In part 1 of this blog series, I referenced the famous bank run scene in the movie It’s a Wonderful Life. In the scene, a mob of depositors gather around the Bailey Building and Loan and demand withdrawal of their deposits. George Bailey, the film’s protagonist, attempts to calm the crowd by telling them, “…. you’re thinking of this place all wrong! As if I had the money back in a safe. The money’s not here…..”
George is attempting to explain to the crowd the nature of fractional reserve banking. With fractional reserve banking, deposit-taking institutions, such as the Bailey Building and Loan, function as more than a warehouse for deposits. Rather, such banking institutions hold only a portion of the deposits as required by law or by prudence. The balance is lent out at interest in order for the bank to earn a profit.
This arrangement rests on the assumption that only a small portion of depositors will withdraw their funds at any one time. This highlights an inherent fragility of the banking system – the mismatch between assets (loans) and liabilities (deposits). In other words, banks finance their longer-term assets with liabilities which depositors can redeem on demand. Up until the early 1930s (at which time Congress created the Federal Deposit Insurance Corporation), bank runs were a common feature of the banking system. Many banks failed because of bank runs.
The other feature of fractional reserve banking is far more mysterious. This is the way in which banks create money.
Money Creation: A Simplified Example
For illustrative purposes, let us imagine a simplified economy in which gold serves as the monetary base. In such a system, law defines (a) the number of monetary units per ounce of gold, and (b) the fraction of gold reserves which banks must hold against the outstanding money stock. In this case, the monetary unit is the dollar ($).
Suppose that in a small town, local residents strike gold. The residents extract 10,000 ounces of gold, which they then send to the mint to create 10,000 one-ounce coins.
Federal law defines gold as $2,500 per ounce. Also, by law, banks must hold gold reserves equal to 20% of their dollar issuance.
The residents then deposit these coins into the town’s only bank. When the residents make the deposits, the bank credits the accounts of the depositors. The impact to the bank’s balance sheet is as follows:
Assets: Reserves $25,000,000 (Increase)
Liabilities: Customer Deposits $25,000,000 (Increase)
Because the $25,000,000 in gold reserves need only equal 20% of the bank’s total dollar issuance, the bank can create loans of $4 for every $1 in gold reserves. Suppose the bank does just that and issues loans to other residents (who also have accounts at the bank). The bank credits the borrowers’ accounts and recognizes the loans as assets. The bank’s balance sheet is now:
Assets: Reserves $25,000,000; Loans $100,000,000
Liabilities: Customer Deposits $125,000,000
In this example, we can see that the newly minted gold increased the monetary base by $25,000,000 but increased deposits by five-times that amount.
Most economists agree that fractional reserve banking originated with the Goldsmith bankers in seventeenth century England. The goldsmiths, by virtue of their expertise in metallurgy and their ability to store precious metals, diversified into banking services. Households and firms would store their gold stocks with the goldsmiths who would, in turn, issue receipts to the depositors. These receipts soon circulated as money, as they were a more convenient medium of exchange than the underlying metal. The goldsmith bankers realized that as long as they can maintain the trust of the depositors, few would redeem their gold deposits at any one time. The goldsmith bankers thus issued warehouse receipts in excess of gold deposits.
Money Creation and The Money Multiplier
The above example is a highly simplified one with gold as the monetary base. Of course, gold no longer plays a direct role in the international monetary system. Rather, industrial economies are on a “monetary standard” in which central bank reserves function as the monetary base. The mechanics of money creation in a monetary standard are similar, however.
When I was in school, a popular tool for teaching money creation was the money multiplier. This tool is no longer an accurate description of the money supply process (if it ever truly was), due to changes in the Federal Reserve’s operating procedures. However, the money multiplier is an important device for showing the theoretical maximum amount of money which banks can create in a modern economy.
Commercial banks keep reserves in two forms: cash held in vaults and amounts held in deposits at the central bank, with central bank reserves being the far larger and more important of the two.
Central banks can expand or contract the level of reserves, and thus the monetary base, through open market operations. Open market operations consist of the central bank purchasing or selling assets from participating institutions and settling the transactions by debiting or crediting the institutions’ reserve accounts. Thus, the central bank can use open market operations to create or destroy reserves in the banking system.
To see how the banking system can create the theoretical maximum amount of money for a given level of reserves, let us make the following four assumptions: (1) the central bank imposes a legal reserve requirement on banks, (2) banks hold no reserves beyond the legal minimum, (3) loan proceeds flow to other banks, and (4) currency held by the public is constant.
Suppose that Bank A’s assets consist of $1,000,000 of U.S. Treasury securities and $1,000,000 of reserves held at the central bank. The central bank purchases $500,000 of Bank A’s Treasury securities and pays for them by increasing Bank A’s reserve account by the same amount. Thus, Bank A’s assets are now:
Assets: Securities $500,000 ; Reserves $1,500,000 (including $500,000 in excess reserves)
Bank A lends out the $500,000 in excess reserves. The loan proceeds end up in an account at Bank B. Bank A’s assets are now:
Bank A
Assets: Securities $500,000 ; Reserves $1,000,000 ; Loans $500,000
The changes to Bank B’s balance sheet are:
Bank B
Assets: Reserves $500,000 (increase)
Liabilities: Customer Deposits $500,000 (increase)
Bank B then retains 10% of the deposits and lends out the rest. The proceeds end up in Bank C. Bank B’s balance sheet is now:
Bank B
Assets: Reserves $50,000 ; Loans $450,000
Liabilities: Customer Deposits $500,000
Bank C’s balance sheet changes as follows:
Assets: Reserves $450,000 (increase)
Liabilities: Customer Deposits $450,000 (increase)
Bank C retains 10% of its new deposits and lends out the rest. The loan proceeds end up in Bank D. Bank C’s balance sheet is now:
Bank C
Assets: Reserves $45,000 ; Loans $405,000
Liabilities: Customer Deposits $450,000
Bank D’s balance sheet changes as follows:
Assets: Reserves $405,000 (increase)
Liabilities: Customer Deposits $405,000 (increase)
Bank D retains 10% of the new deposits and lends out the rest. And the process continues until the banking system has exhausted the excess reserves.
The new lending eventually creates $5,000,000 in new deposit money for the $500,000 in excess reserves created during the initial open market purchase. This example highlights the concept of the money multiplier. The equation for the money multiplier is as follows:
Money Multiplier = 1 ÷ Reserve Requirement
As mentioned above, the money multiplier shows the theoretical maximum amount of deposit money which the banking system could create for every dollar of excess reserves. While the concept may continue to have value as a teaching device, it no longer accurately describes the policy / money supply relationship. We will discuss central bank policy further in the next post, but for now we note the change in the Federal Reserve’s operating procedures after the 2007-2009 financial crisis.
In battling the crisis and attempting to stimulate the economy in its aftermath, the Fed engaged in “quantitative easing” in which it purchased various assets and created substantial excess reserves in the process. The Fed later modified its operations to accommodate an “ample reserves regime.” The banking system, which as a whole had held little excess reserves prior to 2008, would now hold excess reserves as a permanent feature of the monetary system. As a result, open market operations no longer influence the money supply as it once did.
Conclusion
Fractional reserve banking is a mysterious process in that it allows commercial banks to create deposit money.
Modern economies operate under a “monetary standard.” In such a system, central bank reserves serve as the monetary base. When the central bank creates excess reserves, banks can, through their lending operations, create a greater amount of deposits. The concept of the money multiplier shows the money creation process taken to its theoretical extreme.
In the next post we will examine the workings of modern central banks, with an emphasis on the U.S. Federal Reserve system.
Sources:
Mishkin, Frederic. The Economics of Money, Banking, and Financial Markets, 2nd ed. New York: Addison-Wesley, 2010.
Murphy, Robert. Understanding Money Mechanics. Auburn: Mises Institute, 2021.
