10.4 Banks and Other Financial Intermediaries

A financial intermediary is an institution that amasses funds from one group and makes them available to another. A pension fund is an example of a financial intermediary. Workers and firms place earnings in the fund for their retirement; the fund earns income by lending money to firms or by purchasing their stock. The fund thus makes retirement savings available for other spending.

Insurance companies are also financial intermediaries because they lend some of the premiums paid by their customers to firms for investment. Banks play a vital role as financial intermediaries. Banks accept depositors’ money and lend it to borrowers. With the interest they earn on their loans, banks can pay interest to their depositors, cover their operating costs, and earn a profit. One key characteristic of banks is that they offer their customers the opportunity to open chequing accounts, thus creating chequable deposits. These functions define a bank, as a financial intermediary that accepts deposits, makes loans, and offers chequing accounts.

10.4.1 How Banks Create Money: Fractional Reserve System

Banks and money are intertwined. It is not just that most money is in the form of bank accounts. The banking system can create money through the process of making loans. Let’s see how.

A balance sheet is an accounting tool that lists assets and liabilities. An asset is something of value that is owned and can be used to produce something. For example, the cash you own can be used to pay your tuition. A home provides shelter and can be rented out to generate income. Loans are the largest assets of any bank because loans generate maximum earnings for the banks through interests. A liability is a debt or something you owe. Many people borrow money to buy homes. In this case, the house is the asset, but the mortgage (i.e. the loan obtained to purchase the home) is the liability. Deposits are the largest liability of a bank because the bank is liable to pay the deposits back to its customers.

Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. When it holds all the deposits in its vaults, the chequing account balance sheet for Singleton Bank is shown in Figure 10.4. A deposit is a liability because the bank is liable to pay the deposit back to its depositors. At this stage, Singleton Bank is simply storing money for depositors; it is not using these deposits to make loans, so it cannot pay its depositors interest either. This is called a 100% reserve banking system.

Refer to Fig 10.5 below; Singleton Bank keeps 10% of its total deposits with the Bank of Canada, or $1 million, on reserve. This is called the reserve ratio. It will loan out the remaining $9 million. The loan is an asset because the bank earns interest from the loan. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton. Singleton Bank can become a financial intermediary between savers and borrowers. In this example, the money supply is $10 million (remember deposits are counted as Money Supply).

Singleton’s assets have changed; it now has $1 million in reserves and a loan to Hank’s Auto Supply of $9 million.

Singleton Bank lends $9 million to Hank’s Auto Supply. Hank’s Auto Supply obtained this loan and purchased auto parts from Ben’s Company. Ben’s Company has an account with First National Bank. When Hank pays the $9 million he lent from Singleton Bank to Ben’s Company, Ben deposits this money into the First National Bank. Every loan creates a deposit. Therefore, now money supply is [latex]\$10\;\text{million}+\$9\;\text{million}=\$19\;\text{million}[/latex].

Below is First National’s balance Sheet:

Suppose First National holds only 10% as reserves ($900,000) but can lend out the other 90% ($8.1 million) in a loan to Jack’s Chevy Dealership, as shown in Figure 10.6. This $8.1 million loan goes as a deposit to Second National Bank.

Below is Second National’s balance sheet:

[latex]\text{The new money supply}=\$10\;\text{million}+\$9\;\text{million}+\$7.29\;\text{million}=\$26.29\;\text{million}[/latex].

This is the money-creating process. It is possible because there are multiple banks in the financial system; they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply.

10.4.2 The Money Multiplier

In a multi-bank system, the amount of money the system can create is found using the money multiplier. The money multiplier tells us how many times a loan will be “multiplied” through the process of lending out deposits. Thus, the money multiplier is the ratio of the change in money supply to the initial change in bank reserves.

Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The money multiplier formula is:

[latex]\begin{align*}\frac{1}{\text{Reserve Ratio}}\end{align*}[/latex]

This is also called the simple deposit multiplier. In our example, the reserve ratio is [latex]10\%[/latex], so the money multiplier is [latex]\frac{1}{10\%}=10[/latex]. Therefore, money grows 10 times the original deposit. The original deposit in Singleton Bank was $10 million. So

[latex]\text{total money supply}=10\times\$10\;\text{million}=\$100\;\text{million}[/latex].

The money multiplier will depend on the proportion of reserves that banks wish to hold. The Bank of Canada does not have a reserve requirement from commercial banks. However, banks may decide to hold in reserves with the Bank of Canada for two reasons: macroeconomic conditions and government rules. Banks are likely to hold a higher proportion of reserves when an economy is in recession because they fear loans are less likely to be repaid when the economy is slow. The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. Indeed, all of the money in the economy, except for the original reserves, is a result of bank loans that are re-deposited and loaned out again and again.