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Customers queued for up to an hour and, as news of the
Bank of England bailout spread, the throng inside the branch
was so dense that some struggled to open the door.
Gary Diamond beat the crowd by arriving early. “I came
down here to withdraw my funds because I™m concerned that
Northern Rock are not still going to be in existence,” he said
after closing his accounts. He added that there was a danger
that if others followed suit it could worsen Northern Rock™s posi- SOURCE: Times Online, September 14, 2007.

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Part 3
250 Fiscal and Monetary Policy

Principles of Bank Management: Profits versus Safety
Bankers have a reputation for conservatism in politics, dress, and business affairs. From
what has been said so far, the economic rationale for this conservatism should be clear.
Checking deposits are pure fiat money. Years ago, these deposits were “backed” by noth-
ing more than a particular bank™s promise to convert them into currency on demand. If
people lost trust in a bank, it was doomed.
Thus, bankers have always relied on a reputation for prudence, which they achieved in
two principal ways. First, they maintained a sufficiently generous level of reserves to
minimize their vulnerability to runs. Second, they were cautious in making loans and invest-
ments, because large losses on their loans could undermine their depositors™ confidence.
It is important to realize that banking under a system of fractional reserves is an inher-
ently risky business that is rendered safe only by cautious and prudent management.
America™s long history of bank failures (see Figure 1) bears sober testimony to the fact that
many bankers were neither cautious nor prudent. Why not? Because caution is not the
route to high profits. Bank profits are maximized by keeping reserves as low as possible
and by making at least some loans to borrowers with questionable credit standing who
will pay higher interest rates.
The art of bank management is to strike the appropriate balance between the lure of
profits and the need for safety. If a banker errs by being too stodgy, his bank will earn inad-
equate profits. If he errs by taking unwarranted risks, his bank may not survive at all.

Bank Regulation
But governments in virtually every society have decided that profit-minded bankers will
not necessarily strike the balance between profits and safety exactly where society wants
it. So they have constructed a web of regulations designed to ensure depositors™ safety and
to control the money supply.

Deposit Insurance The principal innovation that guarantees the safety of bank de-
posits is deposit insurance. Today, most U.S. bank deposits are insured against loss by the
Deposit insurance is a
system that guarantees that Federal Deposit Insurance Corporation (FDIC)”an agency of the federal government. If your
depositors will not lose bank belongs to the FDIC, as almost all do, your account is insured for up to $100,000
money even if their bank
regardless of what happens to the bank. Thus, while bank failures may spell disaster for
goes bankrupt.
the bank™s stockholders, they do not create concern for many depositors. Deposit insur-
ance eliminates the motive for customers to rush to their bank just because they hear some
bad news about the bank™s finances. Many observers give this innovation much of the
credit for the pronounced decline in bank failures after the FDIC was established in 1933”
which is apparent in Figure 1.
Despite this achievement, some critics of FDIC insurance worry that depositors who are
freed from any risk of loss from a failing bank will not bother to shop around for safer banks.
This problem is an example of what is called the moral hazard problem: the general idea
Moral hazard is the idea
that people insured against that, when people are well insured against a particular risk, they will put little effort into
the consequences of risk making sure that the risk does not occur. (Example: A business with good fire insurance may
will engage in riskier
not install an expensive sprinkler system.) In this context, some of the FDIC™s critics argue
that high levels of deposit insurance actually make the banking system less safe.

Bank Supervision Partly for this reason, the government takes several steps to see
that banks do not get into financial trouble. For one thing, various regulatory authorities
conduct periodic bank examinations to keep tabs on the financial conditions and business
practices of the banks under their purview. After a rash of bank failures in the late 1980s
and early 1990s (visible in Figure 1(b)), U.S. bank supervision was tightened by legisla-
tion that permits the authorities to intervene early in the affairs of financially troubled
banks. Other laws and regulations limit the kinds and quantities of assets in which banks may
invest. For example, banks are permitted to own only limited amounts of common stock.
Both of these forms of regulation, and others, are clearly aimed at keeping banks safe.
That said, there is no such thing as perfect safety, as the subprime mortgage debacle of
2007 illustrated (see the box on the next page).

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Chapter 12 251
Money and the Banking System

What Happened to the Subprime Mortgage Market?
Federal Reserve stepped in to quell the panic by lending massively
One valuable, but also somewhat risky, innovation in American
to banks and then cutting interest rates.
banking during the past decade was the rapid expansion of so-called
The medicine helped a bit, but losses from the housing downturn
subprime mortgages, meaning loans to prospective homeowners
continued, banks remained Jittery, and credit became harder to
with less-than-stellar credit histories. Often, these borrowers were
obtain. By early 2008, talk of an impending recession was rampant.
low-income and poorly educated people. Naturally, bankers expected
higher default rates on subprime loans than on prime loans, and so
they charged higher interest rates to compensate for expected future
losses. That was all perfectly sound banking practice.
But a few things went wrong, especially in 2005 and 2006. For
one thing, subprime loans started to be made with little or no evi-
dence that the homeowners had enough regular income (for exam-
ple, a large-enough paycheck) to meet their monthly payments. That
is not sound banking practice. Second, many subprime loans carried
“adjustable rates,” which in practice meant that the monthly mort-
gage payment was almost certain to skyrocket after, say, two years.
That created a ticking time bomb that should have raised seri-
ous questions about affordability of the mortgages”but apparently
did not. Third, about half of these risky loans were not made by reg-
ulated banks at all, but rather by mortgage brokers”who were not
regulated by the federal government and who sometimes followed
unscrupulous sales practices. Finally, the general euphoria over
SOURCE: © AP Images/Reed Saxon

housing (the housing “bubble”) led many people to believe that all
these dangers would be papered over by ever-rising home prices.
When house prices stopped rising so fast in 2005“2006, the
game of musical chairs ended abruptly. Default rates on subprime
mortgages soared. Then, in 2007, the subprime market virtually
shut down, precipitating a near panic in financial markets in the
United States and around the world. In the United States, the

Reserve Requirements A final type of regulation also has some bearing on safety but Required reserves are
is motivated primarily by the government™s desire to control the money supply. We have the minimum amount of
reserves (in cash or the
seen that the amount of money any bank will issue depends on the amount of reserves it
equivalent) required by
elects to keep. For this reason, most banks are subject by law to minimum required
law. Normally, required
reserves. Although banks may (and sometimes do) keep reserves in excess of these legal
reserves are proportional to
minimums, they may not keep less. This regulation places an upper limit on the money the volume of deposits.
supply. The rest of this chapter is concerned with the details of this mechanism.

Our objective is to understand how the money supply is determined. But before we can
fully understand the process by which money is “created,” we must acquire at least a nod-
ding acquaintance with the mechanics of modern banking.

How Bankers Keep Books
The first thing to know is how to distinguish assets from liabilities. An asset of a bank is An asset of an individual or
business firm is an item of
something of value that the bank owns. This “thing” may be a physical object, such as the
value that the individual
bank building or a computer, or it may be a piece of paper, such as an IOU signed by a cus-
or firm owns.
tomer to whom the bank has made a loan. A liability of a bank is something of value that
the bank owes. Most bank liabilities take the form of bookkeeping entries. For example, if A liability of an individual
you have an account in the Main Street Bank, your bank balance is a liability of the bank. or business firm is an
item of value that the
(It is, of course, an asset to you.)
individual or firm owes.
There is an easy test for whether some piece of paper or bookkeeping entry is a bank™s
Many liabilities are
asset or liability. Ask yourself a simple question: If this paper were converted into cash,
known as debts.
would the bank receive the cash (if so, it is an asset) or pay it out (if so, it is a liability)?

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Part 3
252 Fiscal and Monetary Policy

This test makes it clear that loans to customers are assets of the bank (when a loan is
repaid, the bank collects), whereas customers™ deposits are bank liabilities (when a deposit
is cashed in, the bank pays). Of course, things are just the opposite to the bank™s customers:
The loans are liabilities and the deposits are assets.
When accountants draw up a complete list of all the bank™s assets and liabilities, the
resulting document is called the bank™s balance sheet. Typically, the value of all the bank™s
A balance sheet is an
accounting statement assets exceeds the value of all its liabilities. (On the rare occasions when this is not so, the
listing the values of all bank is in serious trouble.) In what sense, then, do balance sheets “balance”?
assets on the left side and
They balance because accountants have invented the concept of net worth to balance the
the values of all liabilities
books. Specifically, they define the net worth of a bank to be the difference between the value
and net worth on the right
of all its assets and the value of all its liabilities. Thus, by definition, when accountants add
net worth to liabilities, the sum they get must be equal to the value of the bank™s assets:
Net worth is the value of
Assets = Liabilities + Net worth
all assets minus the value
of all liabilities.
Table 1 illustrates this point with the balance sheet of a fictitious bank, Bank-a-mythica,
whose finances are extremely simple. On December 31, 2007, it had only two kinds of
assets (listed on the left side of the balance sheet)”$1 million in cash reserves and $4.5 mil-
lion in outstanding loans to its customers, that is, in customers™ IOUs. And it had only one
type of liability (listed on the right side)”$5 million in checking deposits. The difference
between total assets ($5.5 million) and total liabilities ($5.0 million) was the bank™s net
worth ($500,000), also shown on the right side of the balance sheet.

Balance Sheet of Bank-a-mythica, December 31, 2007

Assets Liabilities and Net Worth
Assets Liabilities
Reserves $1,000,000 Checking deposits $5,000,000
Loans outstanding $4,500,000
Total $5,500,000 Net Worth
Stockholders™ equity 22$500,000
Addendum: Bank Reserves
Actual reserves $1,000,000 Total $5,500,000
Required reserves 21,000,000
Excess reserves 0

Let us now turn to the process of deposit creation. Many bankers will deny that they have
any ability to “create” money. The phrase itself has a suspiciously hocus-pocus sound to it.
But the protesting bankers are not quite right. Although any individual bank™s ability to cre-
ate money is severely limited, the banking system as a whole can achieve much more than
the sum of its parts. Through the modern alchemy of deposit creation, it can turn one dol-
Deposit creation refers to
the process by which a lar into many dollars. But to understand this important process, we had better proceed step-
fractional reserve banking by-step, beginning with the case of a single bank, our hypothetical Bank-a-mythica.
system turns $1 of bank
reserves into several dollars
The Limits to Money Creation by a Single Bank
of bank deposits.
According to the balance sheet in Table 1, Bank-a-mythica holds cash reserves of $1 mil-
lion, equal to 20 percent of its $5 million in deposits. Assume that this is the reserve ratio
prescribed by law and that the bank strives to keep its reserves down to the legal mini-
mum; that is, it strives to keep its excess reserves at zero.
Excess reserves are any
Now let us suppose that on January 2, 2008, an eccentric widower comes into Bank-a-
reserves held in excess of
mythica and deposits $100,000 in cash in his checking account. The bank now has $100,000
the legal minimum.
more in cash reserves and $100,000 more in checking deposits. But because deposits are up
by $100,000, required reserves rise by only $20,000, leaving $80,000 in excess reserves. Table 2
illustrates the effects of this transaction on Bank-a-mythica™s balance sheet. Tables such as

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Licensed to:

Chapter 12 253
Money and the Banking System

Changes in Bank-a-mythica™s Balance Sheet, January 2, 2008

Assets Liabilities
Reserves +$100,000 Checking deposits +$100,000

Addendum: Changes in Reserves
Actual reserves +$100,000
Required reserves +$ 20,000
Excess reserves +$ 80,000

this one, which show changes in balance sheets rather than the balance sheets themselves,
will help us follow the money-creation process.4


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