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Bank Finance and a Fractional Reserve System

25 April, 2016 - 09:12

Bank finance lies at the heart of the process through which money is created. To understand money creation, we need to understand some of the basics of bank finance.

Banks accept deposits and issue checks to the owners of those deposits. Banks use the money collected from depositors to make loans. The bank’s financial picture at a given time can be depicted using a simplified balance sheet, which is a financial statement showing assets, liabilities, and net worth.Assets are anything of value. Liabilities are obligations to other parties. Net worth equals assets less liabilities. All these are given dollar values in a firm’s balance sheet. The sum of liabilities plus net worth therefore must equal the sum of all assets. On a balance sheet, assets are listed on the left, liabilities and net worth on the right.

The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected—to companies seeking to expand their operations, to people buying cars or homes, and so on. Banks keep only a fraction of their deposits as cash in their vaults and in deposits with the Fed. These assets are called reserves. Banks lend out the rest of their deposits. A system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves is called a fractional reserve banking system.

The following Table 24.1 shows a consolidated balance sheet for commercial banks in the United States for June 2008. Banks hold reserves against the liabilities represented by their checkable deposits. Notice that these reserves were a small fraction of total deposit liabilities of that month. Most bank assets are in the form of loans.

Table 24.1 The Consolidated Balance Sheet for U.S. Commercial Banks, June 2008 This balance sheet for all commercial banks in the United States shows their financial situation in billions of dollars,seasonally adjusted, on June 2008.

Assets

Liabilities and Net Worth

Reserves

$300.0

Checkable deposits

$604.5

Other assets

1,357.8

Other deposits

6,306.7

Loans

6,903.4

Borrowings

2,322.1

Securities

2,466.9

Other liabilities

6,576.6

Total assets

$11,928.1

Total liabilities

9,890.9

 

Net worth

1,137.2

 

Source: Federal Reserve Statistical Release H.8, August 1, 2008.

In the next section, we will learn that money is created when banks issue loans.