16.3 Banks and the Money Supply

Example: If a deposit of $100 is made in the bank, the bank will keep the $100 in reserve and will not make any loans.

^{Full Reserve Banking [11]}

16.3 b. Money Creation with Fractional-Reserve Banking

Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties [12].

Example: If a bank has $500 million in assets, it holds $50 million, or 10%, in reserves [12].

^{Fractional Reserve Banking [13]}

16.3 c. The Money Multiplier

The multiplier effect is the expansion of a country’s money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is the money used to create more money and is calculated by dividing total bank deposits by the reserve requirement [14].

Example: If the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64 [14].

^{Money Multiplier [15]}

16.3 d. Bank Capital, Leverage, and the Financial Crisis of 2008-2009

Bank capital is the difference between a bank’s assets and liabilities, and it represents the net worth of the bank or its value to investors. The asset portion of a bank’s capital includes cash, government securities and interest-earning loans, such as mortgages, letters of credit and inter-bank loans, while the liabilities section of a bank’s capital includes loan-loss reserves and any debt it owes [16].

Leverage is the investment strategy of using borrowed money: specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt used to finance assets [17].

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. The leverage ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due [18].

Due to irrational exuberance, people started to buy mortgage based securities following the 2001 stock market crash. The demand for those securities was so high that more and more people with questionable credits were approved to buy houses on mortgages. The banks sold those mortgages to investors as securities and credit default swaps were sold to insure against those securities. When the homeowners were not able to pay their debts, more and more houses were back on the market and the mortgage based securities collapsed, the credit default swap holders did not have enough capital to pay off the banks and investors [19]. The stock market crashed with a $7.4 trillion loss, over 5.5 million people lost their jobs, and the US lost $3.4 trillion in real state wealth [21]. The Federal Reserve and the Treasury had to buy banks and automotive stocks worth $350 billion to mitigate the financial crisis. The government also responded by putting an additional $787 billion directly into the economy instead of the banks [19].

^{2008 Financial Crisis [20]}