L17 - Models of the Banking System Flashcards
What was the Origins of the Modern Banking System?
- Goldsmiths
- The origins of the modern banking system date back to the fifteenth and sixteenth centuries, when gold was used as money but was also inconvenient to carry around.
- People began to place their gold with goldsmiths for safekeeping.
- The receipts issued to the depositor became a form of paper money.
- The receipts were backed 100 percent by gold.
What was the Origins of Bank Notes?
- Goldsmiths and the origins of bank notes
- Their reliability led to usage of the issued papers as means of transactions.
- As a result of this, paper money came into existence.
- The Private Banking System The goldsmiths found that people did not come often to withdraw gold.
- People simply exchanged their paper receipts.
- So the goldsmiths found ‘extra’ gold sitting around that they could put into a use - lend out.
- This service, effectively change them from depositories to bank-like institutions.
- Thus had the power to create money.
- Without adding any more gold to the system, the goldsmiths increased the amount of money in circulation
What are Banks?
- they are special institutions and serve as intermediaries between the lenders and borrowers
- One of the special functions of banks is maturity transformation –> turning short term deposits into long term borrowing e.g. Bonds
- Banks also play an important in monetary policy
What is the Origin of Fractionally Backed Paper Money?
Bank deposit money:
- Goldsmiths and banks realised that they do not need to keep all the deposits to cater for their customers.
- At any time, some customers are withdrawing gold and others are depositing.
- Therefore, the bank can issue more money. Money can be invested profitably (advances) to individuals and firms.
- Such practice led to the growth of loans.
- Currency issue in this way is known as fractionally backed by the reserves
What was the major problem with Fractionally backed paper money?
- The major problem with this was maintaining its convertibility into gold by which it was backed.
What were certain problems that Goldsmiths faced when they turned into bankers?
- Once they started making loans, their receipts outstanding (claims on gold) were greater than the amount of gold they had
in their vaults at any given moment. - In normal times, goldsmiths were safe, but once people started to doubt the safety of the goldsmith, they would be foolish not to demand their gold back from the vault.
- This can lead to what is known today as run on a bank.
What is a Run on a Bank?
- Occurs when many of those who have claims on a bank (deposits) present them at the same time.
- An example is what happened to Northern Rock in September, 2007.
How are Today’s bank different to Goldsmiths?
-The banks are subject to a “ required reserve ratio” –> the required amount a bank is required to have in order to cater to its own customers
- Goldsmiths had no legal reserve requirements.
- However, the amount they loaned out was subject to the restriction imposed on them by their fear of running out of gold.
- Earliest issuers of banknotes are Riksbank of Sweden (1668) and
Bank of England ((1694).
- Fiat Money: legislation.
What are the two models of the creation of deposit money?
- The first shows how banks can create a large volume of deposit money on the basis of a given amount of reserves.
- It is called the ratios approach to the creation of money.
- It is best suited for showing the relation between reserves and deposit money.
The second shows how banks work in a competitive environment to attract the reserves they need in order to create deposit money.
What is the competitive banking model better suited to help us understand?
This model is better suited to understanding:
1 the forces of competition between banks themselves and;
2 the competition between banks and other channels of financial intermediation (such as securities markets).
How is a Loan from a bank categories financially for both yourself and the Bank?
- If you deposit cash with a bank, that deposit is an asset to you and a liability to the bank.
- Because the bank owes that amount to you.
- The bank has the cash as an asset, its assets equal its liabilities.
- If a bank gives you a loan, it writes an extra balance into your account.
- This creates a deposit for you, but it is also a loan that you have to repay.
Note!
1 - In general, banks’ deposits are their liabilities.
2 - Whatever loans they make, or securities they purchase, constitute their assets.
Using the Ratio Model of Banking, How do banks make credit?
- Suppose that in a system with many banks, each bank obtains new deposits in cash, each of equal size of £100
- the banks are on a fractional reserve system and we assume for this purpose they wish to hold 10% cash reserves against all deposits
- The new deposits put the bank into disequilibrium
- since they each have 100 % reserves against these new deposits
- Therefore the bank is required to keep a cash reserve of £10 and the other £90 can be treated as a loans which can be used by the bank to create more money
- As the person who gets the loan of £90 will then eventually spend that and it will eventually end up at another bank
- they will take their 10% (£9) and then loan out £81 and the cycle continues until it creates £1000 which £900 is new money and £100 is actual cash
- The total amount of money created can be figured out my taking the original loan and multiplying it by the inverse of the Reserve Ratio
- The lower the ratio therefore the lower the reserve the higher ability the bank has at creating money
How does the Ratio approach to the determination of the Money Supply look like as a graph?
- With High-Powered Money (cash) on the y-axis and Deposits on the x-axis
- Positive gradient line (CD) starting from the origin represents the cash-deposit ratio for non-bank public –> Its slope is equal to that cash-deposit ratio
- The Negative gradient line (AB) plots the level of deposit creation resulting from each level of cash reserves
- where at the point A (y intercept) represents the point where banks have no cash or deposits (public hold all the money) and point C (origin) represents the point where all cash in the economy is held in bank reserves
- CB represents the value of bank deposits created on that reserve base
- Deposit creation is determined at the point where both lines intercept at point G
- The vertical distance above point G is the cash in reserves at banks and the horizontal distance to the y axis is thee deposits it creates
- and the vertical distance below is the cash held my the public and the horizontal distance is their deposits
- total cash in economy ( monetary base it the y -intercept of AB
- total money supply is the cash held my the public plus the deposits
How can the Ratio approach to the determination of the Money Supply Graph be interpreted?
- The money supply is determined by the stock of high-powered money (monetary base), the reserve ratio of the banks, and the cash-deposit ratio of the non-bank public.
The diagram illustrates the size of deposit creation:
- given the bank’s reserve ration –> x= (AC/CB),
- the public’s cash-deposit ratio –> b= (EC/CF ),
- and the total cash in economy AC.
- Deposits plus cash held by the public make up the total money supply.
How do you calculate the total cash within the economy?
The banks’ reserve ratio and public’s’ ratio of cash to deposit can be used to determine the total level of deposit creation.
Let
- R –> the cash held in bank reserves
- C –> the cash held by the non-bank public
- H –> high powered money, the total cash in the economy ( comes from the Central Bank)
- D –> the size of bank deposit.
Therefore,
C + R = H
-That is, the total cash within the economy is held either by the banks or the public
