Commercial Banking and Credit

Creation
 Commercial Banking

So far we have looked at financial services in the form of life insurance and
general insurance, pension plans and mutual funds

These non-bank financial intermediaries take in money in order to re-lend it.

Commercial banks are alone in that they create deposits. Borrowers have
deposits created for them without ever having deposited cash at the bank and
these deposits are then used as a means of payment or medium of exchange.
No other type of financial intermediary acts in this manner

Commercial banking encompasses several aspects. Retail banking involves

high street branches and the general public, shops, and small businesses high
volume low value. Wholesale banking involves other banks, the central bank,
corporations, and other institutions - low volume high value
 Commercial Banking

Savings banks, mortgage banks, cooperative banks and credit unions are
commercial bank - like following deregulation and M&A.

The major difference in these different types of deposit taking institution is the
type of loan over which they specialise. e.g. savings and loans, mortgage banks
(e.g. building societies in the UK), and mutual savings banks specialise in
residential mortgages, and credit unions in consumer loans.

This shows up internally in differences in the categories of bank lending as

revealed by bank balance sheets

Externally, and from the point of view of the general public and firms, it is not so
easy to tell deposit taking institutions apart.
Balance Sheet of all Commercial Banks (items as a % of total, end 2001)

Assets (Uses of Funds) 1 Liabilities (Sources of Funds)

Reserves and Cash items 1 Sight deposits 10

Securities Time deposits
US Government and Agency 15 Small denomination and savings 48
State, local Government and other 7 deposits
Loans Large denomination 11
Commercial and industrial 18 Borrowings 23
Real estate 35 Bank capital 8
Consumer 6
Interbank 11
Other 2
Other Assets e.g. physical capital 5
Total 100 Total 100

Source: www.federalreserve.gov/releases/z1/current/z1r-4.pdf
1 In order of decreasing liquidity
 Balance Sheet Items of Commercial Banks

Assets

Note the low Reserves i.e. physical notes and coins. Reserves meet obligations
when depositors make withdrawals or payments. Earn no interest

Securities are income earnings safe assets, i.e. not equities, and they are liquid.

72% of assets are in the form of loans. A loan is an asset as the bank receives
income from it. Loans are less liquid - the cash is only realised at loan maturity.
Banks also lend to one another interbank loans tend to be overnight

Other assets include physical capital e.g. the banks offices, land, computers
 Balance Sheet Items of Commercial Banks

Liabilities

Sight deposits are very liquid. Note ratio of Reserves to Sight Deposits

Time deposits used to be less liquid. Often banks now offer automatic transfer
between sight and time accounts so becoming more liquid

Large denomination refers to wholesale deposits e.g. a corporations surplus

cash deposited with a bank at a negotiated interest rate.

Borrowings include funds borrowed from the central bank so as to have enough
reserves to meet regulatory requirements, and amounts borrowed from the
parent bank, and other institutions.

Bank capital is the banks net worth, the difference between total assets and
liabilities. Altered by issuing new equity or from retained earnings.
 Basic Account Operation of a Commercial Bank

Setting 1
Jane Brown opens a sight account at First National Bank and deposits $100

First National Bank

Assets Liabilities
Vault Cash (Reserves) $100 Sight Deposits $100

How is the bank doing?

Reserves pay no interest so bank earns nothing from the $100 of assets.

Servicing the $100 deposit is costly the bank must keep records, pay tellers,
process cheques, service cash machines, and pay interest on the deposit.

The bank is making a loss!

The bank must put to productive use all or part of the $100 assets
 Basic Account Operation of a Commercial Bank

Setting 2
Regulators require the bank to keep 10% of sight deposits as reserves

First National Bank

Assets Liabilities
Vault Cash (Required Reserves) $10 Sight Deposits $100
Excess Reserves $90

Assume the bank knows that 10% of deposits is sufficient to meet day-to-
day withdrawals. It has $90 excess reserves to use
 Basic Account Operation of a Commercial Bank

Setting 3
Short-term liabilities are used to buy longer-term assets such as loans with
higher rates of interest.

First National Bank

Assets Liabilities
Vault Cash (Required Reserves) $10 Sight Deposits $100
Loans $90

If the bank earns 10% in interest on its loans it earns $9 in the year.

If interest on the sight deposit is 3%, or $3, and it costs a further $3 to maintain
and service the account the cost per year of these deposits is $6.

The banks profit on this account is $3 per year, a 3% return on assets

 Principles of Commercial Bank Management

Bank asset and liability management involves four key concerns

liquidity management - ensuring sufficiently liquid assets are held to meet the
banks account payments and withdrawals obligations to depositors

asset management - pursuing a low level of risk through diversification and to

acquire assets with a low rate of default.

liability management - acquiring funds, or liabilities, at low rates of interest (low

cost). Financial strength, brand and reputation help.

capital adequacy management - the amount of capital the bank is to maintain

and the acquisition of the capital
 Liquidity Management

When there are sufficient reserves what happens when $10m of payments or
withdrawals are made from deposit holders

Required reserves are $10m i.e. 10%. Excess reserves are $10m.
First National Bank
Assets Liabilities
Reserves $20m Deposits $100m
Loans $80m Bank Capital $10m
Securities $10m

Excess reserves are now $1m i.e. (required reserves are 10% of $90m). If a bank
has ample reserves a deposit outflow does not necessitate changes in other parts
of its balance sheet.

First National Bank

Assets Liabilities
Reserves $10m Deposits $90m
Loans $80m Bank Capital $10m
Securities $10m
 Liquidity Management

When there are insufficient reserves what happens?

Required reserves are $10m and excess reserves 0. The bank is maximising
short-term profits by holding the required reserve ratio and making additional
loans ($90m as opposed to $80m).
First National Bank
Assets Liabilities
Reserves $10m Deposits $100m
Loans $90m Bank Capital $10m
Securities $10m

If depositors suddenly demand $10m the bank is short $9m reserves (10% of
$90m). The bank needs to deposit $9m at the Central Bank.
First National Bank
Assets Liabilities
Reserves $0m Deposits $90m
Loans $90m Bank Capital $10m
Securities $10m
 Liquidity Management

Since the bank now has no reserves it has 4 choices

1. Borrow from other banks or corporations. The cost is the interest on the loans.
First National Bank
Assets Liabilities
Reserves $9m Deposits $90m
Loans $90m Borrowings $9m
Securities $10m Bank Capital $10m

2. Sell some securities. The bank incurs brokerage, transaction costs, and risks
of selling when fixed income prices are low.
First National Bank
Assets Liabilities
Reserves $9m Deposits $90m
Loans $90m Bank Capital $10m
Securities $1m
 Liquidity Management

3. Borrow from Central Bank. If bank borrows frequently the CB may prevent
further borrowing. Reputational damage of poor cash management and liquidity

First National Bank

Assets Liabilities
Reserves $9m Deposits $90m
Loans $90m Borrowings $9m
Securities $10m Bank Capital $10m

4. Reduce loans. Short-term loans renewed at short intervals are not renewed
when they come due. The bank reduces the amount of loans outstanding fairly
quickly. May antagonize customers whose loans are not renewed. Or can sell
some of loans to other banks
First National Bank
Assets Liabilities
Reserves $9m Deposits $90m
Loans $81m Bank Capital $10m
Securities $10m
 Liquidity Management

Reserves are an insurance against the cost of deposit outflow. There is a

regulatory requirement to hold them, but a bank will want to hold some in any
case

But a bank cannot be too conservative excess reserves earn no return.

Excess reserves are an opportunity cost. the earnings forgone by not holding
income earnings assets.

The higher the interest rate the greater the opportunity cost

The bank must balance a desire for liquidity against a desire for return.
 Asset Management

A bank must simultaneously obtain the highest return possible on loans and
securities, at low risk, whilst maintaining liquidity.

To achieve high returns loans are preferred. To achieve low risk banks diversify
across assets. To maintain liquidity significant amounts are held in Treasuries.

Liability Management

The development of interbank loans and CDs mean that banks do not need to
rely on deposits as the main source of bank funds.

Banks no longer need to think of their liabilities as a given. This frees them to
set targets for asset growth and to issue liabilities as needed.

A bank faced with an attractive loan opportunity can readily acquire the funds to
undertake the loan
 Capital Adequacy Management

Example: Two banks, one with a ratio of capital to assets of 10%, and one with a
ratio of 4%

High Capital Bank Low Capital Bank

Assets Liabilities Assets Liabilities
Reserves $10m Deposits $90m Reserves $10m Deposits $96m
Loans $90m Bank Capital $10m Loans $90m Bank Capital $4m

$5m loans go bad, and when written off are valued at 0. Assets decline by $5m,
and so therefore do liabilities.

High Capital Bank Low Capital Bank

Assets Liabilities Assets Liabilities
Reserves $10m Deposits $90m Reserves $10m Deposits $96m
Loans $85m Bank Capital $5m Loans $85m Bank Capital $-1m

High Capital Bank still has a positive net worth. Low Capital Bank now has a
negative net worth and is insolvent there are insufficient assets to pay all
holders of liabilities (creditors).
 Capital Adequacy Management

Government regulators close Low Capital Bank, sell off its assets to repay
creditors, and fire the managers.

Why did the managers of Low Capital Bank hold less capital? Because of the
effect on profitability.

A key measure of bank profitability is ROE, net profit after tax per dollar of equity
capital:

ROE = net profit after taxes / equity capital

The lower the bank capital for a given level of profit the higher the return for the
owners of the bank.

Suppose net profit is $20m

High Capital Bank ROE = 20/10 or 20%

Low Capital Bank ROE = 20/5 or 40%
 Capital Adequacy Management

The owners of Low Capital Bank were happiest, at the time, earning twice the
return.

Owners do not want the bank to hold much capital for it reduces ROE.

Managers must decide how much safety from more capital they are willing to
trade-off against lower return. Bank capital has an opportunity cost.

The basic concept of the capital ratio is that there needs to be a prudent
relationship between capital and assets. When banks lend money and some
people inevitably default banks can still repay depositors should they need to.
The buffer, the money that the bank can rely on, is capital, and it is mostly
shareholder funds.

Regulation plays an important role. There are minimum capital requirements and
there are maximum exposures to companies, sectors, and countries.
 Bank Performance Statistics, 1985 2001
Year Return on Return on Net Interest
Assets % Equity % Margin
1985 0.72 11.67 3.62
1986 0.64 10.30 3.48
1987 0.09 1.54 3.40
1988 0.82 13.74 3.57
1989 0.50 7.92 3.58
1990 0.49 7.81 3.50
1991 0.53 8.25 3.60
1992 0.94 13.86 3.89
1993 1.23 16.30 3.97
1994 1.20 15.00 3.95
1995 1.17 14.66 4.29
1996 1.19 14.45 4.27
1997 1.23 14.69 4.21
1998 1.18 13.30 3.47
1999 1.31 15.31 4.07
2000 1.19 14.02 3.95
2001 1.17 13.42 3.84
All Federally Insured Commercial Banks. Source: http://www2.fdic.gov/qbp
 Credit / Money Creation by Commercial Banks

Example: You request a lending facility of 2000. The bank opens an account
for you and issues you a debit card and cheque book. You wander down the
high street buying goods to the value of 2000. The shops you bought from
present their electronic or cheque receipts from you to their banks for payment.
3 days later the banks have their money and your account is debited. Your bank
has created 2000 of expenditure where it did not exist 1 week earlier. The shop
owners you bought from are 2000 richer in cash. Where did the money come
from? Not from you because you did not have any. It came from the bank, which
offered you an overdraft. The bank has created money.

In a commercial bank there is not a 1 to 1 correspondence between deposits

and cash in the banks vault. Only a small proportion of deposits is drawn in
cash. This fractional reserve banking increases the total quantity of money in the
economy.
 Credit / Money Creation by Commercial Banks

In the example earlier we examined movements in a small part of the balance

sheet for a single individual making a deposit. The proportion of the deposit
made the bank knew it would not need to hold, i.e. that in excess of desired
reserves, was lent out.

First National Bank

Assets Liabilities
Vault Cash (Required Reserves) $10 Sight Deposits $100
Loans $90

First National Bank

Assets Liabilities
Vault Cash (Required Reserves) $10 Sight Deposits $100
Loans $90

In actual fact a commercial bank does not re lend notes and coin. When it offers
a loan and credits a persons account it does not physically deliver notes and
coins to the persons house! It holds the notes and coins as reserves and lends
a multiple of these by creating deposits.
 Money Creation by the Banking System

Assume a reserve ratio of 10%. The non-bank private sector has 1,000 in
wealth held as cash in their pockets. The banks therefore have none of this.

Assets Liabilities

Start Position Cash 0 Deposits 0

loans 0

Now people pay the 1,000 cash into banks by opening bank deposits. Banks
have assets of 1,000, and liabilities of 1,000 of deposits.

Assets Liabilities
Intermediate Position Cash 1,000 Deposits 1,000

Banks only need 10% (in this example) of all the deposits to be covered by cash
reserves. So they create 9,000 loans which customers can write cheques
against etc. Money in the economy has increased from 1,000, to 10,000.

Assets Liabilities
Final Position Cash 1,000 Deposits 10,000
loans 9,000
Bank Credit Creation - Narrow and Broad Money UK Money for 2001

Calculation Type of Money Amount bn

Wide monetary base M0 33
- Banks cash and balances at Central -7
Bank
= Cash in circulation 26
+ Banks retail deposits 468
+ Building societies deposits and shares 113
+ Wholesale deposits 297
= The Money Stock / Money Supply M4 904

Deposits are 904bn or 27x the monetary base of 33bn set by the central bank.
The banks have used the monetary base and expanded it 27x. They have
created money - the monetary base is only 3.7% of the total stock of money.

Source for Table: Bank of England in Begg, Fischer, & Dornbusch (2003) Economics
 Money Creation by Banks

Monetary Base
33bn

26bn 7bn
Notes and Coins in Circulation

Banks Regulatory and Excess

Reserves

Banks
Multiplication of
Cash Reserves
into Deposits

Money Supply

904bn

This example uses actual UK money supply figures for 2001

 Money Creation by the Banking System

The monetary base is physical notes and coins issued by the central bank. It is
held either as cash with the public or as cash at banks reserves.

The amount of money creation depends on two key ratios:

banks desired ratio of cash reserves to total deposits this determines

how much banks multiply up any given cash reserves into deposit money
(mostly loans).

the publics desired ratio of cash in circulation to total bank deposits.

When more of the monetary base is deposited in banks, banks can create
more deposits.
 Money Creation by the Banking System

The cash reserve ratio that banks maintain relative to deposits determines
credit creation. Reserves as a fraction of deposits in the 2001 UK data
are :

R = cb x D rearranging cb = R / D

= 7 / (904 26) = 0.007973 or 1%

Where R is reserves (cash issued by the central bank and held by banks), cb is
the ratio of cash reserves to deposits, and D is deposits (D includes
reserves held by banks as these are their own deposits)

The notes and coins that the public wish to hold as a proportion of their
deposits reveals the desired ratio of cash holdings. The publics cash
holdings as a fraction of deposits in the UK data are:

C = cp x D rearranging cp = C / D

= 26 / (904 26) = 0.0296 or 3%

Where C is cash in circulation held by the public, cp is the ratio of notes and
coins held by the public to deposits, and D is deposits
 Money Creation by the Banking System

It should now be clear that the lower is banks desired ratio of cash reserves
to total deposits the more deposits they create against a given level of
cash reserves and the greater is their credit creation

Banks will wish to lend more and risk a low ratio of cash reserves to deposits
the higher is the interest rates spread, the more predictable are
withdrawals, or the more the lending opportunities for liquid loans.

It should also be clear that the lower is the publics desired ratio of cash to
bank accounts the greater is the amount of the monetary base deposited
in banks and the greater is banks credit creation.

The publics desired ratio of cash to their deposits will reflect interest rates,
seasonal effects, and institutional factors such as the method firms use to
pay wages, the extent of tax evasion and the black economy, and the
availability of cheque books, credit and debit cards and electronic purses.
 Money Creation by the Banking System

Finally, the money multiplier is the extent to which banks multiply up the
monetary base to arrive at the final money stock:

The money multiplier m = M4/M0

= 904 / 33 = 27

An alternative calculation

The monetary base M0 = C + R = cpD + cbD

The money stock M4 = C + D = cpD + D

Therefore m = (cpD + D) / (cpD + cbD)

dividing this expression through by D gives

m = (cp + 1) / (cp + cb)

= (0.0296 + 1) / (0.0296 + 0.007973) = 27