remain in the bank, required reserves would be $1.6 million, and it would still have $6.4 million of excess reserves. However, the bankers know that the newly created deposits resulting from the $8 million in loans will be quickly withdrawn as the business firms use their loaned funds to finance their investments. Because there are many banks comprising the banking system, spent loan proceeds are unlikely to be redeposited in the bank that initially created the checkable deposit. For example, suppose this bank is located in Denver, Colorado. A firm that receives a loan of §1 million uses the funds to purchase a new conveyor system for its factory. The conveyor system is purchased from a firm in Detroit, Michigan. The SI million check that is written to pay for the conveyor system is therefore deposited in a Detroit bank. The Detroit bank sends the check to its district Federal Reserve bank and requests that it be deposited in its account there. The Federal Reserve bank will then send the check to the Denver bank's district Federal Reserve bank where it will reduce the balance in the Denver bank's account by $1 million. When the Denver bank finally gets the check back, it will reduce by $1 million the sum in the account of the firm that wrote the check. The process of transferring Federal Reserve deposits among banks as checks are paid is called check clearing. Because the Federal Reserve deposits held by banks constitute their reserves, the clearing of the $1 million check will reduce the Denver bank's reserves by $1 million and increase the Detroit bank's reserves by $1 million. Check clearing, which is handled by specialized firms and the Federal Reserve bank, usually takes a few days. The Denver bank can expect all of its $8 million of newly created deposits to clear through the banking system in this way and end up as deposits in other banks. Box 3 shows the Denver bank's balance sheet at the end of the week after all its newly created deposits have been drawn on by the loan clients and the checks have cleared. Look at the liability side of the balance sheet. The bank now has only $10 million of deposits because its $8 million of newly created deposits has been drawn down and paid to other banks. Its net worth remains $500,000. Its assets now consist of $8 million in loans, $500,000 in property, and only $2 million in reserves. What happened to the $8 million in excess reserves that the bank had during its first week? These were paid out to other banks as the checks drawn on the loans cleared. The Denver bank had its account at its district Federal Reserve bank debited by $8 million after all the checks cleared that were written on the newly created checkable deposits. The bank no longer has any excess reserves. It therefore cannot make any more loans. When a bank's excess reserves are zero, the bank is said to be loaned up. This bank will remain loaned up until it obtains more reserves from cash deposits or deposits of checks drawn on other banks that increase the sums in its Federal Reserve account. There's an important difference between deposits that a single bank creates by making loans and those it obtains from customers who actually deposit cash or from checks drawn on other banks. The latter type of deposits increases the bank's reserves, while created deposits do not. This bank cannot create any more checkable deposits by making loans until it receives more deposits that increase its reserves. In general, its reserves will go up if it receives deposits of cash or of checks that are drawn on other banks. Any type of deposit that increases the cash in the bank's vault or its own deposits at its Federal Reserve bank will increase the bank's excess reserves and allow it to make more loans.