3.4.2 A bank’s assets and liabilities
Although banks possess valuable real assets in the form of property and technical equipment (e.g. computers), most of their assets are financial assets. These financial assets take the form of claims against individuals or firms. Thus, when a bank makes a loan, it has acquired an asset – it has a claim against the borrower. To the person borrowing money, of course, the loan is a liability; it is a debt which has to be repaid.
Most of a bank’s liabilities consist of its deposits, because these bank deposits are claims against the bank. If the depositors demand cash, the bank must supply it. If they draw cheques on their deposits, the banks must honor them, that is, make the necessary payments. To a depositor, of course, a bank deposit is an asset.
3.4.3 How bank deposits are created
· When cash is deposited in a bank
A bank deposit is created when someone deposits –notes and coin in a bank. For example, suppose Mr. A makes a deposit 100$ in banknotes. The bank’s assets and liabilities will both increase by 100$.
Deposits +100$ Cash +100$
No money has been created; all that has happened is that Mr. A has changed the form in which he holds some of his money, from cash to a bank deposit.
· When a bank makes a loan
Suppose Mrs. B obtains a bank loan of 500$. The bank will supply this loan in the form of a bank deposit, and Mrs. B’s account will be credited with 500$. If she had say, 50$ in her account before the loan was granted, she will now have 550$ in her account. The effect on the bank’s total assets and liabilities will be as follows:
Deposits +500$ Loans + 500$
In this case, however, money has been created. The new deposit increases the money supply by 500$; this money has not been taken from anyone else’s deposit. Bank deposits are created when banks make loans. The size of the money supply, therefore, depends very much on the extent of the banks’ lending.
3.4.4 Bank lending and the cash reserves
The banks cannot create deposits to an unlimited extent. They must always be in a position to meet their depositors’ demands for notes and coins. This means that they must keep some safe ratio between the amount of cash they hold and the total level of bank deposits.
For example, suppose that the banking system has discovered by long experience that, if banks hold notes and coins equal to 10% of the total value of deposits, it will be more than sufficient to meet all likely demands for cash. The banking system, therefore, decides to operate with a 10% cash ratio. In other words, it will not allow the level of bank deposits to exceed ten times the value of cash in the banks.
A cash ratio of 10% means that for each 1$ of cash they hold, the banks will be able to maintain 10$ in the form of bank deposits. Thus, if the cash in this banking system rose by 5$ million, total bank deposits could be increased by 50$ million. If the banks’ holdings of cash fell by 10$ million, bank deposits would have to be reduced by 100$ million.
In fact, UK banks operate with a cash ratio much smaller than 10%
3.4.5 Types of bank deposit
· Current accounts
A person who holds money in a current account can withdraw cash on demand. Holders of current accounts are given cheque books and can make payments from their bank deposits by cheque. Interest is not usually paid on money in current accounts. These accounts are often described as sight deposits or demand deposits.
· Time deposits
Money placed in a time deposit earns interest. It cannot be withdraw on demand or transferred by means of cheque. The bank normally requires several days’ notice of withdrawal.
3.4.6 Money and near money
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