Menu
Home
Log in / Register
 
Home arrow Business & Finance arrow The art of RF (riba-free) Islamic banking and finance
< Prev   CONTENTS   Next >

Who Owns the Federal Reserve Bank?

All national banks in the United States own shares in the Federal Reserve Bank in proportion to their capital. In addition, other financial institutions, like some state chartered banks and other major financial institutions, can own shares in the Federal Reserve Bank if their boards decide to become members of the Federal Reserve System. This way, the bankers in the system can have a voice in the process of developing the monetary policy of the country.

Credit Creation in the Modern Banking System — The Money Multiplier Concept

[1]

T-accounts are abstracts of a bank's balance sheet that show only the changes in the bank's assets and liabilities.

For the sake of simplicity, assume, in this T-account example, that:

■ All the deposits created by banks stay in the banking system.

■ Demand deposits are the only form in which newly created funds are held.

■ Banks lend out every available dollar.

These assumptions do not by any means reflect reality. Some deposits created by banks leak out of the banking system into nonbank financial institutions and money market instruments. Consumers and businesses typically convert some newly acquired demand deposits into cash.

Banks do not usually lend (or invest) every available dollar — not because they do not want to, but because the pace with which deposits flow in and out of banks on any given day is often so rapid, the volume so large, and the net effect of check collections so uncertain, that only at the end of the day do banks know just how much they have in net funds to support new loans.

Nonetheless, these simplistic assumptions do not distort the fundamental process by which banks create deposits, which takes place in the following sequence of steps:

1. Assume that Bank A receives a cash deposit of $10,000 from a customer for credit to the customer's transaction account. Under Federal Reserve requirements, the bank must hold an amount of reserves — vault cash or deposit balances at a Federal Reserve Bank — equal to a fixed percentage of its deposits (assume 10 percent). Thus, Bank A must hold $1,000 in required reserves against its new $10,000 deposit, and has $9,000 in excess reserves. These excess reserves can support a new $9,000 loan and the creation of $9,000 in demand deposits entailed by such a loan. (See Exhibit 5.1.)

EXHIBIT 5.1 Assets and Liabilities of Bank A

Assets

Liabilities

Cash assets

$10,000a

Demand deposits

$10,000

New loans

$ 9,000b

Created for borrowing

$ 9,000

a (Created for borrowing) $9,000.

b Required reserves $1,000 (10 percent of deposits).

2. When Bank A makes the loan, both its assets and its liabilities will temporarily increase to $19,000, reflecting the addition of the loan to its earning assets portfolio and the addition of the newly created demand deposit to its total liabilities. However, as soon as the borrower uses the newly created funds, Bank A's assets and liabilities will decline to their preloan level as an inevitable result of the check collection process. As can be seen in Exhibit 5.2, if the depositor of $10,000 comes to the bank to withdraw his deposit, the bank will have only $1,000 to give him. If the bank says, “We do not have the cash to give you,” the customer will spread the news to the community and all depositors will come to withdraw their deposits and will not use the services of the bank again. This is called a “run on the bank.” That is why bankers should adjust their loans and deposits as well as guard their reputation in order for that not to happen.

EXHIBIT 5.2 Assets and Liabilities of Bank A after the $9,000 Cash for Loan Is Withdrawn to Another Bank В of Borrower

Assets

Liabilities

Cash assets/reserves

$1,000

Demand deposits

$10, 000

New loans

$9,000

3. Assume that the borrower writes a check for the loan amount to a manufacturing company that has an account at Bank B. When the borrower's $9,000 check clears, Bank A will have to transfer $9,000 of its cash assets in payment for the check to the presenting bank (Bank B). Bank A will also strike the $9,000 demand deposit liability carried for the borrower from its books. Thus, after check clearance, Bank A has $10,000 in assets and $10,000 in liabilities. Note, however, that the composition of its assets has changed. Before the loan, it had $10,000 in cash assets; now it has $1,000 in cash assets and $9,000 in loan assets. The $1,000 in cash assets meets the assumed 10 percent reserve requirement ratio against transaction account liabilities. (See Exhibit 5.3.)

EXHIBIT 5.3 Assets and Liabilities for Banks A and В

Bank A

Assets

Liabilities

Bank B Assets Liabilities

Cash assets

$1,000 Demand deposits

$10,000

Cash assetsa $9,000a Demand deposits $9,000

Loan

$9,000

a Required reserves $900—excess over reserves $8,100.

4. The $9,000 in deposit created by Bank A is now a demand deposit on the books of Bank B, increasing that bank's liabilities. Bank В also received a transfer of $9,000 in cash assets when it received payment for the check deposited by the manufacturing company. Bank B, subject to the same 10 percent reserve requirement as Bank A, must keep $900 (10 percent) against the deposit, but can use the remaining $8,100 to support a new loan and the creation of a new $8,100 deposit. (See Exhibit 5.4.)

EXHIBIT 5.4 Assets and Liabilities of Bank В after Granting Loan of $8,100

Assets

Liabilities

Cash assets/reserves

$ 900

Demand deposits

$9,000

New loans

$8,100

5. When Bank В makes the $8,100 loan, its assets and liabilities will increase initially and then decline to their preloan level in response to the collection of the borrower's check. Assume that the borrower writes a check for the loan amount to pay for a corporate service and that the corporation deposits the check in its account in Bank C. Bank B's newly created $8,100 will now reside as a liability in Bank C, together with the $8,100 in cash assets Bank В had to transfer in payment for the check. (See Exhibit 5.5.)

EXHIBIT 6.6 Assets and Liabilities of Banks В and C

Bank B

Assets Liabilities

Bank C Assets Liabilities

Cash assets Loan

$ 900 Demand deposits $9,000 $8,100

Cash assetsa $8,100a Demand deposits $8,100

a Required reserves $810—excess over reserves $7,290.

6. Bank C, in turn, will now be able to create demand deposits equal to 90 percent of its new cash assets. If it does so, it will give still another bank the ability to create new deposits as shown in Exhibit 5.6.

EXHIBIT 5.6 Assets and Liabilities of Bank C after Granting the New Loan

Assets

Liabilities

Cash assets/reserves New loans

$ 810 $7,290

Demand deposits

$8,100

In theory, this process of bank deposit creation can continue through hundreds of banks, generating, in this example, a total amount of deposits on all banks' books 10 times greater than the $10,000 in cash deposits that started the process. The multiplier, or expansion coefficient, is the reciprocal of the reserve requirement ratio. In this example, and under its ideal assumption, because the reserve requirement ratio is 10 percent, the multiplier is 10. This simple multiplier is valid only in the context of this example. In the real world of banking, there are separate reserve requirements for different types and amounts of liabilities. This multiple expansion of bank-created deposits is characteristic of banking systems, but not of individual banks. No bank can create deposits in any amount greater than its excess reserves. If it did, it would find itself in a reserve deficiency as soon as the borrower's check cleared. This act violates the Federal Reserve rules, and the bank would be subject to several federal stipulations, controls, and penalties. Conceptually, banks participate in the process of money creation.

 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >
 
Subjects
Accounting
Business & Finance
Communication
Computer Science
Economics
Education
Engineering
Environment
Geography
Health
History
Language & Literature
Law
Management
Marketing
Philosophy
Political science
Psychology
Religion
Sociology
Travel