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Creation
Commercial Banking
So far we have looked at financial services in the form of life insurance and
general insurance, pension plans and mutual funds
Savings banks, mortgage banks, cooperative banks and credit unions are
commercial bank - like following deregulation and M&A.
The major difference in these different types of deposit taking institution is the
type of loan over which they specialise. e.g. savings and loans, mortgage banks
(e.g. building societies in the UK), and mutual savings banks specialise in
residential mortgages, and credit unions in consumer loans.
Externally, and from the point of view of the general public and firms, it is not so
easy to tell deposit taking institutions apart.
Balance Sheet of all Commercial Banks (items as a % of total, end 2001)
Source: www.federalreserve.gov/releases/z1/current/z1r-4.pdf
1 In order of decreasing liquidity
Balance Sheet Items of Commercial Banks
Assets
Note the low Reserves i.e. physical notes and coins. Reserves meet obligations
when depositors make withdrawals or payments. Earn no interest
Securities are income earnings safe assets, i.e. not equities, and they are liquid.
72% of assets are in the form of loans. A loan is an asset as the bank receives
income from it. Loans are less liquid - the cash is only realised at loan maturity.
Banks also lend to one another interbank loans tend to be overnight
Other assets include physical capital e.g. the banks offices, land, computers
Balance Sheet Items of Commercial Banks
Liabilities
Sight deposits are very liquid. Note ratio of Reserves to Sight Deposits
Time deposits used to be less liquid. Often banks now offer automatic transfer
between sight and time accounts so becoming more liquid
Borrowings include funds borrowed from the central bank so as to have enough
reserves to meet regulatory requirements, and amounts borrowed from the
parent bank, and other institutions.
Bank capital is the banks net worth, the difference between total assets and
liabilities. Altered by issuing new equity or from retained earnings.
Basic Account Operation of a Commercial Bank
Setting 1
Jane Brown opens a sight account at First National Bank and deposits $100
Reserves pay no interest so bank earns nothing from the $100 of assets.
Servicing the $100 deposit is costly the bank must keep records, pay tellers,
process cheques, service cash machines, and pay interest on the deposit.
The bank must put to productive use all or part of the $100 assets
Basic Account Operation of a Commercial Bank
Setting 2
Regulators require the bank to keep 10% of sight deposits as reserves
Assume the bank knows that 10% of deposits is sufficient to meet day-to-
day withdrawals. It has $90 excess reserves to use
Basic Account Operation of a Commercial Bank
Setting 3
Short-term liabilities are used to buy longer-term assets such as loans with
higher rates of interest.
If the bank earns 10% in interest on its loans it earns $9 in the year.
If interest on the sight deposit is 3%, or $3, and it costs a further $3 to maintain
and service the account the cost per year of these deposits is $6.
liquidity management - ensuring sufficiently liquid assets are held to meet the
banks account payments and withdrawals obligations to depositors
When there are sufficient reserves what happens when $10m of payments or
withdrawals are made from deposit holders
Required reserves are $10m i.e. 10%. Excess reserves are $10m.
First National Bank
Assets Liabilities
Reserves $20m Deposits $100m
Loans $80m Bank Capital $10m
Securities $10m
Excess reserves are now $1m i.e. (required reserves are 10% of $90m). If a bank
has ample reserves a deposit outflow does not necessitate changes in other parts
of its balance sheet.
If depositors suddenly demand $10m the bank is short $9m reserves (10% of
$90m). The bank needs to deposit $9m at the Central Bank.
First National Bank
Assets Liabilities
Reserves $0m Deposits $90m
Loans $90m Bank Capital $10m
Securities $10m
Liquidity Management
1. Borrow from other banks or corporations. The cost is the interest on the loans.
First National Bank
Assets Liabilities
Reserves $9m Deposits $90m
Loans $90m Borrowings $9m
Securities $10m Bank Capital $10m
2. Sell some securities. The bank incurs brokerage, transaction costs, and risks
of selling when fixed income prices are low.
First National Bank
Assets Liabilities
Reserves $9m Deposits $90m
Loans $90m Bank Capital $10m
Securities $1m
Liquidity Management
3. Borrow from Central Bank. If bank borrows frequently the CB may prevent
further borrowing. Reputational damage of poor cash management and liquidity
4. Reduce loans. Short-term loans renewed at short intervals are not renewed
when they come due. The bank reduces the amount of loans outstanding fairly
quickly. May antagonize customers whose loans are not renewed. Or can sell
some of loans to other banks
First National Bank
Assets Liabilities
Reserves $9m Deposits $90m
Loans $81m Bank Capital $10m
Securities $10m
Liquidity Management
Excess reserves are an opportunity cost. the earnings forgone by not holding
income earnings assets.
The higher the interest rate the greater the opportunity cost
The bank must balance a desire for liquidity against a desire for return.
Asset Management
A bank must simultaneously obtain the highest return possible on loans and
securities, at low risk, whilst maintaining liquidity.
To achieve high returns loans are preferred. To achieve low risk banks diversify
across assets. To maintain liquidity significant amounts are held in Treasuries.
Liability Management
The development of interbank loans and CDs mean that banks do not need to
rely on deposits as the main source of bank funds.
Banks no longer need to think of their liabilities as a given. This frees them to
set targets for asset growth and to issue liabilities as needed.
A bank faced with an attractive loan opportunity can readily acquire the funds to
undertake the loan
Capital Adequacy Management
Example: Two banks, one with a ratio of capital to assets of 10%, and one with a
ratio of 4%
$5m loans go bad, and when written off are valued at 0. Assets decline by $5m,
and so therefore do liabilities.
High Capital Bank still has a positive net worth. Low Capital Bank now has a
negative net worth and is insolvent there are insufficient assets to pay all
holders of liabilities (creditors).
Capital Adequacy Management
Government regulators close Low Capital Bank, sell off its assets to repay
creditors, and fire the managers.
Why did the managers of Low Capital Bank hold less capital? Because of the
effect on profitability.
A key measure of bank profitability is ROE, net profit after tax per dollar of equity
capital:
The lower the bank capital for a given level of profit the higher the return for the
owners of the bank.
The owners of Low Capital Bank were happiest, at the time, earning twice the
return.
Owners do not want the bank to hold much capital for it reduces ROE.
Managers must decide how much safety from more capital they are willing to
trade-off against lower return. Bank capital has an opportunity cost.
The basic concept of the capital ratio is that there needs to be a prudent
relationship between capital and assets. When banks lend money and some
people inevitably default banks can still repay depositors should they need to.
The buffer, the money that the bank can rely on, is capital, and it is mostly
shareholder funds.
Regulation plays an important role. There are minimum capital requirements and
there are maximum exposures to companies, sectors, and countries.
Bank Performance Statistics, 1985 2001
Year Return on Return on Net Interest
Assets % Equity % Margin
1985 0.72 11.67 3.62
1986 0.64 10.30 3.48
1987 0.09 1.54 3.40
1988 0.82 13.74 3.57
1989 0.50 7.92 3.58
1990 0.49 7.81 3.50
1991 0.53 8.25 3.60
1992 0.94 13.86 3.89
1993 1.23 16.30 3.97
1994 1.20 15.00 3.95
1995 1.17 14.66 4.29
1996 1.19 14.45 4.27
1997 1.23 14.69 4.21
1998 1.18 13.30 3.47
1999 1.31 15.31 4.07
2000 1.19 14.02 3.95
2001 1.17 13.42 3.84
All Federally Insured Commercial Banks. Source: http://www2.fdic.gov/qbp
Credit / Money Creation by Commercial Banks
Example: You request a lending facility of 2000. The bank opens an account
for you and issues you a debit card and cheque book. You wander down the
high street buying goods to the value of 2000. The shops you bought from
present their electronic or cheque receipts from you to their banks for payment.
3 days later the banks have their money and your account is debited. Your bank
has created 2000 of expenditure where it did not exist 1 week earlier. The shop
owners you bought from are 2000 richer in cash. Where did the money come
from? Not from you because you did not have any. It came from the bank, which
offered you an overdraft. The bank has created money.
In actual fact a commercial bank does not re lend notes and coin. When it offers
a loan and credits a persons account it does not physically deliver notes and
coins to the persons house! It holds the notes and coins as reserves and lends
a multiple of these by creating deposits.
Money Creation by the Banking System
Assume a reserve ratio of 10%. The non-bank private sector has 1,000 in
wealth held as cash in their pockets. The banks therefore have none of this.
Assets Liabilities
Now people pay the 1,000 cash into banks by opening bank deposits. Banks
have assets of 1,000, and liabilities of 1,000 of deposits.
Assets Liabilities
Intermediate Position Cash 1,000 Deposits 1,000
Banks only need 10% (in this example) of all the deposits to be covered by cash
reserves. So they create 9,000 loans which customers can write cheques
against etc. Money in the economy has increased from 1,000, to 10,000.
Assets Liabilities
Final Position Cash 1,000 Deposits 10,000
loans 9,000
Bank Credit Creation - Narrow and Broad Money UK Money for 2001
Deposits are 904bn or 27x the monetary base of 33bn set by the central bank.
The banks have used the monetary base and expanded it 27x. They have
created money - the monetary base is only 3.7% of the total stock of money.
Source for Table: Bank of England in Begg, Fischer, & Dornbusch (2003) Economics
Money Creation by Banks
Monetary Base
33bn
26bn 7bn
Notes and Coins in Circulation
Banks
Multiplication of
Cash Reserves
into Deposits
Money Supply
904bn
The monetary base is physical notes and coins issued by the central bank. It is
held either as cash with the public or as cash at banks reserves.
When more of the monetary base is deposited in banks, banks can create
more deposits.
Money Creation by the Banking System
The cash reserve ratio that banks maintain relative to deposits determines
credit creation. Reserves as a fraction of deposits in the 2001 UK data
are :
R = cb x D rearranging cb = R / D
Where R is reserves (cash issued by the central bank and held by banks), cb is
the ratio of cash reserves to deposits, and D is deposits (D includes
reserves held by banks as these are their own deposits)
The notes and coins that the public wish to hold as a proportion of their
deposits reveals the desired ratio of cash holdings. The publics cash
holdings as a fraction of deposits in the UK data are:
C = cp x D rearranging cp = C / D
Where C is cash in circulation held by the public, cp is the ratio of notes and
coins held by the public to deposits, and D is deposits
Money Creation by the Banking System
It should now be clear that the lower is banks desired ratio of cash reserves
to total deposits the more deposits they create against a given level of
cash reserves and the greater is their credit creation
Banks will wish to lend more and risk a low ratio of cash reserves to deposits
the higher is the interest rates spread, the more predictable are
withdrawals, or the more the lending opportunities for liquid loans.
It should also be clear that the lower is the publics desired ratio of cash to
bank accounts the greater is the amount of the monetary base deposited
in banks and the greater is banks credit creation.
The publics desired ratio of cash to their deposits will reflect interest rates,
seasonal effects, and institutional factors such as the method firms use to
pay wages, the extent of tax evasion and the black economy, and the
availability of cheque books, credit and debit cards and electronic purses.
Money Creation by the Banking System
Finally, the money multiplier is the extent to which banks multiply up the
monetary base to arrive at the final money stock:
= 904 / 33 = 27
An alternative calculation