Banking
Banks can create spending power using the fractional reserve system. It is best to illustrate this process with an example.
Suppose you have a new bank opening in a town that previously had no bank.
The people of the town deposit $100 in the bank.
Period 1:
Banks assets: $100 in cash.
Bank's Liabilities: $100 it owes to depositors.
The bank is only required to keep 10% of the money in reserve in order to pay people who come to claim their money, so they lend $90 out to a local business to build a new store. Once the money is spent by the business on their new store, whoever they paid will put the money back in the bank. Note that in a large town with many banks, a bank may not see the money it lends come back to it directly, but the banking system as a whole will get the money.
Period 2:
Assets: $10 in cash, $90 loan to the business, $90 deposit from the builders of the store.
Liabilities: $100 it owes to depositors, $90 it owes to builders of the store.
Since the bank now has $190 in deposits, they must carry an additional $9 worth of cash to back the deposits. The process will continue until the bank holds all $100 in its vaults and has deposits of $1,000.
Period n (where n is a fairly big number):
Assets: $100 in cash, $900 worth of loans made to homeowners, buisinesses or anyone else.
Liabilities: $1000 owed to depositors.
The bank has 2 main sources of profit: interest from the loans it makes and fees it collects from its customers. A banker's main task is to make loans that will get paid back. If the loans are not paid back, and the bank takes more losses through defaults then they make in interest payments on their good loans, they will be insolvent and (hopefully) go out of business. In a policy regime without deposit insurance, the bank's assets will be sold off and the depositors will be paid a fraction of their deposits.
Now we will introduce equity and debt. A bank that holds currency equal to the reserve requirement can make no new loans using its deposits. However, they can issue equity (stock) to investors. Equity allows banks to make loans in a similar manner to deposits, however, it carries no requirement to be paid back in full. The shareholders bear the risk that if the loans are not repaid, the value of their stock will go down. Suppose the capital requirement is 5% equity, or a 20-1 leverage ratio. The bank can borrow money from other banks, money market funds or investors and lend that money out at a higher interest rate and collect the difference as profit. The capital requirement prevents them from borrowing more than a certain multiple of their equity value.
Example:
The bank has 10 shares of stock, each is worth $10. They are able by law to borrow up to $2000 and lend it out.
Assets: $100 in cash, promises to pay them back worth $2,000.
Liabilities: $100 in equity owed to investors, $2,000 issued debt that they owe to their creditors.
If the banks make good loans, they will be profitable and the investors will get their money back plus some. If not, they can take up to 5% losses and still remain solvent. In between 100% and 95%, the investors will take all of the losses. Above that, the bank's creditors will not be paid back and the bank will hopefully be driven into bankruptcy. In reality, the creditors usually whine to Congress and Congress pays them using taxpayer funds.
To get a full picture of a bank, one needs to combine both pictures above. Banks have liabilities to their creditors, their shareholders and their depositors. They have assets consisting of the loans they made, cash they raised from stock stales and deposits.
Suppose you have a new bank opening in a town that previously had no bank.
The people of the town deposit $100 in the bank.
Period 1:
Banks assets: $100 in cash.
Bank's Liabilities: $100 it owes to depositors.
The bank is only required to keep 10% of the money in reserve in order to pay people who come to claim their money, so they lend $90 out to a local business to build a new store. Once the money is spent by the business on their new store, whoever they paid will put the money back in the bank. Note that in a large town with many banks, a bank may not see the money it lends come back to it directly, but the banking system as a whole will get the money.
Period 2:
Assets: $10 in cash, $90 loan to the business, $90 deposit from the builders of the store.
Liabilities: $100 it owes to depositors, $90 it owes to builders of the store.
Since the bank now has $190 in deposits, they must carry an additional $9 worth of cash to back the deposits. The process will continue until the bank holds all $100 in its vaults and has deposits of $1,000.
Period n (where n is a fairly big number):
Assets: $100 in cash, $900 worth of loans made to homeowners, buisinesses or anyone else.
Liabilities: $1000 owed to depositors.
The bank has 2 main sources of profit: interest from the loans it makes and fees it collects from its customers. A banker's main task is to make loans that will get paid back. If the loans are not paid back, and the bank takes more losses through defaults then they make in interest payments on their good loans, they will be insolvent and (hopefully) go out of business. In a policy regime without deposit insurance, the bank's assets will be sold off and the depositors will be paid a fraction of their deposits.
Now we will introduce equity and debt. A bank that holds currency equal to the reserve requirement can make no new loans using its deposits. However, they can issue equity (stock) to investors. Equity allows banks to make loans in a similar manner to deposits, however, it carries no requirement to be paid back in full. The shareholders bear the risk that if the loans are not repaid, the value of their stock will go down. Suppose the capital requirement is 5% equity, or a 20-1 leverage ratio. The bank can borrow money from other banks, money market funds or investors and lend that money out at a higher interest rate and collect the difference as profit. The capital requirement prevents them from borrowing more than a certain multiple of their equity value.
Example:
The bank has 10 shares of stock, each is worth $10. They are able by law to borrow up to $2000 and lend it out.
Assets: $100 in cash, promises to pay them back worth $2,000.
Liabilities: $100 in equity owed to investors, $2,000 issued debt that they owe to their creditors.
If the banks make good loans, they will be profitable and the investors will get their money back plus some. If not, they can take up to 5% losses and still remain solvent. In between 100% and 95%, the investors will take all of the losses. Above that, the bank's creditors will not be paid back and the bank will hopefully be driven into bankruptcy. In reality, the creditors usually whine to Congress and Congress pays them using taxpayer funds.
To get a full picture of a bank, one needs to combine both pictures above. Banks have liabilities to their creditors, their shareholders and their depositors. They have assets consisting of the loans they made, cash they raised from stock stales and deposits.