How do banks create money? Explain the theory of the credit multiplier

13. How do banks create money? Explain the theory of the credit multiplier.

In order to understand how banks create money we illustrate a simple model of the credit multiplier based on the assumption that modern banks keep only a fraction of the money that is deposited by the public. This fraction is kept as reserves and will allow the bank to face possible requests of withdrawals. Suppose that there is only one bank in the financial system and suppose that there is a mandatory reserve of 10 percent. This means that the bank will have to put aside as reserves 10 percent of its total deposits. We can illustrate the balance sheet of this bank over three time periods in this table.

The case of a single bank under a 10 per cent reserve ratio (£mil)

		Initial period	Intermediate period: increase deposits by £50 000	Financial period: adjust reserve ratio
Liabilities	Deposits	50	50.05	50.05
Assets	Reserves	5	5.05	5.005
	Loans	45	45	45.045
Reserve ratio		10%	10.1%	10%

The credit multiplier is defined as the ratio of change in deposits to the change in level of reserves:

where:

Deposits = the change in the level of deposits

Reserves = the change in the level of reserves.

The credit multiplier is the same as the reciprocal of the reserve ratio (i.e. 1/0.10 = 10).

The credit multiplier explained above has several drawbacks. As with most theories, the assumptions behind this simple model are not very realistic. The creation of deposits is much less “mechanical” in reality than the model indicates and decisions by depositors to increase their holdings in currency or by banks to hold excess reserves will result in a smaller expansion of deposits than the simple model predicts. Further, there are leakages from the system: for example, money flows abroad; people hold money as cash or buy government bonds rather than bank deposits. These considerations, however, should not deter from the logic of the process, which is bank deposits “create” money.

14. Define universal banking. Discuss the adventages and disadventages of a universal banking system.

An institution which combines its strictly commercial activities with operations in market segments traditionally covered by investment banks, securities houses and insurance firms, and this includes such business as portfolio management, brokerage of securities, underwriting, mergers and acquisitions. A universal bank undertakes the whole range of banking activities.

Universal banking Under the universal banking model, banking business is broadly defined to include all aspects of financial service activity – including securities operations, insurance, pensions, leasing and so on.

Conglomeration has become a major trend in financial markets, emerging as a leading strategy for banks. This process has been driven by technological progress, international consolidation of markets and deregulation of geographical or product restrictions. In the EU, financial conglomeration was encouraged by the Second Banking Directive (1989), which allowed banks to operate as universal banks, enabling them to engage, directly or through subsidiaries, in other financial activities, such as financial instruments, factoring, leasing and investment banking. In the US, the passing of the Gramm-Leach-Bliley Act in 1999 removed the many restrictions imposed by the Glass-Steagall Act of 1933. Since 1999 US commercial banks can undertake a broad range of financial services, including investment banking and insurance activities. Similar reforms have taken place in Japan since 1999. As banks nowadays are diversified financial services firms, when we think about banks we should now think more about the particular type of financial activity carried out by a specialist division of a large corporation rather than the activity of an individual firm.

15. Has the 2007-2009 financial crisis exposed yhe weaknesses of the universal bank business model?

Since the immediate aftermath of the 2007–2009 financial crisis, a growing number of academics and policy makers are debating on whether the size and permissible activities of financial institutions should be re-constricted due to increased systemic risk. Narrowing the scope of large financial institutions would require the re-introduction of firewalls like those imposed by the Glass-Steagall Act to limit the risks that depositors are exposed to. The current proposals for regulatory reforms include Basel III, the Dodd-Frank Act in the United States and the UK government’s proposals for “ring-fencing” (Independent Commission on Banking (ICB), also known as the Vickers Commission). At the EU level, structural reforms were discussed by an Expert Group led by Governor Liikanen from the Bank of Finland (the so-called Liikanen Group) and resulted in the publication of the Liikanen Report in October 2012.

16. Discuss the main services offered by banks.

Modern banks offer a wide range of financial services, including:

● payment services;

A payment system can be defined as any organised arrangement for transferring value between its participants. Heffernan defines the payment system as a by-product of the intermediation process, as it facilitates the transfer of ownership of claims in the financial sector. These payment flows reflect a variety of transactions, for goods and services as well as for financial assets. Some of these transactions involve high-value transfers, typically between financial institutions.

● deposit and lending services;

Current or checking accounts that typically pay no (or low) rates of interest and are used mainly for payments. Banks offer a broad range of current accounts tailored to various market segments and with other services attached.

Time or savings deposits that involve depositing funds for a set period of time for a pre-determined or variable rate of interest. Banks offer an extensive range of such savings products, from standard fixed term and fixed deposit rate to variable term with variable rates.

Consumer loans and mortgages are commonly offered by banks to their retail customers. Consumer loans can be unsecured (that is, no collateral is requested – such loans are usually up to a certain amount of money and for a short to medium time period.

● investment, pensions and insurance services;

Investment products offered to retail customers include various securities-related products: mutual funds (known as unit trusts in the UK), investment in company stocks and various other securities-related products (such as savings bonds). In reality there is a strong overlap between savings and investments products and many banks advertise these services together.

Pensions and insurance services are widely offered by many banks. Pension services provide retirement income (in the form of annuities) to those contributing to pension plans. Contributions paid into the pension fund are invested in long-term investments, with the individual making contributions receiving a pension on retirement. The pension services offered via banks are known as private pensions to distinguish them from public pensions offered by the state.

● e-banking.

A number of innovative financial products have been developed taking advantage of rapid technological progress and financial market development. Transactions made using these innovative products are accounting for an increasing proportion of the volume and value of domestic and cross-border retail payments. Mainly, we can refer to two categories of payment products:

-E-money includes reloadable electronic money instruments in the form of stored value cards and electronic tokens stored in computer memory.

-Remote payments are payment instruments that allow (remote) access to a customer’s account.