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A look at the composition and roles in a typical commercial bank

  • In this example, net assets can fall in principle by 72 million before bondholders lose a cent;
  • For whatever reasons, there has been, since 1986, a sharp rise in the ratio of currency to deposits this includes all the deposits counted in M2 ; see Figure 4;
  • As I mentioned, one of the tasks of the Fed is to provide short-term loans to banks;
  • The adjustment for risk weights risky assets more than unrisky assets, so that banks engaged in risky activities must hold more capital.

Introduction To this point we've been a little cavalier about money and financial markets, ignoring the distinctions between between currency and monetary aggregates M in our theories and the roles played by financial institutions in channeling saving to firms and governments, domestic and foreign. In the next two classes we'll rectify some of these oversights, and take a closer look at banking, financial intermediation more generally, and monetary policy in the US and around the world.

With apologies to Goldman Sachs, the word "bank" will generally be used to mean commercial bank in this Chapter of the notes. Commercial Banking in the US Financial intermediaries are "middle-men" or with less gender bias, "middle-people" who funnel funds from sources of funds savers, foreign investors to users business, government.

In principle, savers could purchase assets directly from users, as when an individual buys a treasury bill or share of stock. But in practice, most funds flow through intermediaries of various types: Investment banks play a role here, too, and also help to match borrowers and lenders. To get a rough idea where these institutions stand in the US, here are some numbers for 1991: In fact, their market share has fallen from about 39 percent in 1970 to 29 percent in the numbers above.

Thrifts have done even worse, falling from 20 to 12 percent over the same period and for obvious reasons. The big gainers have been pension funds and mutual funds. While many financial trends are global, there are nonetheless substantial cross-country differences in financial institutions. The most obvious of these concern banks. The US banking system differs from many countries both in the range of services supplied by commercial banks and in the sheer number of them---roughly 12,000 at last count.

This compares with 10 in Canada, of which 4 or 5 have almost all of the business. Or about a hundred in the UK, where 6-8 banks control about 80 percent of the market. We could make similar statements about France, Germany, and Japan: I am referring here to commercial banks or their equivalent in other countries, not thrift institutions, investment banks, or anything else that sounds like a bank. US banks have traditionally accepted deposits from customers individuals and businesses and used the proceeds to finance loans to businesses and individuals and investments in corporate and government securities.

This is often allied with related businesses like credit cards, foreign currency transactions, and so on. But until recently the reach of commercial banks did not extend to investment banking activities, like underwriting. In many countries, however, banks provide a more complete range of financial services.

In Germany, for example, "universal" banks provide investment banking and insurance services. In the US, the banking and insurance industries have been separately regulated almost from the start, and commercial and investment banking were formally torn apart by the Glass-Steagall Act of 1933---hence the separate identities now of Morgan Stanley and JP Morgan.

In recent years, the Act has been weakened, and many of the leading commercial banks now offer some range a look at the composition and roles in a typical commercial bank investment banking services through so-called Section 20 subs. Bankers Trust has moved so far along this path that while it's still officially a commercial bank, it no longer has a retail business.

Conversely, Merrill Lynch and other retail brokers now offer money market accounts that serve much the same purpose as checking accounts at commercial banks. In short, changes in regulations have had an enormous impact on the financial services industry in general, and commercial banking in particular, over the last twenty years or so.

Along with the reduction in the market share of commercial banking, we have seen, and will likely continue to see, a sharp reduction in the number of banks. The huge number of commercial banks in the US reflects a long-standing political impasse.

On the one hand, Alexander Hamilton, resting in the Trinity Church cemetery near the head of Wall Street, argued that a strong banking system was essential to the economic viability of the country. On the other, Thomas Jefferson and his Virginia compatriots thought that large banks would place too much power in the hands of a few individuals.

  1. Commercial banks may offer other services such as brokering insurance contracts, giving investment advice and so on. Other Regulatory Issues Risk-based deposit insurance.
  2. Commercial banks may offer other services such as brokering insurance contracts, giving investment advice and so on.
  3. One of the outcomes, apparently, was the huge losses on loans to the third world, to lower-rated businesses, and on commercial real estate.

The result was a compromise that placed much of the oversight and control of banks in the hands of states. Thus we have, in some ways, not a single national set of banking legislation but fifty different sets.

This has come up in talks with the European Community concerning reciprocal foreign banking regulations: As the regulations supporting the excessive segmentation of the banking industry are relaxed, we can expect to see a steady decline in the number of banks.

Monetary Aggregates One of the ways in which commercial banks show up in this course is through their deposits, which are part of what we generally call "money".

A look at the composition and roles in a typical commercial bank

Money, as the word is understood by economists and business-people, consists of both currency issued by the government and deposits at banks and now at other deposit-taking institutions, as well.

The narrowest monetary aggregate is M1, which consists largely of currency and checking accounts. This aggregate is an attempt to mimic our theory, in which we viewed money as something that could be used to make transaction. We defined this as currency, but in practice it's often easier to write a check than to pay in cash, so we might want to include checking accounts in our measure of money.

  • This compares with 10 in Canada, of which 4 or 5 have almost all of the business;
  • In the next 12 months, the organizers must get their FDIC insurance paid, secure staff, buy equipment and so on, as well as go through two more regulatory inspections before the doors can open;
  • The idea was to make banks healthier and get loans into the system or, in our model, to increase the money multiplier;
  • M3 contains, in addition to M2, large denomination time deposits and Eurodollar accounts, and some other things.

Who has all this? This wasn't always the case, but since these institutions now have deposits that are like bank accounts in everything but name, they are now included in the data and are treated the same by regulators reserve requirements, for example.

M1 is the aggregate that conforms most closely with our macroeconomic theory. We argued that "money" was useful for transactions, but paid no interest.

Particularly during the 1970s and 80s, the line dividing accounts used for transactions and those that were pure investments became extremely fuzzy. Banks, in competing for deposits, offered accounts that paid interest like time deposits yet had some of the check writing capabilities of checking accounts. In fact only a small part of the so-called checkable deposits above consists of pure demand deposits. They also offered, especially to large business customers, demand deposits that could be converted to time deposits or other interest-bearing asset at the end of the day to get higher interest.

As a result, economists who studied this found that M1 seemed to vary erratically over time as demand deposits were relabeled as time deposits and so on, and that the definition of M1 itself was becoming highly arbitrary. In the last decade, emphasis has switched instead to broader definitions of money that include both demand and time deposits and are thus less prone to variation as names and features of deposits change. The disadvantage of the broader definitions is that we are no longer talking about assets held purely for transactions purposes.

In any case, the numbers for M2 and M3 are: M3 contains, in addition to M2, large denomination time deposits and Eurodollar accounts, and some other things. The Federal Reserve currently emphasizes M2 in its policy statements.

Our graphs of "money" in earlier lectures were also M2. It's clear, then, that most of what we call "money" consists of bank deposits and is therefore not under the direct control of the Fed. To see how the Fed might influence M2 indirectly, we need to think a little about how the banking system interacts with monetary policy. That's what we do next. A Theoretical Model of a Banking System Many aspects of economic theory have been around for decades, even centuries. Past and future changes in the global financial system, however, are likely to make some of what we're about to do obsolete before long.

The tradition in theory has been to emphasize the role of banks over other financial intermediaries and focus, in particular, on banks' role as suppliers of assets that are used in making transactions---checking accounts and their close relatives. But as the line between banks and other institutions gets fuzzier, and alternative means of payments arise, these two distinctions may turn out to be less useful than they have been in the past.

Nevertheless, this line of study gives us a start toward understanding how the financial system operates. The objective of this section is to provide a link between the money between the monetary aggregates used in our theory think of this as M2 and the part of "money" that is under the direct control of the Federal Reserve which we call the monetary base, MB.

We try to spell out the link between Fed policy and monetary aggregates, and the role of the banking system in this process. To get ourselves warmed up, as it were, let's look at the balance sheets of the Fed and the Private Sector in a stylized economy that has no banking system, and the effect on these balance sheets of an open market operation.

Then we'll go on to see how a banking system changes the analysis. Let us say, then, that the Private Sector excluding banks has, among other assets, 500 of treasury bills, 100 of currency, and some equity.

Read one sometime to see for yourself. In this economy, like the one I had in mind when we talked about the Keynesian model, the money supply is the supply of currency: We can change this with an open market operation. If the Fed wants to increase the money supply by 10, it simply buys 10 worth of treasury bills from the public. That's what was going on behind the scenes in our discussion of monetary policy in the Keynesian model: That was practice, now we develop the same idea for an economy with a banking system.

We add bank deposits and the corresponding loans to the private sector's balance sheet and bring banks into the picture. A possible configuration is: With more than one type of deposit we have more than one type of money and a more complicated theoretical setup. The question is how an open market operation that changes the monetary base MB influences the monetary aggregate M---whether, that is, we can talk about the Fed influencing a monetary aggregate, when policy involves the narrower monetary base.

We can derive the relation between the monetary base MB and the monetary aggregate M if we make some assumptions about behavior. Let us say, first, that private agents like to hold cash and bank deposits in some strict proportion: The idea is that we make some transactions with cash, others with checks, and the proportions of the two doesn't change much.

A look at the composition and roles in a typical commercial bank us also assume that banks hold a constant fraction of their deposits as reserves: This latter assumption is pretty good, since the Fed requires them to hold reserves proportional to their deposits we'll see the details shortly. From a bank's point of view this acts as a tax on their deposits, since reserves earn no interest. Even if there were no minimum reserves, banks might be expected to hold some fraction of deposits in cash as part of their day to day business.

From this, we can derive a relation between the monetary aggregate and the monetary base. The expression in brackets is referred to as the money multiplier, since we generally see that the stock of money is a multiple of the monetary base. We now have an answer to our question: In that sense, we can speak loosely about the Fed "controlling" M2 and other aggregates.

But are the ratios constant?

A look at the composition and roles in a typical commercial bank

We can get some idea by plotting the data. In Figure 1 and Figure 2 we see how monetary aggregates and related variables have behaved over time.

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In Figure 2 we see the money multipliers for the three aggregates. Again there has been some variation over time as there must be since the aggregates have grown at different rates. You can see the same thing in different form Figure 3where the growth rates of MB and M2 are drawn.

In short, the money multipliers are another case of a reasonable approximation, but in the short run we see some variation which is reflected in different growth rates across aggregates. Thus the money multiplier theory is only a rough guide and in the short run, at least, the Fed may have a difficult time affecting monetary aggregates.

Money in the Depression One of the many unusual events of the 1930s is that the stock of money think of this as M2 actually fell by 35 percent between March 1930 and March 1933.

  1. Particularly during the 1970s and 80s, the line dividing accounts used for transactions and those that were pure investments became extremely fuzzy. Other Regulatory Issues Risk-based deposit insurance.
  2. Reserve requirements are changed infrequently.
  3. It's an open question, given the conflicting evidence, whether we view monetary policy in Japan as loose, tight, or in between.
  4. Reports from the 1930s sound, in some ways, much like the late 1980s.