financial intermediation -- an institution performs financial intermediation if it takes deposits and makes loan, borrows short and lends long

advantages of financial intermediation

1. cost minimization -- pool funds for large loans; monitor borrowers
2. risk pooling -- loan default costs are spread out
3. high liquidity  -- will borrow short and lend long -- fills a gap

types of financial intermediaries

commercial banks

commercial bank -- private firm chartered by a state agency or by the United States Treasury's Comptroller of the Currency to perform financial intermediation

balance sheet -- summarizes the current financial position of firm by comparing the firm's assets and liabilities

We sometimes illustrate the concept of a balance sheet with a pedagogical device: the "T-account".

A T-account will allow us to illustrate money creation and understand some of the activity of a local bank.

A hypothetical T-account might include the following:

To satisfy the cash demands of customers banks must keep on hand a certain amount of vault cash and reserves with the Federal Reserve

The amount that must be kept on hand depends on the:

legal reserve requirement (LRR) -- the percentage of demand deposits banks and other financial institutions must keep in cash or reserves.

• checkable deposit -- a non interest earning deposit of funds that can be withdrawn (demanded) from a depository institution at any time without restriction by writing a check (The check is not money, it is a means of transfer of money.)
• time deposit - a deposit of funds upon which a depository institution can legally require 30 days notice of withdrawal

savings and loan (S&L) -- traditionally obtained funds from savings deposits and made mortgage loans to home buyers

savings banks

savings bank -- owned by the depositors, accept savings deposits and make mostly mortgage loans

credit unions

credit union -- owned by depositors, based on a social or an economic group

money market mutual funds

money market mutual fund -- obtain funds by selling shares, purchases highly liquid assets; can write checks
 

Study Question: Describe the process of financial intermediation and its importance to the economy.  Which institutions perform financial intermediation?

bank regulation

As will become apparent from a brief study of banking history (see "Capsule Monetary History"), the banking industry requires more regulation than many other types of business.  The banking industry faces two broad types of regulation:

1. deposit insurance
2. balance sheet rules

The information in this section was derived from the Federal Deposit Insurance Corporation's web site.  You should visit the site for more information.

The Federal Deposit Insurance Corporation's mission is to maintain the stability of and public confidence in the nation's financial system. To achieve this goal, the FDIC has insured deposits and promoted safe and sound banking practices since 1933.

The FDIC:

1. Insures deposits up to $100,000 in virtually all United States banks and savings associations (also called savings and loan associations or S&Ls).
2. Arranges a resolution for each failing institution - one that is the least costly to the insurance fund and, when possible, the least disruptive for customers.
3. Promotes the safety and soundness of insured depository institutions and the U.S. financial system by identifying, monitoring and addressing risks to the deposit insurance funds. The FDIC also is the primary federal regulator of about 6,000 state chartered "nonmember" banks (commercial and savings banks that are not members of the Federal Reserve System).

1. capital requirements -- minimum amount of owner's money that must be invested into the bank.  This keeps the administration of the bank from dealing with "other people's money" and discourages risky investments.
2. legal reserve requirement (LRR) -- the percentage of demand deposits banks and other financial institutions must keep in cash or reserves.
3. deposit rules -- restrictions on the types of deposits different types of financial intermediaries can accept.  These rules have changed in recent decades with deregulation
4. lending rules -- restrictions on the different type of loans an institution may make.  These rules have changed in recent decades with deregulation.

1.    Depository Institutions' Deregulation and Monetary Control Act (1980)

• removed many of the distinctions between commercial banks and other financial intermediaries
• extended the powers of the Federal Reserve to place reserve requirements on all depository institutions

• eased restrictions on the scale of commercial lending that savings and loan associations  could undertake

• United States banks may establish branches in any state

Money is created by the creation of demand deposit liabilities (money) in the process of making bank loans.

Recall there is a legal reserve requirement (LRR).  Any individual bank may make loans in the amount over and above this legal requirement.  This "extra/surplus" cash is referred to as excess reserves.

excess reserves -- reserves in excess of required (or desired -- banks may not desire to reach the legal minimum) reserves

Excess Reserves (ER) is equal to the difference between Total Reserve (TR) and Required Reserves (RR)

ER = TR - RR

Assume the banking system initially has no excess reserves and a legal required reserve of 10%.  If Granny is convinced by Jethro to deposit the money she has been keeping in her mattress in the First National Bank of Bugtussle:

Granny's deposit does not affect the money supply.  The cash she held outside the banking system has simply be deposited in a local bank.

The money supply is changed when the administrators of FNBB discover the additional demand deposits they have acquired.  Being profit minded they desire to use these funds to the best of their ability.  They decide to make a loan.  to determine how much they can loan, they calculate the bank's excess reserves.

ER = TR - RR

ER = TR - (TR x LRR)

ER = $100 - ($100 x .10)

ER = $100 - $10

ER = $90

With an additional $90 in excess reserves FNBB decides to make the loan for which Ellie May has applied.  She needs extra living quarters for her critters.  When the bank makes the loan:

The money supply has increased by $90 simply because FNBB has made a loan.

When the loan is paid back:

The money supply decreases and returns to its pre loan level.

multiple deposit creation

while no one bank can create more money than its excess reserves, the banking system as a whole can.  The money is lent over and over again from one bank to another.

This process is very similar to the expenditure multiplier of Keynesian economics.

Let's examine what might occur it the banking system as a whole if the quantity of excess reserves changes.  The legal required reserve is 15% and the system is initially "loaned up" - no excess reserves.

There is an initial deposit of $500.  "Bank A" calculates its initial excess reserves.

ER = TR - RR

ER = TR - (TR x LRR)

ER = $500 - ($500 x .15)

ER = $500 - $75

ER = $425

In order to gain the full benefit of this Flash file it will be necessary to scroll down the screen while it is running.  Follow the $ to see the multiple deposit expansion illustration.

The banking system as a whole creates more money than the initial change in excess reserves.

Let's trace this process in the form of a table:

Bank    New Deposits    Loans    Required Reserves

  A        $500.00     $425.00        $75.00
  B         425.00      361.25         63.75
  C         361.25      307.06         54.19
  D         307.06      261.00         46.06
  .            .           .             .
  .            .           .             .
  .            .           .             .
  .            .           .             .
  .            .           .             .
all other       .           .             .
banks      1,740.02    1,479.02    261.00
sum      $3,333.33   $2,833.33       $500.00

The final change in the money supply (total deposits) is equal to the initial change in reserves times a fixed constant - the deposit multiplier.

The deposit multiplier is determined by the following formula:

        deposit multiplier = 1/LRR

In the example given above the deposit multiplier is:

        1/.15 = 6.66

To calculate the final change in the money supply:

        $500 x 6.66 = $3,333.33

The deposit multiplier works in both directions.  An increase in reserves gives rise to a larger increase in the money supply than the initial change in reserves.  A decrease in reserves gives rise to a larger decrease in the money supply than the initial change in reserves.
 

Study Question: Characterize multiple deposit expansion by the banking system.  What is the role of the legal reserve requirement (LRR)?  Be certain to develop the deposit multiplier in your analysis.