Saturday, September 24, 2011

The Banking System

CFA Level 1 - Macroeconomics

Types of Institutions

There are three major types of depository institutions:
1.Commercial banks

2.Thrift institutions such as credit unions, savings and loan associations (S&Ls), and savings banks. Credit unions are cooperative organizations, usually restricted to employees of a particular firm or government entity. The savings banks and S&Ls have historically focused their loan activities to the real estate mortgages.

3.Money market mutual funds offer bank-like features. Shareholders of these funds are allowed to write checks against these funds. However, these funds do have restrictions. The mutual funds specify minimum check amounts such as $250.

Their main economic functions include providing liquidity, lowering the cost of borrowing money, and pooling the risk associated with lending money.
All of these institutions make money by charging more for loans than what they pay for deposits, and they are all subject to substantial regulation.   Major areas of concern for regulation include reserve requirements, capital requirements, lending rules, and deposit rules. For example, in the past, only commercial banks could offer checking accounts, and savings banks could only offer saving accounts. Those restrictions were relaxed in the 1980s.

Money market mutual funds have been a major force in providing competitive interest rates to short-term depositors. Technological innovation has been a major force in providing new services to customers. For example, crediting interest on a daily basis was not feasible before the advent of modern computer technology.

The Fractional Reserve Banking System

A fractional reserve banking system exists when the amount of reserves banks must keep on hand is less than the amount of their deposits.   In the U.S., banks must keep a fraction of their assets as bank reserves - cash plus deposits with the Federal Reserve, which is the nation's central bank.   Banks issue loans with the funds that are not held in reserve; in doing so, they expand the nation's money supply.

The Required Reserve Ratio

The required reserve ratio is the percentage of a particular liability category (to the bank), such as savings accounts, that must be held as reserves. If someone deposits $10,000 at a bank and there is a 20% reserve requirement, the bank must keep $2,000 as reserves and can loan out only $8,000. If the reserve requirement is 10%, the bank could loan out $9,000. The $9,000 that is loaned out can be deposited at the original bank or at another bank; 90% of that $9,000, which is $8,100, can then be loaned out. This process continues until the amount of money supply generated is equal to $10,000 × (1 / .1) = $100,000.

The Actual and Potential Deposit Expansion Multipliers
The potential deposit expansion multiplier is the reciprocal of the required reserve ratio. If the required reserve ratio is 5% (.05), the potential deposit expansion multiplier is equal to 1 / .05 = 20.

The actual deposit expansion multiplier is less than the potential deposit expansion multiplier for two reasons: ·Banks may not loan out all available funds (i.e. they may have excess reserves, which are reserves that exceed required reserves)

·Recipients of loans may not deposit the proceeds; they may instead decide to hold them as currency
Do you like this post?


Post a Comment

Related Posts with Thumbnails