07EconomicsUSA

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OW BANKS CA NE MONEY

Runs on banks are rare now, for several reasons. One is that the gov-emment-including the Federal Deposit Insurance Corporation (FDICj, theFederal Reserve, and other public agencies-has made it clear that it willnot stand by and tolerate the panics that used to occur periodically in thiscountry. The FDIC insures the accounts of depositors in practically allbanks so that even if a bank fails, depositors will get their money back-upto $100,000. Another reason is that the banks themselves tend to be bettermanaged and regulated. For example, bank examiners are sent out to lookover the bankers' shoulders and determine whether they are solvent.

PROBLEMS DURINGTHE NINFI'IESNonetheless, this does not mean that bank regulation has been all that itmight be, or that the health of the banking industry has been robust. Onthe contrary, in early 1991, there were persistent rumors and reports thatmany huge New York banks, as well as a variety of smaller banks elsewhere,were in serious financial troubles because many of their real estate loanswent sour when the real estate market did not live up to expectations.These banks were hurt when, beginning in the 1960s, they started to losethe business of many large firms that began to get funds from foreign banksor from the securities markets because interest rates were lower. Also,some banks had made risky investments in high-yield bonds ("junk bonds"]and had made risky loans to developing countries like Argentina and Bra-zil. While these problems did not mean that your bank deposit was notinsured (up to $100,000),it did mean that your bank might fail, with atten-dant losses to its owners, among others. However, as it turned out, thebanks dodged the bullet. Their earnings rose substantially, and by 1994there was no talk of widespread financial problems among the banks.

HOW BANKS CAN CREATE MONEYGenesis tells us that God created heaven and earth. Economists tell us thatbanks create money. To many people, the latter process is as mysteriousas the former.

To see how banks can create money, imagine the following scenario.First, suppose that someone deposits $10,000 of newly printed money ina particular bank, which we'll call Bank A. Second, suppose that Bank Alends Ms. Smith $8,333 and that Ms. Smith uses this money to purchasesome equipment from Mr. Jones, who deposits Ms. Smith's check in hisaccount at Bank 3. Third, Bank B buys a bond for $6,944 from Ms. Stone,who uses the money to pay Mr. Green for some furniture, Mr. Green depos-its the check to his account at Bank C. We assume that the legal reserverequirements are that $1 in reserves must be held for every $6 in demanddeposits.


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TABLE 8.5 ASSETS LIABILITIES AN0 NET WORTHChanges in BankA's ~alanceSheet (Dollars) Bank receives Reserves + 10,000 Demand deposits + 10,000deposit Loans & investments No change Net worth No changeTO~A + 10,000 Total + 1 0,000

Bank makes loan Reserves No change Demand deposits +8,333Loans& investments +8,333 Net worth No changeTotal +8,333 Total +8,333

Ms. Smith spends Reserves -8.333 Demand deposits -8,333$8,333 , Loans & investments No change Net worth No change

Total -8,333 Total -8,333Total effect Reserves + I,667 Demand deposits + 10,000

Loans& investments +8,333 Net worth No changeTotal + 10,000 Total + 10,000

MONEY CREATION AT BANK AThe first step in our drama occurs when someone deposits $10,000newly printed money in Bank A. The effect of this deposit is shown in first panel of Table 8.5: Bank A's demand deposits and its reserves bothup by $10,000. Now, Bank A can make a loan of $8,333, since this is amount of its excess reserves (those in excess of legal requiremenBecause of the $10,000 increase in its deposits, its legally required reservincrease by ($10,000/6) or $1,667. (Recall that $1 in reserves must be hfor every $6 in deposits.) Thus, if it had no excess reserves before, it nhas excess reserves of $10,000 - $1,667,or $8,333. When Ms. Smith asks oof the loan officers of the bank for a loan to purchase equipment, the loofficer approves a loan of $8,333.Ms. Smith is given a checking accoun

$8.333 at Bank A.The FederalReserve How can Bank A get away wthis loan of $8,333 without wiing up with less than the legarequired reserves? The answergiven in the rest of Table 8.5. Tsecond panel of this table showhat happens to Bank A's balansheet when Bank A makes$8,333 loan and creates a ndemand deposit of $8,333. Oously, both demand deposits aloans go up by $8,333. Next, loothe third panel of Table 8.5, whshows what happens when M


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CASE STUDY 8.2The savings and loan debacle: W h y did it occurand where d id the money go?Tne origins of the savings and loanindustry go back to the nineteenthcentury. Responding to the desireof U.S. families to own their ownhomes, these savings institutions,often relatively small, receivedmodest deposits and lent out themoney in the form of long-termmortgages. By 1990 it was esti-mated that the problems of thesavings and loan industry had costUS. taxpayers roughly $200 billion.Hundreds o f insolvent savings andloan institutions were closed, andsince their deposits were insuredby the federal government, thetaxpayers were stuck with the bill.What brought on this debacle, andwhere did all the money go? Theresponsibility for the crisis lay withmany different institutions and re-suited from the confluence of anumber of trends, some of whichhad little to do with the savingsand loan (S & L) industry itself.One of the foundations of the cri-sis was laid in the early 1980swhen the Fed drove up interestrates to rid the United States ofdouble-digit inflation. Thissqueezed the profit margins ofS & Ls and left many of theminsolvent.

Also in the 1980s a wave of de-regulation hit financial institutionsin the United States. While thefederal government led the way,state governments eagerly fol-lowed. The result was that S & Lswere allowed to make more riskyinvestments in real estate and junkbonds. This. combined with a ,father lax attitude on the part ofmany regulators, provided a strongtemptation for thrift institutions topursue high-risk strategies.in the mid- 1980s the energy bustunmasked the bad investments ofmany Texas S & Ls. Likewise thebursting of the real estate bubblein New England and California inthe late 1980s exposed the shaki-ness of the S & Ls in those areasas well, Finally, partisan politics andthe inability of Congress to quicklyenact an S & L bailout plan com-pounded the problem and raisedthe price tag of the eventual res-cue package.The S & L scandal was one ofthebiggest transfers of wealth in U.S.history. Only about 10 percent ofthe money ended up in the handsof crooks. Most of the moneytraveled over perfectly legal routes

to homeowners, landowners, bigsavers, investment bankers, andWall Street investors. Hofneown-ers were among the largest groupbenefiting from the transfer ofwealth. They received as much as15 percent of the total, or $30 bil-lion, in the form of low mortgagerates. Many S & Ls ended up pay-ing higher rates for deposits thanthey were receiving for mortgagesand were thus caught in a profitssqueeze.Another group that benefited in abig way were landowners and de-velopers who got about $40 bil-lion as a result of the high-risk realestate deals that many of thethrifts financed in the 1980s. Per-haps another $ 1 5 billion ended upbeing squandered by the S & Lsthemselves.Finally, by failing to face up t o thecrisis and by not implementing anaggressive bailout plan soonenough, politicians in Washingtongreatly added to the final cost. Bysome estimates the costs of thisdelay and the government's ad-ministrative tab will add as muchas $60 billion to the eventual pricetag. N.B.

Smith spends the $8,333 on equipment. As pointed out above, she pur-chases this equipment from Mr. Jones. Mr. Jones deposits Ms. Smith'scheck in his account in Bank B, which presents the check to Bank A forpayment. After BankA pays Bank B (through the Federal Reserve System),the result-as shown in the third panel-is that Bank A's deposits go downby $8,333,since Ms. Smith no longer has the deposit. Bank A's reserves also


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MONEY AND THEBANKING SYSTEMCHAPTER 8

go down by $8,333, since Bank A has to transfer these reserves to Bankto pay the amount of the check.As shown in the bottom panel of Table 8.5, the total effect on Bank Ato increase its deposits by the $10,000 that was deposited originally andincrease its reserves by $10,000 minus $8,333, or $1,667. In other worreserves have increased by one-sixth as much as demand deposits. Tmeans that Bank A will meet its legal reserve requirements.

It is important to recognize that Bank A has now created $8,333 in nmoney. To see this, note that Mr. Jones winds up with a demand depoof this amount that he didn't have before; this is a net addition to the monsupply, since the person who originally deposited the $lg,000 in currenstill has his or her $10,000, although it is in the form of a demand deporather than currency.W MONEY CREATION AT BANK BThe effects of the $10,000 deposit at Bank A are not limited to BankInstead, as we shall see, other banks can also create new money as a csequence of the original $10,000 deposit at Bank A. Let's begin with BaB. Recall from the previous section that the $8,333 check made out by MSmith to Mr. Jones is deposited by the latter in his account at Bank B. Tis a new deposit of funds at Bank B. As pointed out in the previous sectiBank B gets $8,333 in reserves from Bank A when Bank A pays Bank Bget back the check. Thus the effect on Bank B's balance sheet, as shownthe first panel of Table 8.6, is to increase both demand deposits areserves by $8,333.Bank B is in much the same position as Bank A was when the latreceived the original deposit of $10,000. Bank B can make loans or inv

TABLE 8.6 ASSETS LIABILITIES AND NET WORTHChanges in BankB's BalanceSheet (Dollars) Bank receives Reserves +8,333 Demand deposits +8,333deposit Loans & investments N o change N et wo rth N o changeTotal +8,333 Total + 8,333

Bank buys bond Reserves N o change Demand deposits +6,944Loans & investments +6,944 N e t wo rth N o changeTotal +6,944 Total +6,944

Mr. Green deposits Reserves -6,944 Demand deposits -6,944money in Bank C Loans & investments N o change N et worth N o chang

Total -6,944 Total -6,944Total effect Reserves + 1,389 Demand deposits +8,333

Loans & investments +6,944 N et wo rth N o changeTota l +8,333 Tota l +8,333


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