Closer Look

In-class Slides (Powerpoint):  Unit11.f2fslides.2013

Tutorials on Money and Banking:

NOTE:  There is a typo on slide 22 of the Money and Banking Tutorial.  The headline on slide 22 says “Reserves increase but M1 stays unchanged”.  It should read “both reserves and M1 stay unchanged”.

Finding Your Way Around a Bank Balance Sheet – the Basics:

A balance sheet is an accounting statement that businesses (or individuals) use to show their financial status at a particular point in time.  Balance sheets represent what economists call “stock” data: information about what the firm owns and owes. We are going to look at what a bank owns and owes. We typically represent simple balance sheets using a “T-account” format that looks something like this:

Example Balance Sheet
Assets Liabilities
 Reserves  Deposits
 Securities Owned  Securities Issued
 Loans  Net Capital
 Other & Fixed Assets

The reason we use this two-column “T-account” format is because of the first rule of balance sheets. The two sides must “balance” or equal each other. On the left side we list everything the bank owns and owes.  What the bank owns are called assets. On the right side, we list what the bank owes to other people or entities. The difference between total assets and total liabilities tells us the amount by which the bank owns more than it owes. This is referred to as the bank’s net worth or net capital.  Net capital is the value that the shareholders of the bank would get if the bank were totally liquidated, assets sold and debts paid today.  Net capital reflects the current investment the shareholders have in the bank.  Total assets (total of left side) must always equal total right side (total liabilities and net capital).

In the balance sheet above, we have listed four types of assets, two liabilities, and net capital. We have listed these types of accounts on each side in decreasing order of liquidity. In other words, the items at the top of the list, Reserves and Deposits, are highly liquid, meaning they can be easily converted into cash payments.  Looking only at assets, we see that the least liquid assets are “fixed assets”, things like buildings, furniture, and computers.  Things that are very difficult to sell or convert into cash on short notice.

That leaves two types of assets in the middle of the list: securities owned and loans.  In a sense, both of these items are a form of “loan” where the bank has loaned money to somebody else, is entitled to repayment at some point, and expects to get paid interest on top of the repayment.  For a bank, though, the critical difference is profits vs. liquidity.  Generally, loans will have a much higher interest rate earning the bank more profits. But loans are things like home mortgages, car loans, business loans, construction loans, student loans, and credit cards. But loans tend to be riskier and definitely less liquid.  That’s why banks also hold securities.  This is a term that refers to buying and owning government bonds, bonds issued by other banks or corporations, derivatives, and short-term loan agreements with other banks (called re-po’s). Securities are considered safer than loans but pay less in interest.  However, securities are more liquid.  They aren’t as liquid as having cash sitting in your vault or on deposit at The Fed, but securities are generally traded in a wide-spread public market meaning they can be sold anytime the bank wants and converted into cash.

Securities also show up on the liabilities side of the balance sheet, but these securities are bonds this bank has issued, re-po’s, or borrowings from The Fed.  Securities on the liability side represent money this bank has borrowed from others.  Securities on the liability side do represent money that the bank has borrowed and usually on short-terms, meaning the bank must pay it back in a short period of time.  The typical large bank borrows significantly using securities and then pays them off by re-issuing new securities, a process called rolling-over the debt.

In September 2008 when most large Wall Street banks ran into difficulties, it was because fear about which banks were healthy and which ones weren’t caused banks and investors to demand repayment of these bank-issued securities without re-investing in new securities. This caused a drain on bank reserves and threatened to topple most banks.

Understanding Reserves

Bank reserves are the monies available to pay a depositor when a depositor wants to withdraw money from their account.  Think of a bank as having “total reserves” – the money available instantly to pay for a withdrawal or to pay for a check when presented to the bank.  We can divide these “total reserves” into two categories according to where the funds are physically being held:

  • Cash – also called vault cash or cash-on-hand, means the money physically present in the bank, in the vault or in the cashiers’ drawers, or in the ATM’s.
  • Deposits at The Fed – all banks are required to hold deposit accounts at The Federal Reserve Bank.  This is money the bank puts on deposit at The Fed.  Think of The Fed as the bank’s banker.  When cash is too much to safely or conveniently hold in the vault, the bank makes a deposit at The Fed. The Fed uses these accounts to clear checks between banks and the money is instantly available electronically.
Regardless of where the reserves are being held, we can also analyze the reserves into:
  • Required Reserves – the minimum amount of reserves a bank must hold given the amount of checkable deposits it has.  To figure required reserves, you figure:
    $ofRequiredReserves = Total$ofCheckableDeposits * RequiredReserveRatio
    If a bank doesn’t keep the minimum required reserves on hand, it is in regulatory failure and it is referred to as a “reserve deficiency”.  The bank has failed.  Typically, The Fed or central bank will lend money (see securities issued above) to the bank before it gets into a required reserve deficiency.
  • Excess Reserves – Excess reserves are exactly that: the excess reserves on hand over and beyond the required minimum.  So we figure excess reserves as:
    TotalReserves - RequiredReserves = ExcessReserves

Every new deposit by a customer does two things:  it raises the total checkable deposits (what the bank owes its customers) and it increases total reserves.  If a customer deposited currency, then the currency goes into the vault and total reserves are increased. If the customer deposited a check from another bank, The Fed will transfer money from the other bank to this bank’s deposit account at The Fed – increasing total reserves.

This relationship of required reserves and excess reserves means that when a new deposit is received, part of the deposit adds to required reserves and part adds to excess reserves.  How much? That depends on the required reserve ratio.  If the RR ratio is 12%, then 12% of the deposit adds to required reserves and the remainder, 88%, adds to excess reserves.