Jeffrey Timmermans

Global Economic JournalismClass 8: The Banking System

Measuring the money supply

✤ M1: Currency + Demand Deposits + Traveler’s Checks + Other Checkable Deposits

✤ M2: M1 + Savings Deposits + Retail Money Market Mutual Funds

U.S. Money Supply

CurrencyCurrencyM1M1

Savings Savings DepositsDeposits

Time DepositsTime Deposits

billions of U.S. dollars

Source: U.S. Federal Reserve

Money Mkt FundsMoney Mkt Funds

Structure of the Banking System

✤ Commercial banks borrow from each other to meet short-term (overnight) needs in the interbank market

✤ The overnight interbank rate is typically influenced by changes in the money supply made by central banks (open-market operations)

✤ Commercial banks take deposits from individuals and lend out some of those deposits

✤ The role of the banking system is channel savings to those who need funds/capital (financial intermediation

The Banking System

Central Bank

Commercial Bank

Commercial Bank

Commercial Bank

Commercial Bank

Discount window

Interbank market

Deposits

Home/car Loans

Business loans

Interbank rate

Base/discount rate

Prime rate

Deposit rate

Commercial lending rate+$ –$

Key interest rates

✤ Interbank rates

✤ Overnight, 1-wk, 1-mth, 3-mth

✤ Deposit rates

✤ interest rate banks pay for funds

✤ Prime (lending) rate

✤ interest rate banks charge for (some) loans

LOW

HIGH

Interbank rates

✤ U.S.: Fed Funds target rate

✤ H.K.: Hong Kong Interbank Offer Rate (Hibor)

✤ U.K.: London Interbank Offer Rate (Libor)

✤ Fed sets Fed Funds target rate; supply/demand determine Hibor & Libor

✤ Banks’ lending rates often based on local interbank rate

Commercial Banks

✤ Take deposits

✤ Deposits are banks’ liabilities

✤ Pay depositors interest (deposit rate)

✤ Make loans

✤ Loans (& reserves) are assets

✤ Banks keep some reserves, lend out the rest

✤ Earn interest from borrowers

Reserve Ratio

✤ Typically set by the central bank

✤ Indicates the percentage of deposits a bank must keep as reserves

✤ In U.S., reserve ratio is now 10% for deposits above $55.2 million

✤ In China, the reserve ratio is now 21% for large banks

✤ An increase in the reserve ratio forces banks to curtail lending, a decrease leads to more lending and an expansion of the money supply

Jeff’s Bank (100% reserve ratio)

AssetsAssets LiabilitiesLiabilities

Reserves $100 Deposits $100

Jeff’s Bank (10% reserve ratio)

AssetsAssets LiabilitiesLiabilities

Reserves $10 Deposits $100

Loans $90

The Money Multiplier

1

reserve ratio

How the multiplier works

Original deposit $100 $100

Jeff’s Bank lending$90 (.9 x

$100)$190

Masato’s Bank lending

$81 (.9 x $90) $271

Diane’s Bank lending

$72.90 (.9 x $81)

$343.90

etc. etc. etc.Total money supply $1,000

$90$90

$81$81

Definition of Capital (Basel III)

✤ Common equity (core) Tier 1 capital: equity

✤ Tier 1 capital: equity + disclosed reserves

✤ in other words: share capital + retained earnings (shareholders’ funds)

✤ Tier 2 capital: undisclosed reserves + revaluation reserves + general provisions/loan-loss reserves + hybrid instruments (equity look-alikes)

Source: Bank for International Settlements

Basel III capital requirements

✤ Minimum capital requirement: 8.0%

✤ Of which:

✤ at least 4.5% is core Tier 1

✤ at least 6% is Tier 1

✤ PLUS conservation buffer: 2.5% (entirely core Tier 1)

✤ PLUS counter-cyclical buffer: 0-2.5%(entirely core Tier 1)

Source: Bank for International Settlements